Microeconomics: Costs of Production

Microeconomics: Costs of Production

• Firms aim to transform inputs into outputs while managing costs.
• Key questions include: What costs do firms face? How do these costs influence production decisions? Understanding production costs is essential for predicting a firm's behavior.

Explicit and Implicit Costs

• Explicit Costs: Monetary payments for resources like wages and materials.
• Implicit Costs: Opportunity costs of using owned resources, like the forgone rental income from using a property or the salary forgone by running a business.

Economic vs. Accounting Costs

• Accounting Costs: Include only explicit costs.
• Economic Costs: Sum of explicit and implicit costs.
• Example: If accounting costs for a business are $100,000 and the opportunity cost of the owner's time is $20,000, then economic costs are $120,000.

Accounting Cost vs. Economic Cost

• Exercise: A student, Jenny, decides to attend college instead of working at her dad's firm. The total cost of college is $20,000. Her potential salary at the firm would have been $50,000.
• Accounting Cost of college: $20,000
• Economic Cost of college: $70,000 ($20,000 + $50,000)

Total Revenue and Profit

• Total Revenue (TR): Income from selling goods; TR = Price (P) x Quantity (Q).
• Accounting Profit: TR - Accounting Costs.
• Economic Profit: TR - Economic Costs.
• Positive economic profit attracts new firms. Zero economic profit indicates normal returns.

The Production Function

• Shows the relationship between inputs and outputs.
• Example: A bakery uses flour and labor to produce bread.
• Formula: Q = f(L,K), where Q is output, L is labor, and K is capital.
• Demonstrates diminishing marginal product.

Total, Marginal, and Average Product

• Total Product: Sum of Marginal Products
• Marginal Product: Slope of the Total Product curve (additional output from one more unit of input).
• Average Product: Average of the Total Product.
• Example data is provided (a table).

Marginal Product (MP)

• Marginal Product: The additional output produced by adding one more unit of input (e.g., worker) to production.
• Formula: MP = ΔQ/ΔInput
• Diminishing marginal product: Marginal product decreases as input increases.
• Example table provided for labor, output, and marginal product.

Short Run: Diminishing Marginal Returns

• Diminishing Marginal Returns: As an input increases, the marginal product decreases..

Total, Marginal, Average Cost

• Total Cost (TC): The sum of all costs.
• Marginal Cost (MC): Cost of producing one additional unit.
• Average Cost (AC): The total cost divided by the quantity produced.

Total Cost (TC)

• Fixed Costs (FC): Do not vary with output (e.g., rent).
• Variable Costs (VC): Vary with output (e.g., materials).
• Formula: TC = FC + VC
• Example calculation provided using the formula.

Average Costs (AC)

• Average Total Cost (ATC): ATC = TC/Q.
• Average Fixed Cost (AFC): AFC = FC/Q.
• Average Variable Cost (AVC): AVC = VC/Q.
• Example calculations.

Marginal Cost (MC)

• Marginal Cost: The cost of producing one additional unit of output.
• Formula: MC = ΔTC/ ΔQ
• Example calculation of marginal cost given quantities.

Short-Run vs. Long-Run Costs

• Short-Run: At least one input is fixed (e.g., capital).
• Long-Run: All inputs are variable.
• Firms adjust fixed inputs (e.g., size of building) over time to optimize production in the long run. 

Short Run: Cost Curves

• Marginal-Average Rule: When marginal is greater than average, average increases. 
• When marginal equals average, average doesn't change (stays constant).
• When marginal is less than average, average decreases.

Long Run: Cost Curves

• In the short run, some inputs are fixed, while in the long run, all inputs are variable.
• A firm's long-run average total cost is the lowest possible cost per unit of output.

Economies of Scale

• Costs decrease as output increases.
• Causes: Specialization, bulk purchasing, efficient capital use.
• Example: Factory producing in bulk. 

Constant Returns to Scale

• Output increases proportionally to inputs (e.g., doubling labor and capital doubles output).
• Occurs in perfectly competitive industries.

Long Run: Economies of Scale

• When the quantity is relatively small, there are many small firms.

Bakery Example

• A bakery example calculating short-run costs (fixed and variable).
• Example calculation.

Quiz

• Sample question relating the increase in total cost to the marginal cost.
• Example problem and solution.

Diseconomies of Scale

• Costs increase as output increases.
• Causes: Coordination difficulties, bureaucratic inefficiencies, high administrative overhead.
• Example: Large corporations with high administrative overhead. 

Real-World Application: Tech Startups

• Tech startups often face high fixed costs (R&D) but low marginal costs (software distribution).
• Scale economies drive profitability (e.g., SaaS companies.)

Break-Even Analysis

• Break-even point: Total revenue equals total costs.
• Helps firms determine the minimum output required to cover all costs.
• Example calculations of break-even quantity.

Shutdown Decisions

• Short-run decision to stop production if revenue is less than variable costs (revenue < variable costs).
• Example scenario and decision.

Problems (1-10)

• Includes various problems relating to different types of costs (opportunity cost, total cost, variable cost, average total cost, and marginal cost); various application examples, and problem solutions.

Review of Key Concepts (Summary)

• Key concepts are reviewed..

Next Lecture Preview

• Topics for the next lecture are listed (Firms in Competitive Markets, Profit Maximization, Applications).

This quiz explores the costs of production in firms, focusing on explicit and implicit costs. It examines how these costs impact decision-making and differentiates between accounting and economic costs. Understanding these concepts is crucial for analyzing firm behavior in the marketplace.