Unit 6 Costs and Decision Making. Role of the Firm Goal  Firms make decisions to maximize profits Production  Transformation of factors into goods Production.

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Presentation transcript:

Unit 6 Costs and Decision Making

Role of the Firm Goal  Firms make decisions to maximize profits Production  Transformation of factors into goods Production Function  Relationship between the amounts of inputs and quantity of outputs a firm produces  Q = A * fcn(Land, Labor, Capital, Entrepreneurship)

Production Decisions Time Frame Short Run (SR)  Time period where at least one input is fixed Long Run (LR)  Time period long enough to where all inputs are variable Very Long Run (VLR)  Allows for technological change to occur

Short Run Costs Fixed Costs (FC)  Costs associated with use of fixed inputs (resources used by a firm that remain constant in the SR)  Example: Property tax, Rental payments, etc. Variable Costs (VC)  Costs associated with the use of variable inputs (inputs that increase as the level of production increases)  Example: Raw material costs, hourly wages, etc. Total Costs (TC) = FC + VC Marginal Costs (MC)  Added cost of an additional unit of output  Change in TC / Change in Q

Short Run Average Costs Average Fixed Costs (AFC)  AFC = FC / Q Average Variable Costs (AVC)  AVC = VC / Q Average Total Costs (ATC)  ATC = AVC + AFC

Observations of Cost Curves AFC continually declines as output expands AVC and ATC decrease at first, then begin to slowly increase  Law of Diminishing Marginal Returns

Production Decision Example Simply - a market with only two inputs: Labor and Capital In the Short Run: Capital is fixed Labor is variable Here, the output produced is said to be the product of labor since nothing is produced without workers. Total Product of Labor = total quantity of output produced by the total number of workers. Marginal Product of Labor = additional output (total product) produced from adding an additional worker.

Law of Diminishing Returns When additional units of labor are added to a fixed input, the Marginal Product of labor must eventually decrease. Why do you think this occurs?

Rib Restaurant Example We have a BBQ Rib Restaurant that hires employees in order to serve dinners to its customers.  Fixed Cost: Restaurant building, ovens, cooking equipment, plates, etc  Variable Cost Workers, dinner ingredients, beverages, etc.

Rib Restaurant Example Simplified to only Labor and Capital:  The Fixed Cost of Capital is $100 per hour rent.  The Variable Cost of Labor is $10 an hour per worker. The Total Product is the number of dinners that the restaurant can serve in an hour.

Rib Restaurant Example Units of Labor Total Product (Q)

Rib Restaurant Example

Rib Restaurant Example Units of Labor Total Product (Q) Marginal Product Average Product

Rib Restaurant Example Units of Labor Total Product (Q) Marginal Product Average Product

Rib Restaurant Example Units of Labor Total Product (Q) Marginal Product Average Product

Rib Restaurant Example

Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example Units of Labor TPFC / hour VC / hour TC / hour AFC / hour AVC / hour ATC / hour MC / hour

Rib Restaurant Example

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Typical Short Run Cost Curves