Chapter 7 Dr. Yuna Chen 1 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Production and Cost in the Firm

2 2 Cost and Profit Producers’ goal: maximize profit Explicit costs: –Actual cash payments for resources (wage, rent…) on the accounting statement Implicit costs: –opportunity cost of using the resources –Not a cash payment –Not on the accounting statement © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 3 Cost and Profit Example1. Eric took $200,000 from his saving account which pays 5% interest, to open his own business. In the 1 st year, he pays $50,000 to the employees, and $150,000 to inventories. He gave up his $32,000 job in order to manage his business. Explicit costs = $50,000 + $150,000 = $200,000 Implicit costs = ($200,000)(5%)+ $32,000 =$42,000 Total costs = $200,000 + $42,000 = $242,000 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Alternative Measures of Profit Accounting profit = Total revenue - explicit costs Economic profit = Total revenue minus total costs (implicit and explicit) Normal profit –Occurred when accounting profit earned can cover all implicit cost – occurred when economic profit = 0 4 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Alternative Measures of Profit Example 2. Continue on Example 1. At the end of the 1 st year, Eric’s yearly total revenue is $220,000. Accounting profit = $220,000 - $200,000 =$20,000 Economic profit = $220,000 – $242,000 = -$22,000 Eric earns normal profit if his accounting profit is $42,000, which can cover his implicit cost. 5

Production in the Short Run Variable resources –Can be varied in the short run to increase or decrease production Fixed resources –Cannot be varied in the short run Short run –At least one resource is fixed Long run –All resources can vary 6 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Diminishing Marginal Returns Total product –A firm’s total output Marginal product –Change in total product from an additional unit of resource Classroom Experiment: Making cookies 7 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Diminishing Marginal Returns Law of diminishing marginal returns –As more of a variable resource is added to a given amount of another resource, marginal product eventually declines Could become negative 8 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Fixed cost, FC –Any production cost that is independent of the firm’s amount of output –Costs that is paid out even when no output is made Variable cost, VC –Any production cost that changes as the amount of output changes Total cost, TC = FC + VC 9 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Marginal cost, MC = ∆TC/∆q –Change in total cost resulting from a one- unit change in output 10 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Example 3. You are thinking about setting up a lemonade stand. The stand itself costs $200. The ingredients for each cup of lemonade cost $0.50. If you make 100 cups, what is FC, VC, TC and MC? FC = $200 (cost for the stand is fixed) VC = ($0.50)(100) = $50 (cost for ingredients varies) TC = $200 + $50 = $250 As for MC, Q = 99, TC = $ Q = 100, TC = $250 MC = $250 - $ = $ © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Cost Curves Let’s draw these 3 cost curves: FC, VC, and TC 12 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Short Run Fixed cost curve –Straight horizontal line Variable cost curve –Starts at the origin and up Total cost curve –Fixed cost curve + variable cost curve Marginal cost - Slope of total cost curve 13 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Average Cost in the Short Run Average variable cost, AVC = VC/q –Variable cost divided by output Average fixed cost, AFC = FC/q –Fixed cost divided by quantity Average total cost, ATC = TC/q –Total cost divided by output –ATC = AFC + AVC 14 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Example 4 See handout 15 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Average Cost in the Short Run AFC is always declining as output increases, but never touch the x axis These curves are U-shaped, first declining then rising, AVC, ATC, MC ATC is always above AVC. The vertical gap between ATC and AVC is AFC. MC goes through the minimum point of AVC and ATC. 16 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Long Run Long run –Planning horizon –All resources can be varied Firms plan for the long run Firms produce in the short run 17 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Example 5 Weekly CostJone’s FarmChicken Little Egg Farm, Inc Labor(15 hours)(Implicit $12/hr) =Wage = $5,128 Feed$25$4,115 Transportation$15$2,431 Land and Capital$17$19,230 Total Cost Total output2400 eggs1,600,000 eggs AT C 18 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Example 5.

Costs in the Long Run Economies of scale – a firm’s average cost declines as the scale of operation increases Diseconomies of scale a firm’s average cost increases as the scale of operation increases Constant returns to scale – a firm’s average cost remains constant as the scale of operation increases 19 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Costs in the Long Run Long-run average cost curve –Indicates the lowest average cost of production in the short run –Planning curve –U-shaped 20 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.