Microeconomics: Costs of Production (L16 PDF)

Principles of Microeconomics: Costs of Production Shuo Xu November 18, 2024 Introduction to Costs of Production I Firms aim to transform inputs into outputs while managing costs. I Key questions: I What are the costs firms face?...

Principles of Microeconomics: Costs of Production Shuo Xu November 18, 2024 Introduction to Costs of Production I Firms aim to transform inputs into outputs while managing costs. I Key questions: I What are the costs firms face? I How do these costs influence production decisions? I Understanding production costs is essential for predicting firm behavior. Explicit and Implicit Costs I Explicit Costs: Monetary outlays for resources (e.g., wages, materials). I Implicit Costs: Opportunity costs of using owned resources. I Examples: I Rent paid vs. forgone rental income from using a property. I Salary forgone by running a business. Economic vs. Accounting Costs I Accounting Costs: Include only explicit costs. I Economic Costs: Sum of explicit and implicit costs. I Example: I Total accounting costs: $100,000. I Opportunity cost of owner’s time: $20,000. I Economic costs: $120,000. Accounting Cost vs. Economic Cost Exercise Jenny decides to go to college instead of working at her dad’s firm. The all-inclusive cost of going to college for Jenny is $20, 000. Jenny’s salary at her dad’s firm would have been $50, 000. I Accounting Cost of College: $20, 000. I Economic Cost of College: $20, 000 + $50, 000. I Economic Cost = Explicit Cost + Implicit Cost (Salary Forgone) Total Revenue and Profit I Total Revenue (TR): Income from selling goods: TR = P × Q. I Accounting Profit: TR − Accounting Costs. I Economic Profit: TR − Economic Costs. I Insights: I Positive economic profit attracts new firms. I Zero economic profit indicates normal returns. The Production Function I Relationship between inputs and outputs. I Example: Bakery uses flour and labor to produce bread. I Formula: Q = f (L, K ) I Demonstrates diminishing marginal product. Total, Marginal, and Average Product I Total Product is the sum of Marginal Products. I Marginal Product is the slope of Total Product. I Average Product is the average of Total Product. Example Units of Labor Total Product Marginal Product Average Product 1 5 5 5 2 9 4 4.5 3 12 3 4 Marginal Product (MP) I Marginal Product: Additional output from one more unit of input. ∆Q I Formula: MP = ∆Input. I Diminishing marginal product: MP decreases as input increases. Labor Output Marginal Product I Example: 1 10 10 2 18 8 3 24 6 Short Run: Diminishing Marginal Returns Dimining Marginal Returns: As an input increases, the marginal product decreases. Diminishing Marginal Returns kicks in at the 4th unit of labor. Total, Marginal, Average Cost I Total Cost is the sum of Marginal Costs. I Marginal Cost is the slope of Total Cost. I Average Cost is the average of Total Cost. Example Total Product TC MC AC 0 6 - - 1 9 3 9 2 13 4 6.5 3 18 5 6 Total Cost (TC) I Fixed Costs (FC): Do not vary with output (e.g., rent). I Variable Costs (VC): Vary with output (e.g., materials). I Formula: TC = FC + VC. I Example: I FC = $500, VC = $20/unit. I For 10 units: TC = 500 + 20 × 10 = 700. Average Costs (AC) I Average Total Cost (ATC): ATC = TC Q. I Average Fixed Cost (AFC): AFC = FC Q. I Average Variable Cost (AVC): AVC = VCQ. I Example: I TC = 700, Q = 10. I ATC = 700/10 = 70, AFC = 500/10 = 50, AVC = 200/10 = 20. Marginal Cost (MC) I Marginal Cost: Cost of producing one additional unit. I Formula: MC = ∆TC ∆Q. I Example: I TC1 = 700, TC2 = 720, ∆Q = 1. I MC = (720 − 700)/1 = 20. Short-Run vs. Long-Run Costs I Short-Run: At least one input is fixed (e.g., capital). I Long-Run: All inputs are variable. I Transition: Firms adjust fixed inputs over time. I Example: I A restaurant renting additional space over time. Short Run: Cost Curves The Marginal-Average Rule: I When Marginal > Average, Average increases. I When Marginal = Average, Average does not change. I When Marginal < Average, Average decreases. Long Run: Cost Curves I In the short run, some inputs are fixed. In the long run, all inputs are variable. Therefore, a firm necessarily has a lower costs in the long run. I For each output level, compare the short-run average total costs. Then, the smallest number is the firm’s long run average total cost. Economies of Scale I Economies of Scale: Costs decrease as output increases. I Diseconomies of Scale: Costs increase as output increases. I Example: I Factory achieves lower costs by producing in bulk. I Causes of Economies of Scale: I Specialization. I Bulk purchasing. I Efficient capital use. Constant Returns to Scale I Output increases proportionally to inputs. I Example: Doubling labor and capital doubles output. I Typical in perfectly competitive industries. Long Run: Economies of Scale Economies of Scale and # of Firms: I When QMES is small, there are large number of small firms. Bakery Example I Scenario: Bakery’s short-run production. I Fixed Costs: Oven rental ($500/month). I Variable Costs: Ingredients ($2/loaf). I For 100 loaves: I Total Cost = 500 + 2 × 100 = $700. I Average Cost = 700 100 = $7/loaf. Quiz Question: If Total Cost increases from $100 to $130 when output increases from 5 to 6 units, what is the Marginal Cost? I A) $5 I B) $10 I C) $30 I D) $50 Answer: B) $30 Diseconomies of Scale I Causes: I Coordination difficulties. I Bureaucratic inefficiencies. I Example: Large corporations with high administrative overhead. Real-World Application: Tech Startups I Tech startups often face high fixed costs (R&D) but low marginal costs (software distribution). I Scale economies drive profitability (e.g., SaaS companies). Break-Even Analysis I Break-Even Point: When total revenue equals total costs. I Helps firms determine minimum output required. I Example: I Fixed Costs: $1,000. I Price per unit: $10. I Variable Cost: $6/unit. I Break-Even Quantity = 1, 000/(10 − 6) = 250 units. Shutdown Decisions I Short-run decision to stop production if: I Revenue < Variable Costs. I Example: I Revenue: $500. I Variable Costs: $600. I Decision: Shutdown. Problem 1: Types of Costs Question: This chapter discusses many types of costs: opportunity cost, total cost, fixed cost, variable cost, average total cost, and marginal cost. Fill in the type of cost that best completes each sentence: 1. What you give up in taking some action is called the. 2. is falling when marginal cost is below it and rising when marginal cost is above it. 3. A cost that does not depend on the quantity produced is a(n). 4. In the ice-cream industry in the short run, includes the cost of cream and sugar but not the cost of the factory. 5. Profits equal total revenue minus. 6. The cost of producing an extra unit of output is the. Problem 2: Amulet Store Opportunity Cost Buffy is thinking about opening an amulet store. She estimates that it would cost $350,000 per year to rent the location and buy the merchandise. In addition, she would have to quit her $80,000 per year job as a vampire hunter. 1. Define opportunity cost. 2. What is Buffy’s opportunity cost of running the store for a year? 3. Buffy thinks she can sell $400,000 worth of amulets in a year. What would her accountant consider the store’s profit? 4. Should Buffy open the store? Explain. 5. How much revenue would the store need to generate for Buffy to earn positive economic profit? Problem 3: Fisherman’s Costs A commercial fisherman notices the following relationship between hours spent fishing and the quantity of fish caught: Hours Quantity of Fish (lbs) 0 0 1 10 2 18 3 24 4 28 5 30 1. What is the marginal product of each hour spent fishing? 2. Graph the fisherman’s production function and describe its shape. 3. The fisherman has a fixed cost of $10 (his pole) and an opportunity cost of $5 per hour. Graph his total cost curve and explain its shape. Problem 4: Nimbus, Inc. Nimbus, Inc. makes brooms and sells them door-to-door. Here is the relationship between the number of workers and Nimbus’s output during a given day: Workers Output 0 0 1 20 2 50 3 90 4 120 5 140 6 150 7 155 1. Fill in the column of marginal products. 2. A worker costs $100 a day, and the firm has fixed costs of $200. Fill in the columns for total and average total costs. 3. Graph average total cost and marginal cost. What patterns do you see? Problem 5: Marginal Decision Your current level of production is 600 consoles, all of which have been sold. Someone calls, desperate to buy one of your consoles. The caller offers you $520 for it. Should you accept the offer? Why or why not? Problem 6: Pizzeria Costs Consider the cost information for a pizzeria: Quantity Total Cost Variable Cost 0 300 0 1 350 50 2 390 90 3 420 120 4 450 150 5 490 190 6 540 240 1. What is the pizzeria’s fixed cost? 2. Calculate the marginal cost per dozen pizzas and explain the relationship between total cost and variable cost. Problem 7: Painting Company Your cousin Vinnie owns a painting company with fixed costs of $200 and the following schedule for variable costs: Houses Painted Variable Costs 1 $10 2 $20 3 $40 4 $80 5 $160 6 $320 7 $640 Calculate average fixed cost, average variable cost, and average total cost for each quantity. Problem 8: Tax Policies The city government is considering two tax proposals: I A lump-sum tax of $300 on each producer of hamburgers. I A tax of $1 per burger, paid by producers of hamburgers. How would each tax affect the producer’s cost curves (fixed, variable, total, and marginal costs)? Graph the results. Problem 9: Juice Bar Costs Jane’s Juice Bar has the following cost schedules: Quantity Variable Cost Total Cost 0 0 30 1 10 40 2 25 55 3 45 75 4 70 100 5 100 130 6 135 165 1. Calculate average variable cost, average total cost, and marginal cost. 2. Graph all cost curves and explain the relationships. Problem 10: Long-Run Costs Consider the following table of long-run total costs for three firms: Quantity Firm A Firm B Firm C 1 $60 $11 $21 2 $70 $24 $34 3 $80 $39 $49 4 $90 $56 $66 5 $100 $75 $85 6 $110 $96 $106 7 $120 $119 $129 Does each firm experience economies or diseconomies of scale? Explain. Review of Key Concepts I Explicit vs. Implicit Costs. I Short-Run vs. Long-Run Costs. I Economies of Scale and Diseconomies of Scale. I Shortrun shutdown decision. Next Lecture Preview I Firms in Competitive Markets. I Profit Maximization. I Application to