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Chapter 6: Production and Costs economic costs & profits short run long run economic costs & profits short run long run.

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Presentation on theme: "Chapter 6: Production and Costs economic costs & profits short run long run economic costs & profits short run long run."— Presentation transcript:

1 Chapter 6: Production and Costs economic costs & profits short run long run economic costs & profits short run long run

2 big picture understand behavior of firm understand & measure  production  costs understand behavior of firm understand & measure  production  costs

3 I. economic costs & profits firm’s goal: maximize profit look at factors that affect firm’s decision firm’s goal: maximize profit look at factors that affect firm’s decision

4 economic costs opportunity cost of resources used explicit costs  paid in money  wages, rent, material, etc. implicit costs  opportunity cost of resources used opportunity cost of resources used explicit costs  paid in money  wages, rent, material, etc. implicit costs  opportunity cost of resources used

5 example: smoothie shop explicit costs:  wages  interest on loan  rent on store  fruit, blenders explicit costs:  wages  interest on loan  rent on store  fruit, blenders

6 implicit costs  forgone interest on funds used to buy capital  owner’s forgone wages  owner’s forgone profit from other venture implicit costs  forgone interest on funds used to buy capital  owner’s forgone wages  owner’s forgone profit from other venture

7 accounting profit total revenue – explicit costs ignores opportunity cost total revenue – explicit costs ignores opportunity cost

8 economic profit includes opp. costs = total revenue - total costs = (price)(quantity) - (explicit + implicit costs) includes opp. costs = total revenue - total costs = (price)(quantity) - (explicit + implicit costs)

9 normal profit occurs when amount of accounting profit = opportunity costs of resources if earning a normal profit,  economic profit = 0 occurs when amount of accounting profit = opportunity costs of resources if earning a normal profit,  economic profit = 0

10

11 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 Short Run (SR)  time frame where some resources are fixed -- plants, equipment  some inputs variable -- labor  SR decisions are reversible

12 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 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

13 II. SR Production measures of output  total product  marginal product  average product measures of output  total product  marginal product  average product

14 total product (TP) total quantity of good produced in a given period at first, increases with labor, then falls total quantity of good produced in a given period at first, increases with labor, then falls

15 TP: gal. of smoothies per hour # workersTP

16 # workers 5 6 9

17 marginal product (MP) change in TP due to one more worker = change in TP change in labor

18 At first MP rises with workers add more workers greater specialization MP of each worker added is larger than previous worker increasing marginal returns add more workers greater specialization MP of each worker added is larger than previous worker increasing marginal returns

19 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 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

20 TP, MP: gal. of smoothies # workersTP MP

21 MP Q = # workers 03 3

22 law of decreasing returns As firm uses more labor  with capital fixed,  MP of labor will eventually fall As firm uses more labor  with capital fixed,  MP of labor will eventually fall

23 Average Product (AP) = TP labor = productivity

24 # workersTP MP AP

25 MP # workers AP

26 MP & AP MP intersects AP at max of AP why? MP > AP  AP is rising MP < AP  AP is falling MP intersects AP at max of AP why? MP > AP  AP is rising MP < AP  AP is falling

27 III. SR cost measure cost 3 ways:  total cost  marginal cost  average cost measure cost 3 ways:  total cost  marginal cost  average cost

28 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 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

29 example : yogurt labor = $6/ hour TFC = $10/ hour labor = $6/ hour TFC = $10/ hour

30 workersTPTFCTVCTC

31 Q = output TC TFC 10 TC TVC

32 Marginal Cost change in TC due to one-unit increase in output (Q) = change in TC change in Q

33 TPTFCTVCTC MC

34 Average Cost (ATC) = TC/Q average fixed cost (AFC)  (TFC/Q) average variable cost (AVC)  (TVC/Q) ATC = AFC + AVC = TC/Q average fixed cost (AFC)  (TFC/Q) average variable cost (AVC)  (TVC/Q) ATC = AFC + AVC

35 TPTFCTVCTC AFC AVC AC

36 Q = output AC, MC AFC ATC AVC MC

37 MC & AC MC intersects AC at its minimum MC < AC  AC is falling MC > AC  AC is rising MC intersects AC at its minimum MC < AC  AC is falling MC > AC  AC is rising

38 AC is U-shaped why? AFC falls with Q AVC falls then rises  decreasing marginal returns so ATC falls, then rises why? AFC falls with Q AVC falls then rises  decreasing marginal returns so ATC falls, then rises

39 cost & product curves when MP is at maximum, MC is at minimum when AP is at maximum, AVC is at minimum when MP is at maximum, MC is at minimum when AP is at maximum, AVC is at minimum

40 what shifts cost curves? technology  make more with same inputs  shifts TP, MP, AP up  changes ATC curve technology  make more with same inputs  shifts TP, MP, AP up  changes ATC curve

41 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 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

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

43 Economies of scale increase inputs 10%  output increase > 10%  ATC falls why?  gains from specialization -- labor -- capital increase inputs 10%  output increase > 10%  ATC falls why?  gains from specialization -- labor -- capital

44 Diseconomies of scale increase inputs 10%  output increase < 10%  ATC rises why?  too hard to control large firm increase inputs 10%  output increase < 10%  ATC rises why?  too hard to control large firm

45 Constant returns to scale increase inputs 10%  output increase = 10%  ATC stays same increase inputs 10%  output increase = 10%  ATC stays same

46 LR Average Cost (LRAC) lowest average cost when all inputs are variable SRAC curves from different plant sizes lowest average cost when all inputs are variable SRAC curves from different plant sizes

47 Q = output AC ATC1 ATC2 ATC3 ATC4 LRAC

48 Q = output AC ATC1 ATC2 ATC3 ATC4 economies of scale constant returns to scale diseconomies of scale

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


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