1. The Costs of Production Please listen to the audio as you work through the slides.

2. Where are we going? Going forward we will bring product demand, product price, and revenue together and explain how firms compare revenues and costs in determining how much to produce (the profit maximizing level of output). Ultimate goal – to show how those comparisons relate to economic efficiency in various market structures.

3. Learning objectives Students should be able to thoroughly and completely explain: 1.How the long run ATC curve is derived. 2.How the presence of economies of scale or diseconomies of scale impact the shape of the LR ATC curve. 3.The Short Run Production Relationships 4.The Law of Diminishing Returns

4. Economic Costs From a general economic perspective The measure of economic cost, or opportunity cost, of any resource used to produce a good is – The value or worth the resource would have in its best alternative use.

5. Economic Costs From the firm’s point of view Economic Costs – the payments a firm must make, or the incomes it must provide, to attract the resources it needs away from alternative production opportunities More Specifically we consider: Explicit Costs – actual (payments to resource suppliers) Implicit Costs – opportunity costs of using (self-owned or self- employed) resources. - The money payments those resources could have earned in their best alternative use.

6. Accounting profit versus Economic profit An example: 1.You go from being an employee to a business owner 2.Formerly Earning $22,000 / yr as sales rep for T-shirt mfr. 3.Invest $20,000 of savings that were earning $1000 /yr. 4.Start your own T-shirt company. 5.Use a store that you have been renting out for $5000 / yr. 6.Hire a clerk at $18,000 / yr How successful is this business?

7. Explicit Costs Implicit costs How successful is this business?

8. Treated as a cost Required to attract & retain resources - (entrepreneurial ability) Economic or Pure Profits Economic Profit Total Revenue Economic Cost Normal Profits Economic Costs

9. Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs TOTALREVENUETOTALREVENUE Profits to an Economist Profits to an Accountant Economic Costs

10. Economic profit = total revenue – economic cost Economic cost = explicit cost + implicit cost Just to be clear

11. Short run and long run: The role of Time When the demand for a firm’s product changes, the firm’s profitability may depend on how quickly it can adjust the amounts of the various resources it employs in the production of that product.

12. Short Run and Long Run Accounting: Short and long run is based upon annual chronology. Economics: Short run has fixed plant capacity. Long run all resources are variable For the industry, the long run includes enough time for firms to enter and exit the industry

13. Short-Run Production Relationships Firm’s costs of producing a specific output are a function of: 1. Resource prices and 2. The quantities of inputs needed to produce that level of output. Resource demand and supply determine resource prices. The production function: The technological relationship between inputs and output determine the quantities of resources needed: called (Google this to learn more)

14. Average Product (AP) – output per unit of (labor) input (labor productivity) Total Product (TP) – total output of the good produced. Marginal Product (MP) – the extra output that results from adding a unit of a variable resource. 3 Short-Run Production Relationships Marginal Product = Change in Total Product Change in Labor Input Average Product = Total Product Units of Labor

15. Concerns of the firm 1.In the short run, a firm can for a time, increase its output by adding units of labor to its fixed plant. 2.But by how much will output rise when the firm adds each unit of labor? 3.How long will the firm be able to get increased output? 4.Why do we say “for a time”? Transition to Law of Diminishing Returns

16. Law of Diminishing Returns Assumptions: 1.Technology is fixed 2.Production techniques do not change. 3.All units of labor are of equal quality. Definition: As successive units of a variable resource are added to a fixed resource, beyond some point the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline.

17. Increasing Marginal Returns Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) 012345678012345678 0 10 25 45 60 70 75 70 10 15 20 15 10 5 0 -5 - 10.00 12.50 15.00 14.00 12.50 10.71 8.75 ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns

18. 0 10 20 30 Total Product, TP 123456789 20 10 Marginal Product, MP 123456789 TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns Q Q

19. Fixed Costs – do not vary with changes in output Total Fixed Costs – rent, insurance, interest Average Fixed Costs = Total Fixed Costs Quantity of output Variable Costs – change with level of output. Total Variable Costs – materials, fuel, transportation, labor Average Variable Costs = Total Variable Costs Quantity of output Short-run Production Costs

20. Total Cost Total of Fixed and Variable Costs at each level of output Average Total Cost = Total Costs Quantity of output Marginal Cost The additional cost of inputs required to produce each successive unit of output. Marginal Cost = Change in Total Costs Change in Quantity of output Short-run Production Costs

21. Fixed costs and variable costs from the point of view of the business manger 1.Variable costs can be controlled in the short-run by changing production levels. 2.Fixed costs are beyond the control of the business manager, in the short run. 3.Those fixed costs must be paid regardless of output level.

22. Marginal Cost = MC = change in TC / change in quantity Total Fixed Costs = TFC Total Variable Costs = TVC Average Variable Costs = AVC = TVC / quantity Total Costs = TC = TFC + TVC Average Total Costs = ATC = TC / quantity Average Fixed Costs = AFC = TFC / quantity Summary of Definitions Short-run Production Costs

23. Short-Run Costs Graphically Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost

24. Short-Run Costs Graphically Quantity Costs (dollars) AFC AVC ATC MC Plotting Average and Marginal Costs

25. Productivity and Cost Curves Costs (dollars) Average product and marginal product Quantity of labor Quantity of output MP AP MC AVC If all units of a Variable resource (labor) are the same price, The MC of each extra unit of output will fall as long as the Marginal product of each additional worker is rising.

26. Production Relationships - Summary Marginal cost and diminishing returns – The shape of the MC curve is a consequence of the law of diminishing returns. Marginal cost and marginal product – As MP increases, MC decreases Marginal cost and average variable cost – When AVC is falling, MC is rising Marginal cost and average total cost and AVC – MC curve intersects both at their respective minimum points. Productivity curves and cost curves – When MP is rising, MC is falling and when MP is falling, MC is rising Shifts in cost curves – Changes in either resource prices or technology will cause costs to change and cost curves to shift.

27. Long-Run Production Costs All such plant capacities can be plotted. For every plant capacity size... there is a short-run ATC curve.

28. Long-Run Production Costs Unit Costs Output

29. Long-Run Production Costs Unit Costs Output

30. Long-Run Production Costs The long-run ATC curve just “envelopes” all of the short-run ATC curves. Unit Costs Output

31. Long-Run Production Costs Unit Costs Output long-run ATC

32. Economies of Scale Reductions in the average total cost of producing a product, as the firm expands the size of its plant (its output) in the long run; The economies of mass production

33. Factors that influence Economies of Scale 1.Labor specialization 2.Managerial specialization 3.Efficient use of capital 4.Declining start-up costs 5.Learning by doing All lead to lower long run ATC as the firm expands

34. Diseconomies of Scale Increases in the average total cost of producing a product as the firm expands the size of its plant (its output) in the long run. Factors that influence Diseconomies of Scale 1.Increasing levels of complexity. 2.Increasing # of management levels 3.Worker alienation

35. Constant Returns to Scale The range over which long – run average total cost does not change

36. Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1q1 q2q2 8-36

37. Output Long-run ATC curve where costs are lowest only when high levels of output are achieved Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC Long-Run ATC Shapes

38. Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and become dis-economies of scale. Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale Long-Run ATC Shapes 8-38

39. Minimum Efficient Scale and Industry Structure Minimum Efficient Scale - MES The lowest level of output at which a firm can minimize long – run average total costs. Why would this be a good level of output to achieve?

40. Economies and Diseconomies of Scale Unit Costs Output long-run ATC Economies of scale

41. Unit Costs Output long-run ATC Economies of scale Constant returns to scale Economies and Diseconomies of Scale

42. Unit Costs Output long-run ATC Where economies of scale are quickly exhausted Case for many Small firms in An industry MES achieved quickly Many retail trades, some farming Economies and Diseconomies of Scale

43. Minimum Efficient Scale and Industry Structure Natural Monopoly A relatively rare situation in which average total cost is minimized when only one firm produces the particular good or service Example: electricity generation

44. The shape of the long-run ATC curve Determined by: 1.Technology – how? 2.Economies of scale – how? 3.Diseconomies of scale – how?

45. Applications & Illustrations Rising Cost of Insurance and Security, the 9/11 case In the short run they are fixed – independent of output levels. Short-run ATC shifted upward. Successful Start-Up Firms Specialization, new technology Short-run cost curves shift downward with output expansion. Economies of scale The Verson Stamping Machine large firm size leads to achievement of economies of scale Aircraft and Concrete Plants MES radically different in the two industries Economies of scale extensive in aircraft manufacture Economies of scale exhausted quickly in cement plants Different geographic market sizes

46. economic (opportunity) cost explicit costs implicit costs normal profit economic profit short run long run total product (TP) marginal product (MP) average product (AP) law of diminishing returns fixed costs variable costs total cost average fixed cost (AFC) average variable cost (AVC) average total cost (ATC) marginal cost (MC) economies of scale diseconomies of scale constant returns to scale minimum efficient scale natural monopoly