Producer Choice: The Costs of Production and the Quest for Profit Mr. Griffin AP ECON MHS

Do Now  You sell T-shirts at your school’s football games. Each shirt costs $5 to make and sells for $10. You sell 100 shirts per game. What is your profit from selling shirts at a game?

An accountant would say… (100 * $10) – (100 * $5) = $500 But, what if an economist told you that you could be earning $8 per hour at another job (Each football game lasts two hours)…

Your Economic Profit is $500 – ($8 * 2 hours) = $484

Production, Inputs, and Cost

THE FIRM IN THE CIRCULAR FLOW MODEL BUSINESSES / FIRMS HOUSEHOLDS RESOURCE MARKET RESOURCESINPUTS $ COSTS$ INCOMES PRODUCT MARKET GOODS & SERVICES GOODS & SERVICES $ CONSUMPTION$ REVENUE

COSTS  You must assess costs before you assess profit  “You must pay your bills before you can put money in the bank”

ECONOMIC COSTS Economic Costs (or Opportunity Costs) Forgoing the opportunity to produce alternative goods and services

 Accounting Profit = Total Revenue – Explicit Costs Explicit Costs are Expenditures. ECONOMIC COSTS & PROFIT

Economic (or Pure) Profits ECONOMIC COSTS & PROFIT  Economic Profit = Total Revenue – All Opportunity Costs

Economic Profit = 0 Required to attract & retain entrepreneurial ability Normal Profit (TR = TC) ECONOMIC COSTS & PROFIT

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

Short-run versus Long-run Costs  The Economic Short Run vs. the Long Run  Short run  a period of time during which some of the firm’s cost commitments have not ended.  In the short run, output can change but some resources are fixed. Generally, the fixed resources are plant size and capital.

Short-run versus Long-run Costs  The Economic Short Run vs. the Long Run  Long run  a period of time long enough for all of the firm’s cost commitments to come to an end.  In the long run, all inputs can be varied.

Short-run versus Long-run Costs  Fixed Costs and Variable Costs  Fixed costs = costs that cannot be changed  Variable costs = costs that can be changed  In the short run, some costs are fixed. In the long run, all costs are variable.

Average Product (AP) Total Product (TP) Marginal Product (MP) SHORT-RUN PRODUCTION RELATIONSHIPS Marginal Product = Change in Total Product Change in Labor Input Average Product = Total Product Units of Labor

TPP for Al’s Building Company Find the Average Product at each level of output. Find the Marginal Product of each additional carpenter.

Al’s Product Schedule

TPP with Different Quantities of Carpenters TPP G F E D C B A 5 Quantity of Carpenters per Year Garages per Year Total Output in

Al’s Marginal Physical Product (MPP) Curve 6 MPP Negative marginal returns Diminishing marginal returns Increasing marginal returns Number of Carpenters –2 –4 –6 MPP in Garages per Year 0

MPP and the “Law” of Diminishing Marginal Returns   one input (holding all others constant)   additional output created  Only applies past a certain point  Explains the shape of the marginal physical product curve

MPP and the “Law” of Diminishing Marginal Returns  Marginal Revenue Product = Marginal Physical Product  Output Price  The amount of an input is optimal when Marginal Revenue Product = Price of the Input

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Increasing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Diminishing Marginal Returns

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and Marginal Product, MP Quantity of Labor Total Product Marginal Product Average Product Negative Marginal Returns

Multiple Input Decisions  Substitutability: The Choice of Input Proportions  Firms usually have a variety of tech. options and can substitute one input for another.  The least-cost choice of inputs depends upon their relative prices.  A production function shows the max amount produced by any combination of inputs.

Multiple Input Decisions  The Marginal Rule for Optimal Input Proportions  Rule for optimal input proportions = the ratio of marginal physical product to price should be the same for all inputs  MPP a /P a = MPP b /P b  If the ratio is higher for one input, more of that input should be used, and less of the others, until the ratios are equal.

Multiple Input Decisions  Changes in Input Prices and Optimal Input Proportions   input price   ratio of marginal physical product to price  To maximize profits, the firm should switch away from that input until its marginal physical product rises enough to equalize the ratios again.

Fixed Costs Total Fixed Costs Average Fixed Costs = Total Fixed Costs Quantity Variable Costs Total Variable Costs Average Variable Costs = Total Variable Costs Quantity SHORT-RUN PRODUCTION COSTS

Total Cost Total Fixed and Variable Costs Average Total Cost = Total Costs Quantity Marginal Cost Total Variable Costs Marginal Cost = Change in Total Costs Change in Quantity SHORT-RUN PRODUCTION COSTS

Input Quantities and Total, Avg, and Marginal Cost Curves  Total Cost = Total Fixed Cost + Total Variable Cost  Total Fixed Cost is constant over all levels of output.  Total Variable Cost changes as output changes.

Input Quantities and Total, Avg, and Marginal Cost Curves  Average Fixed Cost = Total Fixed Cost per unit of output  Average Fixed Cost falls as output rises  Marginal Cost = increase in total cost from producing an additional unit of output

Marginal Cost = MC Total Fixed Costs = TFC Total Variable Costs = TVC Average Variable Costs = AVC Total Costs = TC Average Total Costs = ATC Average Fixed Costs = AFC Summary of Definitions SHORT-RUN PRODUCTION COSTS

Al’s Variable Cost Schedules * Marginal Variable Cost is equivalent to Marginal Cost…Why?

Al’s Fixed Costs

SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost

SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) AFC AVC ATC MC Plotting Average and Marginal Costs

PRODUCTIVITY AND COST CURVES Costs (dollars) Average Product and Marginal Product Quantity of labor Quantity of output MP AP MC AVC

The Average Cost Curve in the Short and Long Run  A typical average cost curve declines at first because average fixed costs decline.  It then reaches a minimum and begins to rise because of diminishing marginal returns.

The Average Cost Curve in the Short and Long Run  Costs differ in the short and long runs, because in the long run, more adjustments can be made.  The long-run average cost curve shows the lowest possible short-run average cost corresponding to each output level.

LONG-RUN PRODUCTION COSTS All such plant capacities can be plotted. For every plant capacity size... there is a short-run ATC curve.

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS The long-run ATC just “envelopes” all of the short-run ATC curves. Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Output long-run ATC

ECONOMIES AND DISECONOMIES OF SCALE Labor Specialization Managerial Specialization Efficient Capital Other Factors Diseconomies of Scale Constant Returns to Scale graphically presented...

Economies of Scale  Economies of scale = output rises faster than the common growth rate of all inputs.  Economies of scale = increasing returns to scale

Economies of Scale  The law of diminishing returns applies to expanding of a single input, holding other inputs constant.  In the long run, all inputs can be changed.

Possible Shapes for the Long-Run AC Curve Long-Run Average Cost (c) Quantity of Output Decreasing returns to scale Long-Run Average Cost (b) Quantity of Output Constant returns to scale Long-Run Average Cost (a) Quantity of Output Increasing returns to scale AC

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale Constant returns to scale

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Economies of scale Diseconomies of scale Constant returns to scale

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Where extensive economies of scale exist

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output long-run ATC Where economies of scale are quickly exhausted

Output, Price, and Profit

Price and Quantity: One Decision, Not Two  Firms face a demand curve on which price and quantity are related.  They can choose either price or quantity, but not both.

Total Profit: Keep Your Eye on the Goal  Simplifying assumption: maximum total profit is the firm’s goal.  Total Profit = Total Revenue - Total Costs  Economists are concerned with Economic (not Accounting) Profit.

Total Profit: Keep Your Eye on the Goal  Total, Average, and Marginal Revenue  Total Revenue = Price  Quantity  Average Revenue = TR/Q = (P  Q)/Q = P  Marginal Revenue =  total revenue from one more unit of output.

Marginal Analysis and Profit Marginal Cost =  in TC /  in Q Marginal Revenue =  in TR /  in Q

Marginals Analysis For The Producer Firm  Inputs  Output  How much does one more unit of input change output?  Output  Profit  How much revenue will additional output generate?  How much are the additional costs of producing more output?  Will one more unit of output increase or decrease profit?  If MR > MC,  production to  profits  If MR < MC,  production to  profits  Profit maximizing level output: MR = MC

Total Profit: Keep Your Eye on the Goal  Maximization of Total Profits  Profits typically increase with output, then fall.  Some intermediate level of output, therefore, generates the maximum profit.

Marginal Analysis and Maximization of Total Profit  Marginal profit is the slope of the total profit curve.  Profit is at a maximum when the marginal profit is zero.

Profit Maximization TC TR 22,000 Profit (a) Total Revenue. Total Cost Output, Garages per Year 5 Total Revenue, Total Cost per Year (thousands $) B 96 A

Profit Maximization 5 (b) Total Profit Output, Garages per Year Total profit F D E C –80 –60 –40 – Total Profit per Year (thousands $) M 34

Al’s Marginal Revenue and Marginal Cost

Profit Maximization: Another Graphical Interpretation Output, Garages per Year (a) Marginal Revenue and Marginal Cost 5 MR and MC per Garage per Year (thousands $) – MR MC E

Marginal Analysis and Maximization of Total Profit  Finding the Optimal Price from Optimal Output  MR = MC: rule for determining the level of output  Demand curve  price buyers will pay to purchase that level of output  Both output and price are now determined for the profit maximizing firm.

Logic of Marginal Analysis & Maximization  If a decision is to be made about the quantity of some variable, then maximize net benefit.  Net Benefit = Total Benefit - Total Cost  To maximize net benefit, select a value of the variable at which marginal benefit = marginal cost.

Logic of Marginal Analysis & Maximization  Application: Fixed Cost and Profit Maximization  An increase in fixed costs does not change optimal output or price because it does not affect marginal costs.

Rise in Fixed Cost: Total Profits Before and After

Fixed Cost Does Not Affect Profit-Maximizing Output Profit with a fixed cost Profit with zero fixed cost N Total Profit per Year (thousands $) Output in Garages per Year M

The Role of Marginal Analysis  Marginal analysis can be used to illuminate many everyday problems, in business and elsewhere, sometimes with surprising results.  For example, a new activity will add to profits if it more than covers its marginal cost.

The Role of Marginal Analysis  Any problem involving optimization can be illuminated with marginal analysis.  The logic of marginal analysis can be applied to government, universities, hospitals and other organizations as well as businesses.

Theory and Reality  Business people seldom use marginal analysis in a literal sense.  They often rely on intuition and hunches.  But these theories can be used to understand and predict behavior.

 Average = total  the number of units  Total = average  the number of units Relationships Among Total, Average, and Marginal Data

 Marginal value of the xth unit = total value of x units - total value of (x - 1) units  Total value of x units =  marginal values of the first x units

 The marginal, average and total values for the first unit are usually equal.  If marginal < average, the average is falling.  If marginal > average, the average is rising.  If marginal = average, the average is constant; that is, the average is at a maximum or minimum. Relationships Among Total, Average and Marginal Data

Relationship Between Marginal and Average Curves F E A D B C Average weight Marginal weight Marginal and Average Weight (pounds) Number of Persons