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Chapter 6: Production and Costseconomic costs & profits short run long run
big picture understand behavior of firm understand & measureproduction costs
I. economic costs & profitsfirm’s goal: maximize profit look at factors that affect firm’s decision
economic costs opportunity cost of resources used explicit costspaid in money wages, rent, material, etc. implicit costs
example: smoothie shopexplicit costs: wages interest on loan rent on store fruit, blenders
implicit costs forgone interest on funds used to buy capital owner’s forgone wages owner’s forgone profit from other venture
accounting profit total revenue – explicit costsignores opportunity cost
economic profit includes opp. costs = total revenue - total costs= (price)(quantity) - (explicit + implicit costs)
normal profit occurs when amount of accounting profit= opportunity costs of resources if earning a normal profit, economic profit = 0
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
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
II. SR Production measures of output total product marginal productaverage product
total product (TP) total quantity of good produced in a given periodat first, increases with labor, then falls
TP: gal. of smoothies per hour# workers TP 1 2 3 4 5 6 7 1 3 6 8 9
TP 5 6 9 # workers
marginal product (MP) change in TP due to one more worker change in TP= change in labor
At first MP rises with workersadd more workers greater specialization MP of each worker added is larger than previous worker increasing marginal returns
then, MP falls with more workerskeep 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
TP, MP: gal. of smoothies 1 2 3 4 5 6 7 1 3 6 8 9 # workers TP MP 1 21 2 3 4 5 6 7 1 3 6 8 9 1 2 3 2 1 -1
MP 3 Q = # workers
law of decreasing returnsAs firm uses more labor with capital fixed, MP of labor will eventually fall
Average Product (AP) TP = labor = productivity
AP # workers TP MP 1 2 3 4 5 6 7 1 3 6 8 9 1 2 3 -1 1 1.5 2 1.8 1.1
MP 3 AP # workers
MP & AP MP intersects AP at max of AP why? MP > AP AP is risingAP is falling
III. SR cost measure cost 3 ways: total cost marginal costaverage cost
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
example : yogurt labor = $6/ hour TFC = $10/ hour
workers TP TFC TVC TC 4 5 8 9 10 24 30 34 40
Q = output TC TC TVC TFC 10
Marginal Cost change in TC due to one-unit increase in output (Q)= change in Q
TP TFC TVC TC MC 6 3.6 2.4 8 9 10 24 30 34 40 6
Average Cost (ATC) = TC/Q average fixed cost (AFC) (TFC/Q)average variable cost (AVC) (TVC/Q) ATC = AFC + AVC
TP TFC TVC TC AFC AVC AC 8 9 10 24 30 34 40
Q = output AC, MC AFC ATC AVC MC
MC & AC MC intersects AC at its minimum MC < AC AC is fallingAC is rising
AC is U-shaped why? AFC falls with Q AVC falls then risesdecreasing marginal returns so ATC falls, then rises
cost & product curves when MP is at maximum, MC is at minimumwhen AP is at maximum, AVC is at minimum
what shifts cost curves?technology make more with same inputs shifts TP, MP, AP up changes ATC curve
changes in factor pricesincrease fixed costs -- TFC, AFC shift up -- TC shift up increase wages (variable) -- TVC, AVC, MC shift up
IV. LR costs all inputs (and costs) are variablewhat happens if increase plant AND labor by 10%? ATC fall? ATC rise? ATC stay same?
Economies of scale increase inputs 10% output increase > 10%ATC falls why? gains from specialization -- labor -- capital
Diseconomies of scale increase inputs 10% output increase < 10%ATC rises why? too hard to control large firm
Constant returns to scaleincrease inputs 10% output increase = 10% ATC stays same
LR Average Cost (LRAC) lowest average cost when all inputs are variable SRAC curves from different plant sizes
Q = output AC ATC1 ATC2 ATC3 ATC4 LRAC
Q = output AC ATC1 ATC2 ATC3 ATC4 diseconomies of scale economies of scale constant returns to scale
summary: costs = implicit + explicit SR, only labor variableLR, all inputs variable Production & costs total, marginal, average fixed, variable
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