chapter 23 –production costs how much output can a firm produce? how do the costs of production...
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CHAPTER 23 –Production Costs
How much output can a firm produce?How do the costs of production vary
with the rate of outputDo larger firms have a cost advantage
over smaller firms?We are talking about the Production
Function…i.e. Costs of Production
Next Step for Production FunctionHow many inputs does it take to arrive at the desired mix
of outputs. (from the factors)*How many workers will it take to make the new Board
Game… I LOVE ECONOMICS?
Definition of Production Function: Relationship between the maximum quantity of a good
attainable from different combinations of factor inputs.
Maximum Output/Minimum InputsProduction of goods equates cost!Idea for a firm (large or small) is to minimize
the cost while maximizing output.How best to produce?What’s the smallest amount of resources
needed to produce a specific product? *What is the least number of workers we can hire to handle the noon counter trade? (McDonalds). Can we lay off another 1,000 workers and still be competitive (IBM) Ford lays off 15,000 workers
(Factors of production=land,labor,capital, entrepreneurship
Answers to Production QThe Production Function will answer what
maximum amount of output is attainable from various combinations of factor inputs. (this is getting the mixing bowl filled with right ingredients)
With a fixed amount of capital adding labor inputs can predict outputs---up to a certain point---then more capital needs to be added.
Law of Diminishing Returns *Did you ever fall asleep reading your
economics text after a long day at work? Or maybe you just procrastinated on getting that book open.. Of course you have…..… you have experienced
Diminishing returns. In the short run—Production
function defines the limit to output and how much each worker will contribute to that limit.
The factor that can be adjusted quickly in the SR is Labor.
Yet… as more labor is hired, each unit of labor has less capital and land to work with…
Things get constrained.. Hence. Marginal Physical Product declines
This refers to how many widgets
Example/Build a City game
Set up a small factoryFixed factor of production(4
machines)Functions of machinesAdd variable factors one at a
time.
• If you keep adding workers- will reach a point where the marginal worker adds nothing to our total output.
• A business person must be aware of the law of diminishing returns if he wants to operate efficiently.
Machines Workers Total Output
Approx Average Output
Marginal Product
4 0 0 0 0
4 1 20 20 20
4 2 45 22.5 25
4 3 80 26.5 35
4 4 130 32.5 50
4 5 160 32 30 ***
4 6 180 30 20
4 7 190 27.1 10
4 8 185 23.1 -5
Bottom LineIf we keep adding workers we will reach a
Point where--- the Marginal Worker adds nothing to our total output * All the checkout lanes are filled with Tom Thumb Employees… very few people are checking out. (Is this productive for TT?)
What happens to their Profit Margin?Cost exceeds any benefits of hiring
additional workers.
Long run/short run productivity
Short run= period in which the quantity (and quality of some inputs) cannot be changed.
General assumption: In SR labor can change while capital is held constant
Generally, as amount of labor used increases, the output will also increase (with reservations) See diminishing returns*
Marginal Productivity
• MPP (marginal physical product)=The change in total output that results from
employment of one additional unit of input.
Formula: MPP = change in total output change in input quantity *same figure as approximate avg output.On diminishing returns chart…
MPP and Assembly Lines
Employment Dilemmas
Sometimes employeesdon’t measureup
*Output doesnot justifyTheir negativeinputs
Marginal Physical Product MPP-
• Marginal Productivity• When the MPP of labor (MPPL >0), then
total output increases.• Improving the ratio of labor to other
factors increases the MPP of labor.
MPP Chart
Fixed Input Variable Input labor
Quantity of Output Q
MPP of Variable Input
1 0 0
1 1 18 18
1 2 37 19
1 3 57 20
1 4 76 19
1 5 94 18
Marginal Physical Marginal Physical ProductProduct
MPP = ∆Q ∆ L
MPP GraphMPP Graph(actually (actually diminishing marginal diminishing marginal
physical product.physical product.
01 2 3 4 5 6 7 8
5101520253035404550 Total output
(per day)
Bb
C
c
E
e
I
i
+ 10 jeans
Third worker
D
d
aA
Marginal physical product (per worker)
Falling MPP implies Rising MC
• The MPP actually mirrors the output/worker.• MPP is the additional output obtained by
employing one more unit of input..• If MPP for each additional unit of input is producing less, it ultimately adds more cost
to each additional output.• . (i.e. input cost is rising= marginal cost is
increasing
Diminishing marginal productivity implies . . . Rising marginal cost
Mar
gina
l Phy
sica
l Pro
duct
Labor Input
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0 1 2 3 4 5 6 7 8
Add
ition
al L
abor
Cos
t
1.20
1.00
0.80
0.60
0.40
0.20
0 1 2 3 4 5 6 7Labor Input
Dim
inishing
marginal physical product
i
b
c
d
ef
g h1/b 1/c 1/d
1/e
1/f
1/g
Ris
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mar
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l cos
t
Reducing output with indivisible inputs
• Often the production process is set so that it cannot be minimized.
• Machinery all set-up, cannot just make a l/2 widget to reduce outputs
• Example: Railway has tracks that run between cities – need both sets to run trains – cannot establish a half a set of tracks and get shipment there.
• What about Marginal Revenue? The change in total revenue associated with one additional unit of input.
• If marginal costs are increasing marginal revenue is decreasing.
Productivity- Right Mix of Output
REVIEW TERMINOLOGYFactors of production- Resource inputs used to
produce goods and services (land,labor,capital, entrepreneurship)
Productivity-Output per unit of input (output per labor hour)
Efficiency-maximum output of a good from the resources used in production
Opportunity Cost-The MOST DESIRABLEG&S that are forgone in order to obtain something else.Short Run-The period in which the quantity (and/or
quality) of some inputs cannot be changed.
Quick quiz
1. If input prices are rising, will Marginal cost be rising?
2. If you have a fixed amount of capital and continue to add labor inputs, will marginal product always increase?
3. What is marginal physical product?
Costs, Prices, Output in Competitive Markets
• All competition that is not PURE is IMPERFECT• Whether a firm exists in a perfectly
competitive market or imperfectly competitive market, it will TRY to
• MAXIMIZE PROFITS or MINIMIZE LOSSES.
Fixed, Variable, Total CostsWhat is a definition of profit?
What economic conditions might exist for this scenario?
ANSWER!• TR-TC=PROFIT
• How much money am I taking in? (TR)• How much is it costing me to produce my
output? (TC)
WHAT IS PROFIT?
Economic Profit vs Accounting Profit
(the difference lies in how cost is defined)
Economic Cost = Explicit Cost + Implicit Cost
Accounting Costs are all the costs that have an explicit dollar cost attached to it. TR-TC
•Economic cost represents in addition to explicit cost the opportunity cost of resources used.
You start a business- you own the building – you earn $50,000 in revenue- costs are $20,000. (what could you have rented the building for if you were not using it?
Accounting, Economic and Normal Profit II
Suppose a company incurs the following costs: labor, $400; equipment, $300; and materials, $100. The company owns the building so it doesn’t have to pay the usual $800 in rent.
a) What is the total accounting cost?b) What is the total economic cost?c) How would accounting and economic costs
change if the company sold the building and then leased it back?
Fixed Costs:All costs are classified as fixed or variable. In the
short run, the firm can only use its existing facilities to increase its output. During the short-run, there are several important costs that are fixed.
Fixed costs do not change when the firm changes its level of output
Name some—-interest on debts of the firm, payments for
rent, insurance premiums, taxes on real property, salaries.
Average Fixed Cost AFC
• Average fixed cost, AFC declines as the firm increases its output.
• Divide TFC by Q = AFC
TFC/Q = AFC
Graph
2 3 4 5 6 7 8 9 10
cOSTS
Quantity
AFC
Graph explanation
If a firm had nothing but fixed costs, the more it produced the lower its unit cost (AFC) However, the firm is also confronted by variable costs.
What are Variable Costs?Variable Costs increase as the firm increases its
output.All costs that are not fixed---are variable!
Continued Variable CostsWhen a firm increases its output, it must
acquire more productive resources.Examples:More laborersWagesElectricityPaint, sugar, plastic, steel, etc.***Variable costs: any costs that rises as the
firm produces more; and costs that fall as the firm produces less.
****This is the cost that producers have control over.
Quick QuizIdentify which is Fixed or Variable Cost1. Mortgage payments on a factory2. Electric bills at a print shop3. The cost of a new robot at General Motors
plant4. Premiums on liability insurance at the XYZ
Corporation5. Wages paid to auto workers6. Contract paid to top management at GE
Bottom Line--- The bottom line is
productivity whether it is a worker on an assembly line or a CEO.
“Whenever you are asked if you can do a job, tell 'em, 'Certainly I can!' Then get busy and find out how to do it.” ― Theodore Roosevelt
Why is productivity measured by the federal government?
Total Variable Cost and Average Variable Cost
AVC is found by dividing TVC by QTVC/Q = AVC
Although Average fixed cost declines continually, average variable cost does not. At first AVC usually declines as the firm’s output increases. After reaching a minimum, then AVC begins to rise.
AVC and Diminishing Returns
The AVC curve will have the general shape of the letter U. This is explained by the Law of diminishing returns.
Law says: as more and more units of a variable factor of production are added to a fixed factor of production (such as capital equipment) eventually a point will be reached at which the output accounted for by each additional unit of the variable factor will start to decline.
Total Cost
Total Cost is the sum of total fixed cost and total variable cost.
When a firm increases its output, total cost tends to rise
Fixed cost remains unchanged, naturally, but total cost will be pulled up by the rise in total variable cost with the rise in output.
ATC= TC/Q or adding AFC + AVC
Marginal Cost- controllable cost
• Marginal Resource Cost• Marginal cost (MC) is the increase in total
costs associated with a one unit increase in production.
How to determine marginal costTotal Output
Total FC Total VC Total Cost Marginal Cost
0 $2000 $ 0 $2,000 $ 0
1 $2000 $l,500 $3,500 $1,500
2 $2000 $2,600 $4,600 $1,100
3 $2000 $3,600 $5,600 $1,000
4 $2000 $4,800 $6,800 $1,200
5 $2000 $6,125 $8,125 $1,325
6 $2000 $7,800 $9,800 $1,675
7 $2000 $9,800 11,800 $2,000
8 $2000 12,000 14,000 $2,200
Graph ATC/AVC/AFC$24
20
16
12
8
4
0 10 20 30 40 50Rate of Output (pairs per day)
Cos
ts (
dolla
rs p
er p
air)
I
J
KL M N
O
ATC
AVC
AFC
Minimum Average Cost
• The bottom of the U-shaped average total cost curve represents the minimum average total costs.
• It identifies the lowest possible opportunity costs to produce the product.******
A Cost Summary
• The output decision has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions).
A Cost Summary
• The marginal cost curve always intersects the ATC curve at its lowest point.
ATCmc
Basic Cost Curves$32
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24
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16
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8
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0 1 2 3 4 5 6 7 8
Co
st (
dol
lars
per
uni
t)
Rate of Output (units per time period)9
ATC
n
mAVC
AFC
MC
Mathematical RuleWhenever a number added to a series of
numbers is less than their average, the average must decline……….
When a number added to a series of numbers is larger than their average, the average must rise…..
Marginal Cost helps a firm decide whether to increase or decrease output.
Marginal cost is the cost that the firm can control most directly.
Adding numbers
A Cost Summary
If MC > ATC, ATC is increasing
If MC < ATC, ATC is decreasing
If MC = ATC, ATC at minimum
Identify these curves!
$32
28
24
20
16
12
8
4
0 1 2 3 4 5 6 7 8
Co
st (
dol
lars
per
uni
t)
Rate of Output (units per time period)
9
Production and Cost:Short and Long Run
Short Run - A period of time in which some inputs in the production process are fixed.
Long Run - A period of time in which all inputs in the production process can be varied (no inputs are fixed).
LONG RUN CostsOver the long-run---ALL COSTS ARE VARIABLE.Taxes, interest rates, and other costs that are fixed in the
SR can change.The size of the firm can also affect costs. The principle that
explains this is called:
ECONOMIES OF SCALE- (means as firms enlarge their plants, their unit costs decline because of mass production and other factors such as:
Specialization, factor substitution, better equipment, research, marketing advantages, stability.
Long- Run Costs ContinuedThere are no fixed costs in the long-runThe long-run cost curve is just a summary of
our best short-run cost possibilities using existing technology facilities.
Like all average cost curves, the long-run LATC curve has its own marginal cost curve. The long-run marginal cost LMC curve is not a composite of short-run marginal cost curves. Rather it is computed on the basis of the costs reflected in the long-run ACT curve itself.
Marginal Physical Product and Marginal Cost I
Notice that as the MPP curve rises, the MC curve falls; and as the MPP curve falls, the MC curve rises.
Sunk Cost
• A cost incurred in the past that cannot be changed by current decisions and therefore cannot be recovered.
Long-Run Average CostsLR Costs are determined by SR options.
The key word is efficiency- operating at efficient point
ATC1ATC2
ATC3
Long-run average total cost (LATC)
Cos
ts (
dolla
rs p
er p
air)
0 40 a 60 b cRate of Output (pairs of jeans per day)
Best for output levels below aBest for output levels in Excess of b
Long-Run Marginal Costs
• The long-run marginal costs curve intersects our long-run cost curve at its lowest point.
Long-Run Costs with Unlimited Options
0 q2Rate of Output (jeans per day)
Cos
ts (
dolla
rs p
er p
air)
LMC
LATC
ATC2
m2
Economies of Scale
• There are many optional plant sizes available in long-run production.
One option is the decision to use one large plant or several smaller plants to produce a given amount of output.
Constant Returns to Scale and Diseconomies of Scale
Constant Returns= increases in plant size do not affect minimum average cost… minimum per-unit costs are identical for small plants and large plants.
Diseconomies of Scale=increase in plant size results in reducing operating efficiency
Economies of Scale
QM0
CO
ST
(do
llars
per
uni
t)
Constant returns to scale
c
ATC1
m1
RATE OF OUTPUT (units per period)
ATCS
QM0
Economies of scale
c
ATC2
m2
ATCS
RATE OF OUTPUT (units per period)
QM0
Diseconomies of scale
c
ATC3
m3ATCS
RATE OF OUTPUT (units per period)
Next Assignment
Time to begin thinking outside the box!