The Costs of Production

How firms compare revenues and costs in determining how much to produce?  Explicit and implicit costs  Law of diminishing returns  Fixed and variable costs  Total, average, and marginal costs  The firm’s size in the long run 8-2

Cost exist because resources are scareced  Economic Costs (EC) are equal to opportunity costs  The measure of EC of any resource is the value or worth the resource would have in its best alternative use

Economic Costs  Explicit + implicit costs  Explicit costs ( revealed and expressed) Monetary payments  Implicit costs (not obvious) Value of next best use Self-owned resources Self-employed resources 8-4

Implicit costs  Ex: Forgone incomes:  providing your own  - financial capital (%)  - building (rent)  - labor (wages)  - entrepreneurial income (worth in other businesses)

Profit  Accounting profit Total revenue less explicit cost  Normal profit = cost of doing business Equal to implicit cost+  Economic or pure profit Total revenue less economic cost 8-6

Profits Compared Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Economic Accounting 8-7

Note!  Even if the economic profit is 0, the entrepreneur is still covering all explicit and implicit costs + a normal profit

Adjustment time =2 conceptual periods = Short and Long Run  The short run = too brief to alter the Fixed plant capacity Enough to Variable intensity of plant use Variable output 8-9

The long run = Adjustment of all resources Variable plant capacity Firms enter and exit

Production Relationships: short- and long-run  Total product (TP) = total output of a good produced  Marginal product (MP)= extra output(added product due to adding a unit to variable resources  Average product (AP)=labor productivity Average Product Total Product Units of Labor = Marginal Product Change in Total Product Change in Labor Input =

The short run  A Co has time to increase the output by adding units of labor the fixed plant  ?How much the output will rise by adding units of labor?

Law of Diminishing Returns Assume:  Fixed technology (technology does not change)  All units of labor are of equal quality Add variable resource to fixed resource = Marginal product of variable units will decline

Why?  –all workers are used relative to the amount of plant and equipment available  But due to the dynamics of MP line when it increases so smaller additional amounts of variable resources are required to produce successive output.=> The VC of these units decreases. As diminishing returns are encountered, MP begins declining. Larger extra amounts of variables are needed to produce successive units.

Increasing Marginal Returns Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 8-15

Total Product, TP Marginal Product, MP TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns 8-16

Short-Run Production Costs  Fixed Costs Do not vary with output  Variable Costs Materials, most labor  Total Cost TC = TFC + TVC 8-17

Per-Unit Production Costs  Average fixed cost AFC = TFC/Q  Average variable cost AVC = TVC/Q  Average total cost ATC = TC/Q = TFC/Q + TVC/Q ATC = AFC+AVC 8-18

Short-Run Production Costs Costs Q $1100 TFC TC TVC Total Cost Variable Cost Fixed Cost 8-19

Per-Unit Production Costs  Marginal cost = extra or additional cost of producing one more unit of output MC = change in TC/change in Q

Short-Run Production Costs (per unit) Costs Q $200 AFC MC ATC AVC AFC 8-21

Production Relationships: Marginal cost and marginal product Assume: all units of variable resources are hired at the same price Marginal cost shape as a consequence of diminishing returns Results: 1 As long as MP (per unit of labor) is rising, MC will fall. 2 When MP is at its max, MC is at its min 3 When MP is falling, MC is rising 8-22

Marginal cost and average variable cost and average total cost  MC intersects both the AVC and ATC at their respective minimum points Note!  No such relationship with AFC  MC = addition either to total cost or to total variable cost

Shifts in cost curves Changes in  - technologies  - resource prices cause costs to change and cost curves to shift 1 FC prices of VC resources are the same - => AFC shifts upward - But - The position of AVC and MC would be unaltered

Shifts in cost curves  2 more efficient technology=> increase the productivity of inputs  - all inputs=> the costs would be lower  An upward shift in the productivity curves means a downward shift in the cost curves

Average Product and Marginal Product Cost (Dollars) Graphical Relationships MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves 8-26

Long-Run Production Costs All resources are variable Choose your plant size: Minimize ATC  Different ATC curves which correspond do different plant sized Task: determine the output to pass to enlargement (when per-unit costs for a larger plant drop below those for the current smaller plant) 8-27

Long-Run ATC Curve Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output Any number of short-run optimum size cost curves can be constructed 8-28

Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The long-run ATC curve just “envelopes” the short run ATCs 8-29

 The plant larger => larger are ATC =>  => U-shaped curve  Why so?  Economies of Scale + Diseconomies of Large-Scale Production  Assume:  - resource prices are constant  - law of diminishing returns does not apply to production in the long-run (productive resources are not held constant)

Long Run Production Cost  Economies of Scale = of mass production (explain the downsloping long-run ATC curve) Labor specialization (one task of the worker instead of 5) Managerial specialization Efficient capital (equipment) Other factors (as fixed one: start-ups, learning by doing…) 8-31

Diseconomies of Scale  - difficulty of control  - of coordination  - problems of communication  - bureaucracy  - problems of decision-making,  - their fulfillment  - moral problems (alieniation, …)  Constant Returns to Scale

Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1q1 q2q2 8-33

Output Long-run ATC curve where costs are lowest only when large numbers are participating Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC Long-Run ATC Shapes 8-34

Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale Long-Run ATC Shapes 8-35

Industry Structure  Minimum efficient scale (MES) = lowest level of output at which a firm can minimize long-run AC (ex.q1q2\...) Subjects to MES ?  SMB cannot realize the MES => Natural monopoly of BB Note!  Where economies of scale are few and diseconomies come quickly, the MES occurs at lower level of output  Ex: retailers, some type of farming, …  In such industries SMB is more efficient than BB

illustrations Price of corn Successful start-up firms The Verson stamping machine The daily newspaper Aircraft and concrete plants

Sunk Costs Once the costs are incurred they cannot be recovered (“steep price for the ticket”)  Irrelevant in decision making  Cannot be recovered  Do not affect marginal benefit and marginal cost  Firm example: R&D costs 8-38