Chapter 6: Production and Costs

economic costs & profits short run long run

big picture

understand behavior of firm understand & measure

production costs

I. economic costs & profits

firms goal:
maximize profit look at factors that affect firms decision

economic costs

opportunity cost of resources used explicit costs

paid in money wages, rent, material, etc.

implicit costs
opportunity cost of resources used

example: smoothie shop

explicit costs:
wages interest on loan rent on store fruit, blenders

 implicit costs
forgone interest on funds used to buy capital owners forgone wages owners forgone profit from other venture

accounting profit

total revenue explicit costs ignores opportunity cost

economic profit

includes opp. costs

= total revenue - total costs = (price)(quantity) - (explicit + implicit costs)

normal profit

occurs when amount of accounting profit

= opportunity costs of resources if earning a normal profit, economic profit = 0

Short Run vs. Long Run

Short Run (SR)

time frame where some resources are fixed -- plants, equipment some inputs variable -- labor SR decisions are reversible

 Long Run (LR)

time frame where all inputs are variable --build a bigger plant LR decisions are hard to reverse -- cannot easily get rid of capital -- sunk cost

II. SR Production

measures of output
total product marginal product average product

total product (TP)

total quantity of good produced

in a given period at first, increases with labor, then falls

TP: gal. of smoothies per hour

# workers TP

0 1 2 3 4 5 6 7

0 1 3 6 8 9 9 8

TP 9

56

# workers

marginal product (MP)

change in TP due to one more worker

= change in TP change in labor

At first MP rises with workers

add more workers greater specialization MP of each worker added is larger

than previous worker increasing marginal returns

then, MP falls with more workers

keep adding workers but same amount of capital so eventually get in the way MP of more workers smaller than
MP of previous workers decreasing marginal returns

TP, MP: gal. of smoothies

# workers TP MP 1 2 3 2 1 0 -1

0 1 2 3 4 5 6 7

0 1 3 6 8 9 9 8

MP

Q = # workers

law of decreasing returns

As firm uses more labor

with capital fixed, MP of labor will eventually fall

Average Product (AP)

= TP labor

= productivity

# workers

TP

MP 1 2 3 2 1 0 -1

AP

0 1 2 3 4 5 6 7

0 1 3 6 8 9 9 8

1 1.5 2 2 1.8 1.5 1.1

MP

AP 3

# workers

MP & AP

MP intersects AP at max of AP why? MP > AP

AP is rising

MP < AP
AP is falling

III. SR cost

measure cost 3 ways:

total cost marginal cost average cost

Total Cost (TC)

cost of all factors used total fixed cost (TFC)

cost of land, capital, etc. does not change in SR

total variable cost (TVC)

cost of labor changes in SR

TC = TFC + TVC

example : yogurt

labor = $6/ hour TFC = $10/ hour

workers 0 1 1.6 2

TP 0 1 2 3

TFC 10 10 10 10

TVC 0 6 9.6 12

TC 10 16 19.6 22

4 5

8 9

10 10

24 30

34 40

TC TC TVC

10

TFC Q = output

Marginal Cost

change in TC due to one-unit

increase in output (Q)
= change in TC change in Q

TP 0 1 2 3

TFC 10 10 10 10

TVC 0 6 9.6 12

TC 10 16 19.6 22

MC 6 3.6 2.4

8 9

10 10

24 30

34 40

Average Cost (ATC)

= TC/Q average fixed cost (AFC)

(TFC/Q)

average variable cost (AVC)

(TVC/Q)

ATC = AFC + AVC

TP 0 1 2 3

TFC 10 10 10 10 10 10

TVC 0 6 9.6 12

TC 10 16 19.6 22

AFC 10 5 3.33 1.25 1.11

AVC 6 4.8 4 3 3.33

AC 16 9.8 7.33 4.25 4.44

8 9

24 30

34 40

AC, MC

MC ATC AVC AFC Q = output

MC & AC

MC intersects AC at its minimum MC < AC

AC is falling

MC > AC
AC is rising

AC is U-shaped

why? AFC falls with Q AVC falls then rises

decreasing marginal returns

so ATC falls, then rises

cost & product curves

when MP is at maximum,
MC is at minimum when AP is at maximum, AVC is at minimum

what shifts cost curves?

technology
make more with same inputs shifts TP, MP, AP up changes ATC curve

 changes in factor prices

increase fixed costs -- TFC, AFC shift up -- TC shift up increase wages (variable) -- TVC, AVC, MC shift up -- TC shift up

IV. LR costs

all inputs (and costs) are variable what happens if increase plant
AND labor by 10%? ATC fall? ATC rise? ATC stay same?

Economies of scale

increase inputs 10%

output increase > 10% ATC falls

why?
gains from specialization -- labor -- capital

Diseconomies of scale

increase inputs 10%

output increase < 10% ATC rises

why?
too hard to control large firm

Constant returns to scale

increase inputs 10%

output increase = 10% ATC stays same

LR Average Cost (LRAC)

lowest average cost when all inputs

are variable SRAC curves from different plant sizes

AC ATC1 ATC2 ATC3 ATC4

LRAC

Q = output

AC ATC1 ATC2 ATC3 ATC4

economies of scale

constant diseconomies of scale returns to scale Q = output

summary:

costs = implicit + explicit SR, only labor variable LR, all inputs variable Production & costs
total, marginal, average fixed, variable