1. Production and Costs

2. The How Question?
From the circular flow diagram, resource markets determine input or resource prices.
Profit-maximizing firms select the production technology, given the input prices, to select the combination of input that minimize the cost of producing any given output level.
This helps answer the second condition for economic efficiency.
Economic efficiency – maximum satisfaction from scarce resources: The two conditions are:
Produce the combination of goods and services that consumers most highly value
Produce the combination of goods and services at least possible cost.

3. Economic versus Accounting Costs
Understanding costs will help to understand efficiency as well as behavior.
Economic costs are theoretical constructs which are intended to aid in rational decision-making.
Accounting costs are legal constructs intended to provide uniformity in measurement.

4. Profit = Total Revenue – Total Costs
Total Net Benefits = Total Benefits minus Total Costs
Costs as Opportunity Costs
Explicit Costs
Implicit Costs
Opportunity cost of entrepreneur’s invested capital
Opportunity cost of entrepreneur’s time
Economic versus Accounting Profit
Normal Profits: the accounting profits that just covers implicit or opportunity costs

5. Figure 1 Economic versus Accountants
How an Economist
How an Accountant
Views a Firm
Views a Firm
Revenue
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Total
opportunity
costs
Explicit
costs
Explicit
costs
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6. Production and Costs
Intuitively, costs of production depend on two things:
Production technology
Input Price
Technology is the state of knowledge about how to combine inputs to produce output.
Production Function describes the relationship between inputs and outputs
Q = F ( K, L , NR, E)

7. Short-run versus Long-run
SR - at least one input is fixed – limits to adjustment – diminishing returns
LR – all inputs are variable – complete flexibility – returns to scale
Remember the widget example!
Applying more labor resulting in a diminishing marginal product of labor and increasing marginal costs.
Let’s see this at work again in a more detailed way.

8. A Short-Run Production Function and Costs
Assume two inputs, capital (say a factory) and labor, and that capital is fixed in the short-run.
Marginal Product of Labor – change in total output from added one more laborer.
MPL = change in Q / change in L
Preview of Costs: Production + input prices
With only one variable input, say labor,
MC= wage/MPL=(wage x change L)/change Q
Table and exercise

9. Figure 2 Hungry Helen’s Production Function
Quantity of
Output
(cookies
per hour)
150
Production function
140
130
120
110
100 90 80 70 60 50 40 30 20 10 1 2 3 4 5
Number of Workers Hired
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10. Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory
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11. Different Measures of Cost
Total Cost (TC) = FC+VC
Fixed Cost (FC) – are costs that do not vary with output. FC only are present in the short-run are the result of fixed factors.
Variable Cost (VC) – are costs that vary with output. VC result from different levels of fixed factors. All costs are VC in the long-run.
Marginal Cost (MC) = change in TC/ change in Q and measures the cost of producing another unit. (general formula)
Average Cost (AC) = TC/Q and measures the cost of a typical unit of output.

12. Cost Formulas TC = FC +VC
Dividing both sides of the total cost formula by Q, we get the average cost formula:
TC/Q = FC/Q + VC/Q
ATC = AFC +AVC
Average Total Cost = Average Fixed Cost + Average Variable Cost

13. Marginal and Average Costs Revisited
As Q increases if
MC<AC AC is falling
MC>AC AC is rising
So, when MC=AC AC is at its minimum
The above also applies to MC and AVC
The height example

14. The Cost Curves
Short-run Cost Curves – at least one fixed factor, so fixed costs exist. Economist like to use the example of the factory or plant size being fixed and labor being the variable input.
Law of Diminishing Marginal Returns implies that the MC will eventually increase.
Increasing MC results in U-shaped ATC curves.
If MC initially falls and then begins to rise, both the ATC and AVC curves will be U-shaped.
Since capital is often assumed to be fixed, the short-run cost curves describe costs associated with the utilization of existing plant capacity.

17. Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
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18. Excel Cost Curves
Changes in input prices or productivity change the cost curves
Change in fixed costs do not affect MC
Increases in prices or or decreases in productivity of variable inputs cause VC, TC, AVC, ATC, and MC to increase
Decreases in prices or increases in productivity of variable inputs causes VC, TC, AVC, ATC, and MC to decrease

19. Long-run Cost Curves
Long-run cost curves – all factors are variable, so there are no fixed costs and all costs are variable.
Economies and diseconomies of scale
benefits to a larger scale of operations – specialization, purchasing volume, efficient use of capital, design and development costs
costs of a larger scale of operation – coordination problems
LR cost curves are U-shaped if a production process is characterized by first by economies of scale, and then diseconomies of scale.
Since capital can be varied, the long-run cost curves describe the costs with changing the scale of operations (reducing or increasing plant size).

20. The long-run cost curve is constructed from various short-run cost curves.
Remember increasing capital makes labor more productive, so increase plant size makes labor more productive and decreases marginal costs
Even though marginal costs decline, average costs may go up or down because of the cost of capital and labor are added together to calculate average costs.

21. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
$12,000
ATC
in long run
1,200
Quantity of
Cars per Day
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22. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
ATC
in long run
Economies of
scale
Diseconomies of
scale
1,200
$12,000
1,000
10,000
Constant
returns to
scale
Quantity of
Cars per Day
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23. Summary
Short-run – at least one input is fixed so the primary decision is how best to use existing plant capacity
Long-run – all inputs are variable so the primary decision is what overall scale of operations or plant size should be chosen.