1. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 1 ECON Designed by Amy McGuire, B-books, Ltd. McEachern 2010-2011 7 CHAPTER Production and Cost in the Firm Micro

2. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 2 LO 1 Cost and Profit  Producers: Maximize profit  Opportunity cost –All resources have an opportunity cost  Explicit costs –Payments for resources  Implicit costs –Opportunity cost of resources owned by the firm / firm owners –No cash payment

3. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 3 LO 1 Alternative Measures of Profit  Accounting profit –Total revenue minus explicit costs  Economic profit –Total revenue minus all costs (implicit and explicit) Opportunity cost of all resources  Normal profit –“Accounting profit in excess of normal profit” Accounting profit = Economic + Normal profit

4. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 4 LO 1 Wheeler Dealer Accounts, 2010 Exhibit 1

5. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 5 LO 2 Production in the Short Run  Variable resources –Can be varied quickly  Fixed resources –Cannot be altered easily  Short run –At least one resource is fixed  Long run –No resource is fixed

6. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 6 LO 2 Law of Diminishing Marginal Returns  Total product  Production function –Relationship between amount of resources employed and total product  Marginal product –Change in total product from an additional unit of resource

7. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 7 LO 2 Law of Diminishing Marginal Returns  Increasing marginal returns –Marginal product increases  Diminishing marginal returns –Marginal product decreases  Law of diminishing marginal returns

8. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 8 LO 2 The Short-Run Relationship Between Units of Labor and Tons of Furniture Moved Marginal product increases as the firm hires each of the first three workers, reflecting increasing marginal returns. Then marginal product declines, reflecting diminishing marginal returns. Adding more workers may, at some point, actually reduce total product (as occurs here with an eighth worker) because workers start getting in each other’s way. Exhibit 2

9. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 9 LO 2 Effects of an Increase in Demand Exhibit 3 5 10 15 Total product (tons/day) 5 10 Workers per day0 510 Workers per day 1 3 5 Marginal product (tons/day) 0 2 4 Total product Marginal product Negative marginal returns Diminishing but positive marginal returns Increasing marginal returns (a) Total product (b) Marginal product

10. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 10 Costs in the Short Run  Fixed cost FC  For fixed resources  Variable cost VC  For variable resources  Total cost TC = FC + VC  Marginal cost MC = ∆TC/∆q  Change in TC to produce one more unit of output LO 3

11. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 11 Costs in the Short Run  Changes in MC  Reflect changes in marginal productivity  Increasing marginal returns  MC falls  Diminishing marginal returns  MC increases LO 3

12. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 12 LO 3 Short-Run Total and Marginal Cost Data for Smoother Mover First 3 workers: increasing marginal returns: MC declines With the 4 th worker: diminishing marginal returns: MC increases Exhibit 4

13. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 13 LO 3 Total and Marginal Cost Curves for Smoother Mover FC = $200 at all levels of output VC starts from origin; increases slowly at first; with diminishing returns, VC increases rapidly TC is the vertical sum of FC and VC MC first declines: increasing marginal returns; then increases: diminishing marginal returns Exhibit 5

14. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 14 Average Cost in the Short Run  Average variable cost AVC = VC/q  Average total cost ATC = TC/q  When MC < average cost  The marginal pulls down the average  When MC > average cost  The marginal pulls up the average  U-shape of average cost curves  Law of diminishing marginal returns LO 3 $

15. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 15 LO 3 Short-Run Total, Marginal, and Average Cost Data for Smoother Mover MC first falls then increases (increasing then diminishing marginal returns) As long as MC < AC, average cost declines Once MC > AC, average cost increases Exhibit 6

16. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 16 LO 3 Average and Marginal Cost Curves for Smoother Mover ATC and AVC: decline, reach low points, then rise. When MC is below AVC (ATC), AVC (ATC) is falling When MC = AVC (ATC), AVC (ATC) is at its minimum. When MC is above AVC (ATC), AVC (ATC) is increasing. Exhibit 7

17. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 17 Costs in the Long Run LO 4  All resources can be varied  Planning horizon  Firms plan in the long run  Firms produce in short run

18. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 18 Costs in the Long Run LO 4  U-shaped long-run average cost curve  Economies of scale –LRAC falls as output expands  Diseconomies of scale –LRAC increases as output expands  Constant lung-run average cost

19. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 19 LO 4 Short-Run Average Total Cost Curves Form the Long-Run Average Cost Curve, or Planning Curve Exhibit 8 Cost per unit 0qqaqa q’q’Output per periodqbqb S S’S’ M M’M’ L L’L’ SS’, MM’, LL’ are short run ATC curves Long run ATC curve: SabL’ a b

20. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 20 LO 4 Many Short-Run ATC Curves Form a Firm’s LRAC Curve, or Planning Curve ATC 1 ATC 2 0qq’q’ Output per period Many possible plant sizes Cost per unit $11 10 9 b ATC 3 ATC 4 ATC 5 ATC 6 ATC 7 ATC 8 ATC 9 ATC 10 Long-run average cost c a Each short-run curve is tangent to the long run average cost curve Each point of tangency represents the least cost way of producing that level of output Exhibit 9

21. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 21 LO 4 A Firm’s Long-Run Average Cost Curve Cost per unit 0AOutput per periodB Economies of scale Long-run average cost Diseconomies of scale Constant average cost Exhibit 10

22. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 22 LO 4 Case Study Scale Economies and Diseconomies at the Movies  Movie theaters  Economies of scale  Decrease in LRAC as the number of screens initially increases  Diseconomies of scale  Adding even more screens  Problems arise  LRAC starts to increase

23. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 23 Economies and Diseconomies of Scale LO 4  Plant level –Particular location  Firm level –Collection of plants

24. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 24 LO 4 Case Study Scale Economies and Diseconomies at McDonald's  Economies of scale  At plant level  Specialization  At firm level  Sharing: information; technology  Diseconomies of scale  At firm level  Uniform menu

25. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 25 A Closer Look at Production and Cost Appendix  Production function  Technologically efficient production  Isoquant –All technologically efficient combinations of 2 resources

26. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 26 A Firm’s Production Function Using Labor and Capital: Production per Month Exhibit A

27. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 27 A Closer Look at Production and Cost Appendix  Isoquants –Farther from origin: greater output rates –Negative slope –Don’t intersect –Convex to the origin

28. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 28 A Closer Look at Production and Cost Appendix  Marginal rate of technical substitution –MRTS –Slope of isoquant –MRTS = MP L /MP C

29. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 29 A Firm’s Isoquants Exhibit B 05 Units of labor per month 10 Units of capital per month 5 10 Q 1 (290) Q 2 (415) Q 3 (475) a b c d e h f g Q 1 : all technologically efficient combinations of labor and capital that can be used to produce 290 units of output Q 2 : 415 units of output Q 3 : 475 units of output Isoquants: - negative slope - convex to the origin

30. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 30 A Closer Look at Production and Cost Appendix  Isocost line  All combinations of capital and labor  Can be hired for a given total cost  Are parallel  Slope of isocost line –Negative –Price of labor divided by price of capital

31. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 31 A Firm’s Isocost Lines Exhibit C 51015 0 Units of labor per month 5 10 Units of capital per month TC = $15,000 TC = $19,000 TC = $22,500 Slope = -w/r = -$1,500/$2,500 = -0.6 Each isocost line –Combinations of labor and capital that can be purchased for a given amount of total cost –Slope is negative wage divided by the rental cost of capital Higher costs: isocost lines farther from origin

32. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 32 A Closer Look at Production and Cost Appendix  Profit maximization  Cost minimization  Minimum cost to produce a given output –Tangency between isocost line and isoquant Slope = MRTS = w/r  Expansion path

33. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 33 A Firm’s Optimal Combination of Inputs Exhibit D Q 1 (290) Q 2 (415) Q 3 (475) f 510 0 Units of labor per month 5 10 Units of capital per month TC = $19,000 a e e: isoquant Q 2 is tangent to the isocost line

34. Chapter 7Copyright ©2010 by South-Western, a division of Cengage Learning. All rights reserved 34 A Firm’s Expansion Path Exhibit E Expansion path Q2Q2 LL’ 0 Units of labor per month C Units of capital per month Q4Q4 Q3Q3 Q1Q1 d h TC 3 TC 2 TC 1 TC 4 a b c Expansion path -Slopes up to the right -More of both resources is needed to increase output