1. Production and Costs

2. Economic versus Accounting Costs Economic costs are theoretical constructs which are intended to aid in rational decision-making. Accounting costs are legal constructs intended to provide uniformity in measurement.

3. Profit = Total Revenue – Total Costs Total Net Benefits = Total Benefits minus Total Costs Costs as Opportunity Costs –Explicit Costs –Implicit Costs Opportunity cost of entrepreneur’s invested capital Opportunity cost of entrepreneur’s time Economic versus Accounting Profit

4. Figure 1 Economic versus Accountants Copyright © 2004 South-Western Revenue Total opportunity costs How an Economist Views a Firm How an Accountant Views a Firm Revenue Economic profit Implicit costs Explicit costs Explicit costs Accounting profit

5. Production and Costs Technology is the state of knowledge about how to combine inputs to produce output. Production Function describes the relationship between inputs and outputs –Q = F ( K, L, NR, E) Short-run versus Long-run –SR - at least one input is fixed – limits to adjustment –LR – all inputs are variable – complete flexibility

6. A Short-Run Production Function and Costs Remember the widget example! Assume two inputs, capital (say a factory) and labor, and that capital is fixed in the short-run. Marginal Product of Labor – change in total output from added one more laborer. MP L = change in Q / change in L

7. Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory Copyright©2004 South-Western

8. Figure 2 Hungry Helen’s Production Function Copyright © 2004 South-Western Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 Number of Workers Hired 012345 Production function

9. Different Measures of Cost Total Cost (TC) = FC+VC –Fixed Cost (FC) – are costs that do not vary with output. FC only are present in the short-run are the result of fixed factors. –Variable Cost (VC) – are costs that vary with output. VC result from different levels of fixed factors. All costs are VC in the long-run. Marginal Cost (MC) = change in TC/ change in Q and measures the cost of producing another unit. Average Cost (AC) = TC/Q and measures the cost of a typical unit of output.

10. Cost Formulas TC = FC +VC Dividing both sides of the total cost formula by Q, we get the average cost formula: –TC/Q = FC/Q + VC/Q –ATC = AFC +AVC –Average Total Cost = Average Fixed Cost + Average Variable Cost

11. Marginal and Average Costs Revisted As Q increases if –MC<AC AC is falling –MC>AC AC is rising –So, when MC=AC AC is at its minimum The above also applies to MC and AVC The height example

12. The Cost Curves Short-run Cost Curves – at least one fixed factor, so fixed costs exist. Economist like to use the example of the factory or plant size being fixed and labor being the variable input. –Law of Diminishing Marginal Returns implies that the MC will eventually increase. –Increasing MC results in U-shaped ATC curves. –If MC initially falls and then begins to rise, both the ATC and AVC curves will be U-shaped. –Since capital is often assumed to be fixed, the short-run cost curves describe costs associated with the utilization of existing plant capacity.

13. Figure 5 Thirsty Thelma’s Average-Cost and Marginal- Cost Curves Copyright © 2004 South-Western Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 Quantity of Output (glasses of lemonade per hour) 014327659810 MC ATC AVC AFC

14. Long-run cost curves – all factors are variable, so there are no fixed costs and all costs are variable. –Economies and diseconomies of scale benefits to a larger scale of operations – specialization, purchasing volume costs of a larger scale of operation – coordination problems –LR cost curves are U-shaped if a production process is characterized by first by economies of scale, and then diseconomies of scale. –Since capital can be varied, the long-run cost curves describe the costs with changing the scale of operations (reducing or increasing plant size.

15. Figure 7 Average Total Cost in the Short and Long Run Copyright © 2004 South-Western Quantity of Cars per Day 0 Average Total Cost 1,200 $12,000 ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run

16. Figure 7 Average Total Cost in the Short and Long Run Copyright © 2004 South-Western Quantity of Cars per Day 0 Average Total Cost 1,200 $12,000 1,000 10,000 Economies of scale ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Diseconomies of scale Constant returns to scale

17. Summary Short-run – at least one input is fixed so the primary decision is how best to use existing plant capacity Long-run – all inputs are variable so the primary decision is what overall scale of operations or plant size should be chosen.