1. 1 Production and Cost in the Short Run Chapter 7 © 2006 Thomson/South-Western

2. 2 Explicit and Implicit Costs  Explicit costs  Refer to the firm’s actual cash payments for resources  wages, rent, taxes, etc.  Implicit costs  The opportunity costs of using resources owned by the firm or provided by the firm’s owners  Require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profits

3. 3 Alternative Measures of Profit  Wanda Wheeler currently earns $50,000 in her current job  She decides to start her own business  She withdraws $20,000 from her savings account, hires and assistant and uses a spare bay in her garage that had been renting for $1,200 a year  Exhibit 1 shows the results after the first year

4. 4 Exhibit 1: Accounts of Wheeler Dealer 2004

5. 5 Normal Profit  Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost  normal profit  Recall that the accounting profit = $64,000  Normal profits = $50,000 + $1,200 + $1,000 = $52,200: normal profit  $11,800:economic profit

6. 6 Fixed and Variable Resources  Variable resources can be varied quickly to change the output rate  Fixed resources are those resources which cannot be easily changed  This provides us the distinction between the short run and the long run  Short run: at least one resource is fixed  Long run: all resources are variable  Varies from industry to industry

7. 7 Exhibit 2: Short-Run Relationship

8. 8 Law of Diminishing Marginal Returns  As more of a variable resource is combined with a given amount of a fixed resource, marginal product eventually declines  This is the most important feature of production in the short run  dictates the shape of the production function and the cost curves

9. 9 Exhibit 3: Total and Marginal Product of Labor  Because of increasing marginal returns, marginal product increases with each of the first three workers: total product is increasing at an increasing rate  Once diminishing returns sets in with the 4 th worker, marginal product declines: total product increases at a decreasing rate  As long as marginal product is positive, total product increases, and when marginal product turns negative, total product starts to fall

10. 10 Costs in the Short Run  Fixed costs pay for fixed resources and must be paid even if no output is produced – they do not vary when output varies  Variable cost is the cost of variable resources – labor in our example – and vary with the amount of labor employed in the production process: as more labor is employed, output and variable cost both increase  The firm can hire labor at $100 per worker day: variable cost equals $100 times the number of workers hired

11. 11 Tons Moved Fixed Variable Marginal per Day cost Workers Cost Total Cost Cost (q) (FC) per Day (VC) TC=FC+VC MC=  TC/  q (1) (2) (3) (4) (5) (6) $0 $200 0 $0 $200 - 2 200 1100300 50.00 5 200 2200400 33.33 9 200 3300500 25.00 12 200 4400600 33.33 14 200 5500700 50.00 15 200 6600800100.00 Exhibit 4: Short-Run Cost Data  Since total cost is the opportunity cost of all resources employed by the firm, it includes a normal profit but not an economic profit.  Marginal cost is simply the change in total cost divided by the change in output  MC = ΔTC / Δq  Changes in MC reflect changes in marginal productivity of the variable resource employed

12. 12 Marginal Cost and Marginal Productivity  When the firm experiences increasing marginal returns – marginal product is increasing – the marginal cost decreases  When the firm experiences diminishing marginal returns – marginal product begins to decline – the marginal cost of output increases  Exhibit 5 provides a graphical illustration of our cost curves

13. 13 Exhibit 5: Total and Marginal Cost Curves

14. 14 Exhibit 5: Total and Marginal Cost Curves ( Tons per day $1,000 500 200 Total cost Variable cost Fixed cost Fixed cost 3 0 691215 Total dollars Tons per day $100 50 25 Marginal cost 306912 Cost per ton 15  Since total cost does not vary with output, the fixed cost curve is a horizontal line at $200  Variable cost is zero when output is zero – the variable cost curve starts at zero  The total cost curve sums the variable and fixed cost curves  Because a constant fixed cost is added to variable cost, the total cost curve is the variable cost curve shifted vertically by the amount of fixed cost  Marginal cost declines until the 9 th unit of output and then increases  This reflects labor’s increasing, and then diminishing, marginal returns

15. 15 Average Cost in the Short Run  The average cost per unit of output is another of the useful cost measures  There are average cost measures corresponding to variable cost, fixed cost and variable cost  Exhibit 6 provides a detailed listing of the variable costs for our example

16. 16 Exhibit 6: Short Run Cost Data  Average variable cost, AVC, equals variable cost divided by output  AVC = VC / q  Average total cost, ATC = TC / q  Both average variable cost and average total cost first decline as output expands, then increase Tons Moved Variable Marginal Average Average per Day Cost Total Cost Cost Variable Cost Total Cost (q) (VC) TC=FC+VC MC=∆TC/∆q AVC=VC/q ATC=TC /q (1) (2) (3) (4) (5) =(2) / (1) (6)=(3) / (1) 0 $0 $200 $0.00 -  2 100 300 50.00 $50.00 $150.00 5 200 400 33.33 40.00 80.00 9 300 500 25.00 33.33 55.55 12 400 600 33.33 33.33 50.00 14 500 700 50.00 35.71 50.00 15 600 800 100.00 40.00 53.33

17. 17 Marginal and Average Cost  The relationship between marginal and average cost is also important  When marginal cost is below or less than average cost it pulls average cost down  When marginal cost is above or higher than average cost it pulls average cost up  Exhibit 7 depicts this relationship

18. 18 Exhibit 7: Average and Marginal Cost Curves $150 125 100 75 50 25 0 5 10 15 Tons per day Marginal cost Average total cost Average variable cost Notice also that the rising marginal cost curve intersects both the average variable and total cost curves at their minimums. The distance between the average variable and total cost gets smaller as output increases because average fixed costs decline as output increases Cost per ton

19. 19 Costs in the Long Run  All inputs that are under the firm’s control can be varied  there are no fixed costs  Long run is best thought of as a planning horizon  Choice of input combinations is flexible, but that flexibility is available only to firms that have not yet acted on their plans  Firms plan for the long run, but they produce in the short run

20. 20 Long-Run Average Cost Curve  Suppose that, because of the special nature of technology in the industry, a firm must choose among only three possible sizes  Small  Medium  Large

21. 21 Long-Run Average Cost Curve  Now suppose there are many possible plant sizes  Exhibit 9 presents a sample of short-run average total cost curves shown in purple  The long-run average cost curve, shown in red, is formed by connecting the points on the various short-run average cost curves that represent the lowest per-unit cost for each rate of output

22. 22 Exhibit 8: Long-Run Planning Curve

23. 23 Exhibit 9: Firm’s Long-Run Planning Curve

24. 24 Economies of Scale  Notice that the long-run average curve is U-shaped, a result of economies and diseconomies of scale  Economies of scale imply that long-run average costs decline as output expands while diseconomies of scale imply that long-run average costs increase as output increases

25. 25 Economies of Scale  A larger size often allows for larger, more efficient, machines and allows workers a greater degree of specialization  Production techniques such as the assembly line can be utilized only if the rate of output is large enough  Typically, as the scale of the firm increases, capital substitutes for labor and complex machines substitute for simpler machines

26. 26 Diseconomies of Scale  As a firm expands, diseconomies of scale, eventually take over: long-run average cost increase as output expands  Additional layers of management are needed to monitor production  The more levels of management in an organization, the more difficult it is for top management to communicate with those that perform most of the production tasks

27. 27 Exhibit 10: A Firm’s Long-Run Average Cost Curve