Dr. Katie Sauer Principles of Microeconomics
The Costs of Production (Ch 13) Basic economic assumption: firms firms attempt to ____________________. It is possible for firm owners to have different goals. The one motive that makes the most accurate prediction about how firm managers behave is the assumption of profit maximization. I. Profit The goal of a firm is to maximize profit. _________ = Total Revenue ± Total Cost = TR ± TC Total ___________ = price x quantity Total ___________ = market value of all inputs used in production To an economist, the costs of producing an item must include all of the ___________________costs of inputs used in production. Costs include both implicit and explicit costs. explicit costs: input costs that require an outlay out lay of money by the firm ex: wages, electricity, electricity, raw materials implicit costs: input costs that do not require an o utlay of money by the firm ex: forgone interest interest earned on money spent spent ________________________________________________________________ Ex: Caroline uses $300,000 of o f her savings to start her firm. It was in a savings acco unt paying 5% interest. When she takes the money out of savings, she no longer earns interest on it. forgone interest = Because Caroline could have earned $15,000 per year on this savings, we should include this in her total cost. implicit cost=forgone interest = explicit cost = total cost = _________________________________________________________________ Ex: If Caroline had instead borrowed $200,000 from a bank at 7% interest and used $100,000 from her savings: Forgone interest = Implicit Costs = Explicit cost = $__________________________ from savings + $_________________________ borrowed + $ ________________________ _________________________in _interest terest payments payments Total cost =
The inclusion of all opportunity costs in calculating profits is the major way in which accounta nts and economists _________________________in analyzing the performance of a business. Accountants focus on explicit costs. Economists examine both explicit and implicit implicit costs. Economic Profit vs Accounting Profit = total revenue ± explicit costs E = total revenue ± explicit costs co sts ± implicit costs A
Accounting profit will always __________________ economic profit. (as long as there are implicit implicit costs) ________________________________________________________ Ex: Wages $10,000 Supplies $20,000 Forgone interest $1,500 Utilities $2,000 Price of Product $33 Quantity sold 1000 Calculate Accounting profit and economic eco nomic profit. Total Revenue = Explicit Costs = Implicit Implicit Costs Co sts = A = E = ______________________________________________________________ II. Production and Costs in the Short Run Short Run = one or o r more inputs are fixed Long Run = all inputs are variable
A. Production Production function = the relationshi r elationship p between the t he quantity of inputs used and the t he quantity of output that results Total Product = TP = Output = Q
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Ex: Let¶s grow grow some some rice. Number of Workers
Amount Produced
Average amount produced per worker (average product)
Additional amount produced from each extra worker (marginal product)
Trends we notice: As the number of workers rises, what happens to total output?
0 As the number of workers rises, what happens to average product?
1 2 3 4
As the number of workers rises, what happens to marginal product?
5 6 7 8
Graph the resulting production function:
Graph the resulting output per worker curves:
________________________________________________________________________ Recap: Total Product (TP) is the amount produced. aka output, quantity(Q) quantity(Q) Average Product of Labor =
total output = AP # workers Marginal Product of Labor = change in output = MP change in labor 3
In general, marginal product is the increase in output that arises from an additional unit o f input. As the amount of labor used u sed increases, the marginal product of labor falls. falls. __________________________________________ is the property whereby the marginal product of an input declines as the quantity of o f the input increases. - the more of an input used, output will increase by less and less - output increases at a decreasing rate ___________________________________________________________________________ Ex: Consider the short-run short-run production of a small firm that makes makes sweaters. These sweaters are made using a combination co mbination of labor and knitting machines. In the short run, the firm has signed a lease to rent one o ne machine. Therefore, in the short run, the t he firm cannot vary the amount of knitting machines it uses. The firm can vary the amount a mount of labor it employs. Labor (#workers) 0 1 2 3 4 5
Total Output 0 4 10 13 15 16
Average Product
Marginal Product
Trends we notice: As the number of workers work ers rises, rises, what happens happe ns to total output? As the number of workers rises, what happens to average product? As the number of workers rises, what happens to marginal product? Here
are the shapes of typical Total Product, Average Product, and Marginal Product curves:
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The Average-Marginal Rule: If MP > AP then AP is rising. If MP < AP then AP is falling. If MP = AP then AP is at its maximum. _________________________________________________________ Example: Suppose triplets are enrolled in Principles of Microeconomics. They each had a ³B´ average (GPA = 3.0) before taking the class. Triplet One gets a ³C´ in the course. What happens to her GPA? Triplet Two gets an ³A´ in the class. What happens to her GPA? Triplet Three gets a ³B´ in the class. What happens to her GPA? When the additional grade (marginal ( marginal grade) is higher« the overall GPA (average grade) ___________. When the additional grade (marginal ( marginal grade) is lower« the overall GPA (average grade) ___ _________. When the additional grade (marginal grade) is the same« the overall GPA (average grade) __________. __________________________________________________________ B. Costs Inputs are not free. free. The more output a firm firm produces, the more inputs it it needs to acquire. Intuitively, we understand that as total output out put rises, so do total costs of production. There are two types of costs: 1. ____________costs: costs that do not vary with the quantity of output produced. ex: warehouse lease, lease, payments on a loan loan 2. ____________ costs: costs that do vary with the quantity of output produced. ex: raw materials, electricity
Consider the sweater manufacturer again. Suppo se the firm is currently renting one machine for $25 per day. Each worker is also paid $25 per day. Labor Total Fixed Variable Total (#workers) Output Cost Cost Cost 0 0 1 4 2 10 3 13 4 15 5 16 Trends we notice: What happens to fixed costs as output increases? What happens to variable costs as output increases? What happens to total cost as output increases? 5
total cost = fixed costs + variable costs. TC = FC + VC
Because fixed costs don¶t vary with the a mount produced, the fixed cost curve is a horizontal line at the value of the fixed cost. Even if the firm produces nothing, it will incur the fixed cost. Variable costs increase as output increases, so the variable cost curve is upward sloping. If the firm produces nothing, then it incurs no variable cost. - curve starts at zero Since total cost is the sum of o f fixed cost and variable cost, it slopes up and has an intercept equal equ al to the value of fixed cost. In addition to total costs, firms are interested in the co st per unit of output produced: q uantity of output average total cost : total cost divided by the quantity
average fixed cost : fixed costs divided by the quantity of output
average variable cost : variable costs divided by the quantity of output
tot al cost that arises from an extra unit of production marginal cost : the increase in total
Labor (#workers)
Total Output
Fixed Cost
Variable Cost
Total Cost
0 1 2 3 4 5
0 4 10 13 15 16
25 25 25 25 25 25
0 25 50 75 100 125
25 50 75 100 125 150
Average Average Average Fixed Variable Total Marginal Cost Cost Cost Cost
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Trends we notice: What happens to Average Fixed Cost Co st as output increases? What happens to Average Variable Var iable Cost as output increases? What happens to Average Total To tal Cost as output increases? What happens to Marginal Cost as output increases?
Here
are the shapes of typical average fixed cost, average variable cost, average total cost, and marginal cost curves.
Focus for a moment on the relationship between average cost and marginal cost: The Average-Marginal Rule applies here: If MC > AC then AC rising. If MC < AC then AC falling. If MC = AC then AC is at its minimum. The quantity that corresponds to the minimum of Average Total Cost has a special name: efficient scale
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Note the relationship between marginal product and marginal cost:
III. Production and Cost in the Long Run A. Production In the long run, all a ll inputs are variable.
B. Costs In the long run, there are no fixed costs. The __________________________________________ is found by tracing out the minimums of all of the Short Run Average Total T otal Cost curves.
For a given firm, its LRAC is usually a flat u-shape. - range of output where average costs are falling as output rises - range of output where average costs are rising as output rises
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_______________________ of Scale often occur when a firm has high overhead and large fixed costs. - automobile manufacturer needs to make a high volume of vehicles to make up for the factory costs _______________________ of Scale often occur when a firm is so big that it is experiencing coordination and communication issues. - different branches of Sony have sued each other not realizing they were both part of Sony _________________________ to Scale = average costs stay constant as output increases. ___________________________________________________________________ Chapter Summary: The goal of firms firms is to maximize profit profit (total revenue minus minus total cost). When calculating profits, it is important to include all the opp ortunity costs of production. A firm¶s costs reflect its production pro cess. - diminishing marginal product - total cost curve gets steeper steeper as the quantity rises rises
A firm¶s total costs can be divided between fixed costs and variable costs. - Fixed costs are costs that do not change when the firm changes the quantity of output. - Variable costs are costs that do change when the firm changes the quantity of output.
Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total t otal cost rises if output increases by one unit. For a typical firm, marginal cost rises with the quantity qua ntity of output. Average total cost first falls as output increases and then r ises as output increases further. The marginal-cost curve always crosses the average total cost curve at the minimum of average total cost.
A firm¶s costs often depend on the time t ime horizon being considered. - many costs are fixed fixed in the short sho rt run but variable in the long run
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