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The Costs of
Production
12
Now we are going to study how firms decisions about prices and
quantities depend on the costs of production faced by the firms.
Total Cost
The market value of the inputs a firm uses in production.
http://video.cnbc.com/gallery/?video=3000095750
http://money.cnn.com/video/news/2012/05/30/fleadership-gm-ceo-competition.fortune/
http://digitaljournal.com/article/330804
Global company, large scale. How does this affect GMs
costs?
Global platforms?
The sales of GM have gone up over the last two years
(everywhere except Europe). Nevertheless the profit and
stock price has gone down. Why?
10
11
Example:
1. Helen uses $300,000 of her savings to start her firm. It was in a
savings account paying 5 percent interest.
2. Since Helen could have earned $15,000 per year on this savings,
we must include this implicit opportunity cost.
Note that an accountant would not count this $15,000 as part of the firm's
costs.
According to the economist the total opportunity cost would not change
But the accountant would only count the $10,000 in interest paid for the
bank loan.
12
13
An Example
It is possible for a firm that appears profitable according to
an accountant to be unprofitable according to an economist.
Suppose a firm incurs $20,000 in explicit costs to produce
output that is sold for total revenue of $30,000.
However, the owner/manager of the firm could have worked
for another firm and earned $15,000 during this period.
According to the accountant, the firms profit is $30,000 $20,000
= $10,000
By contrast, the economist would argue that the firm is not
profitable because the total explicit and implicit costs are $20,000
+ $15,000 = $35,000 which exceeds the $30,000 of total revenue.
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
15
Important concepts
The Production Function
The production function shows the relationship between
quantity of inputs used to make a good and the quantity
of output of that good.
Marginal Product
The marginal product of any input in the production
process is the increase in output that arises from an
additional unit of that input.
17
18
An Example
Consider the short-run production of a small firm that
makes sweaters.
These sweaters are made using a combination of labor and knitting
machines.
The firm has signed a lease to rent 1 machine.
Therefore, in the short run, the firm cannot vary the amount of knitting machines
it uses.
19
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
21
We can represent the relationship between the output and the total cost
graphically =>
$80
70
60
50
40
30
20
10
10 20 30 40 50 60 70
Quantity
of Output
(cookies per hour)
Example
24
Use the following data to graph the farmers production function and the total-cost
curve.
25
26
TC = FC + VC
Copyright2004 South-Western
28
Fixed cost FC
AFC
Quantity
Q
AVC
ATC
Variable cost VC
Quantity
Q
Total cost TC
Quantity
Q
29
Marginal Cost
Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
(change in total cost) TC
MC
(change in quantity)
Q
is a Greek letter Delta, which is used to represent the
change in variable.
30
Marginal Cost
Thirsty Thelmas Lemonade Stand
Quantity
Total
Cost
0
1
2
3
4
5
$3.00
3.30
3.80
4.50
5.40
6.50
Marginal
Cost
$0.30
0.50
0.70
0.90
1.10
Quantity
6
7
8
9
10
Total
Cost
$7.80
9.30
11.00
12.90
15.00
Marginal
Cost
$1.30
1.50
1.70
1.90
2.10
$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
Quantity
of Output
(glasses of lemonade per hour)
8
10
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0
Quantity
of Output
(glasses of lemonade per hour)
9
10
Marginal cost
rises with the
amount of
output
produced.
This reflects
the property of
diminishing
marginal
product.
2.75
2.50
2.25
MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
Quantity
of Output
(glasses of lemonade per hour)
9
10
AFC declines as
output expands
AFC is high when
output levels are low.
AVC typically
increases as output
expands.
As output expands,
AFC declines pulling
ATC down.
As fixed costs get
spread over a large
number of units, the
effect of AFC on ATC
falls and ATC begins
to rise because of
diminishing marginal
product.
3.25
3.00
2.75
2.50
2.25
2.00
1.75
ATC
1.50
1.25
This quantity is
sometimes called
the efficient scale
of the firm.
1.00
0.75
0.50
0.25
0
Quantity
of Output
(glasses of lemonade per hour)
9
10
2.00
1.75
ATC
1.50
1.25
1.00
0.75
0.50
0.25
0
Quantity
of Output
(glasses of lemonade per hour)
9
10
Whenever marginal
cost is less than
average total cost,
average total cost is
falling.
Whenever marginal
cost is greater than
average total cost,
average total cost is
rising.
The marginal-cost
curve crosses the
average-total-cost
curve at the efficient
scale.
Efficient scale is
the quantity that
minimizes average
total cost.
36
Example
Two twins are enrolled in Principles of Economics.
They each had a B average (GPA = 3.0) before
taking the class.
Twin One gets a C in the course and Twin Two
gets an A in the class.
What happens to their GPAs?
Twin One will have a lower GPA (less than 3.0) and
Twin Two a higher GPA (greater than 3.0).
A marginal grade lower than the average will pull
down the average.
A marginal grade higher than the average will increase
the average.
The same is true of marginal cost and average costs. If marginal cost is less
than average cost, the average cost will fall. If marginal cost is higher than
average cost the average cost will rise.
37
Total
Cost
TC
$18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
Why? =>
2.00
0
10
12
14
$3.00
2.50
MC
2.00
1.50
ATC
AVC
1.00
Adding variable
inputs when there are
few of them, might
initially increase
productivity of each
additional input:
Team effect,
0.50
AFC
0
10
12
14
Synergies
between workers.
But then marginal
product begins to
diminish =>MC rises
40
41
Many costs are fixed in the short run but variable in the long
run => a firms long-run cost curves differ from its shortrun cost curves.
For example, in the long run a firm could choose the size of its
factory.
Once the factory size is chosen, the firm must deal with the shortrun costs associated with that plant size.
ATC in short
run with
small factory
$12,000
10,000
If the size of the assembly line is fixed, then the only way to increase the output of cars from
5000 to 6000 is by hiring more workers
5,000 6,000
Quantity of
Cars per Day
=> because of the diminishing marginal product the AC rises from $10K to $12K
In the long run, the capacity of the assembly line can be increased, the AC will return to $10K.
ATC in short
run with
small factory
Quantity of
Cars per Day
The long-run average-total-cost curve lies along the lowest points of the
short-run average-total-cost curves because the firm has more flexibility
in the long run to deal with changes in production.
44
Diseconomies of scale refer to the property whereby longrun average total cost rises as the quantity of output
increases.
Mainly due to coordination problems inherent in large
organizations (bureaucracy).
45
46
Example
If Boeing produces 9 jets per month, its long-run total cost
is $9.0 million per month.
If it produces 10 jets per month, its long run total cost is
$9.5 million per month.
Does Boeing exhibit economies or diseconomies of scale?
The long-run average total cost of producing 9 planes is
$9 million/9 = $1 million.
The long-run average total cost of producing 10 planes is:
$9.5 million/10 = $0.95 million.
Since the long-run average total cost declines as the number
of planes increases, Boeing exhibits economies of scale.
47
An example
John owns a car painting shop with fixed costs of $200 (rent
of the building per week) and the following schedule for
variable costs:
48
An Example: Cont.
Calculate average fixed cost (AFC), average variable cost
(AVC), and average total cost ( ATC) for each quantity of
cars.
Firm A
TC
ATC
60
60
70
35
80
26.7
90
22.5
100
20
110
18.3
120
17.1
Firm B
TC
ATC
11
11
24
12
39
13
56
14
75
15
96
16
119
17
Firm C
TC
ATC
21
21
34
17
49
16.3
66
16.5
85
17
106
17.7
129
18.4
49
50
Summary
The goal of firms is to maximize profit, which
equals total revenue minus total cost.
When analyzing a firms behavior, it is important to
include all the opportunity costs of production.
Some opportunity costs are explicit while other
opportunity costs are implicit.
51
Summary
A firms costs reflect its production process.
A typical firms production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
A firms total costs are divided between fixed and
variable costs. Fixed costs do not change when the
firm alters the quantity of output produced; variable
costs do change as the firm alters quantity of output
produced.
52
Summary
Average total cost is total cost divided by the
quantity of output.
Marginal cost is the amount by which total cost
would rise if output were increased by one unit.
The marginal cost always rises with the quantity of
output.
Average cost first falls as output increases and then
rises.
53
Summary
The average-total-cost curve is U-shaped.
The marginal-cost curve always crosses the averagetotal-cost curve at the minimum of ATC.
A firms costs often depend on the time horizon
being considered.
In particular, many costs are fixed in the short run
but variable in the long run.