Principle of Economics Chapter 6 PDF

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 6 Production and Cost  The Concepts of Cost: Explicit Cost and Implicit Cost, Accounting Profit Versus Economic Profit INTHISLECTURE Production: Short Run Versus Long Run, Production in the...

PRINCIPLE OF ECONOMICS NOOR SA'ADAH SABUDIN SEFB CHAPTER 6 Production and Cost  The Concepts of Cost: Explicit Cost and Implicit Cost, Accounting Profit Versus Economic Profit INTHISLECTURE Production: Short Run Versus Long Run, Production in the Short Run: Marginal Physical Product (MPP) and Marginal Cost (MC), Average Productivity (AP) – numerical/table and graphical. Cost: Cost in the Short Run: Fixed Cost, Variable Cost, Total Cost, Average Fixed Cost, Average variable Cost, Average Total Cost, Marginal Cost – numerical/table and graphical, Average Marginal Rule, The Relationship between Production to Cost Production and Cost in the Long Run: Long Run Average Total Cost Curve (LRATC), Economies, Constant and Diseconomies of Scales After studying this chapter, you will be able: To explain the definition of explicit costs and implicit costs. To explain the difference between accounting profit and economic profit. To distinguish the short run and long run production. To explain the production in the short run (numerical/table and graph). After studying this chapter, you will be able: To explain the cost in short run (numerical/table and graph). To explain the relationship between marginal and average cost as well production. To explain the relationship between marginal and average cost as well production.. To explain the production and cost in the long run. To explain the concept and the characteristics of economies of scale and diseconomies of scale.  THE BEHAVIOR OF PROFIT-MAXIMIZING FIRMS All firms must make several basic decisions to achieve what we assume to be their primary objective— maximum profits. The Three Decisions That All Firms Must Make  PROFITS AND ECONOMIC COSTS Profit: The difference between total revenue and total cost π = (TR – TC) A firm’s cost of production includes all the opportunity costs of making its output of goods and services. A firm’s cost of production include explicit costs and implicit costs.  PROFITS AND ECONOMIC COSTS Explicit Cost - A cost incurred when an actual (monetary) payment is made. For example, payment to factors of production such as labor services, machinery hirer, transport, etc. Implicit Cost - A cost that represents the value of resources used in production for which no actual (monetary) payment is made. For example, wages should be received as a worker (for their time and talents), the rent should be received if the business premises rented to others, and the rate of interest should be received if the money is kept at the bank.  PROFITS AND ECONOMIC COSTS Accounting Profit vs Economic Profit Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs [π = TR – (exp + imp)]. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. [π = TR – (exp)].  PROFITS AND ECONOMIC COSTS Accounting Profit vs Economic Profit When total revenue exceeds both explicit and implicit costs, the firm earns economic profit (positive economic profit). Economic profit is smaller than accounting profit. A firm that earns normal profit / zero economic profit / normal rate of return is earning revenue equal to its total costs (explicit plus implicit costs). This is the level of profit necessary to keep resources employed in that particular firm.  PROFITS AND ECONOMIC COSTS Accounting Profit vs Economic Profit  PROFITS AND ECONOMIC COSTS How an Economist How an Accountant Views a Firm Views a Firm Economic profit Accounting profit Implicit Revenue costs Revenue Total opportunity costs Explicit Explicit costs costs  PROFITS AND ECONOMIC COSTS Accounting Profit vs Economic Profit Example of Calculation Ali has two choices either to receive job offers with salaries RM 30,000 per year or open his own printing business. If he chooses to do business, he needs to invest RM50,000 which now kept in the bank with interest rate of 7% per annum. He plans to use his own building which is currently rented to others at RM 1500 per month. Expected total revenue (TR) in the first year is RM 107,000. Other expenses involved are: advertising (RM5000), photocopier rental (RM10,000), tax (RM5000), wages (RM40,000) and materials (RM5000).  PROFITS AND ECONOMIC COSTS Accounting Profit vs Economic Profit ACCOUNTING PROFIT APPROACH Total Revenue (TR) RM107,000 Minus: Explicit Cost Advertising RM 5,000 Rental (machine) RM10,000 Tax RM 5,000 Wages RM40,000 Materials RM 5,000 Total Cost (TC) -RM 65,000 Net Accounting Profit +RM 42,000  PROFITS AND ECONOMIC COSTS Accounting Profit vs Economic Profit ECONOMIC PROFIT APPROACH Total Revenue (TR) RM107,000 Minus: Explicit Cost Advertising RM 5,000 Rental (machine) RM10,000 Tax RM 5,000 Wages RM40,000 Materials RM 5,000 Implicit Cost Opportunity cost (wage) RM30,000 Opportunity cost (interest 7% x RM50,000) RM 3,500 Opportunity cost (rent of RM1,500 x 12) RM18,000 Total Cost (TC) -RM116,500 Net Economic Profit -RM 9,500 PRODUCTION:SHORT RUNVSLONG RUN Two Types of Factor Inputs Fixed Input An input which the quantity does not change according to the amount of output. Example: Machinery, land, buildings, tools, equipment, etc. Variable Input An input which the quantity changes according to the amount of output. Example: Raw materials, electricity, fuel, transportation, communication, etc. PRODUCTION:SHORT RUNVSLONG RUN Short-run and Long-run Periods Short run period is the time frame, which at least one of the inputs (factor of production) is fixed and other inputs can be varied. Long run period is the time frame which all inputs are variable. PRODUCTION IN THE SHORT RUN In the short run, we assume that at least one of the inputs is fixed that is capital. Therefore, in the short run the production function can be written as: Q = ( K , L) Where: Q = Output / Total Production L = Labour K = Capital (fixed) PRODUCTION IN THE SHORT RUN To increase output in the short run, a firm must increase the amount of labor employed. Three concepts describe the relationship between output and the quantity of labor employed: 1. Total product (TP) 2. Marginal product (MP/MPP) 3. Average product (AP/APP)  PRODUCTION IN THE SHORT RUN Production Functions: Total Product (TP), Marginal Product (MP), and Average Product (AP) Total product (TP) is the total output / quantity produced in a given period. The marginal product (MP/MPP) of labor is the change in total product that results from a one-unit increase in the quantity of labor employed, with all other inputs remaining the same. The average product (AP/APP) of labor is equal to total product divided by the quantity of labor employed.  PRODUCTION IN THE SHORT RUN Production Functions: Total Product (TP), Marginal Product (MP), and Average Product (AP) MP/MPP = Changes in Total Production = ∆TP Changes in Labor ∆L AP/APP = Total Production = TP Labor L  PRODUCTION IN THE SHORT RUN Production in the Short Run and the Law of Diminishing Marginal Returns In the short run, as additional units of a variable input are added to a fixed input, the marginal product of the variable input may increase at first. Eventually, the marginal product of the variable input decreases. The point at which marginal physical product decreases is the point at which diminishing marginal returns have set in.  PRODUCTION IN THE SHORT RUN Production in the Short Run and the Law of Diminishing Marginal Returns Law of Diminishing Marginal Returns - As ever-larger amounts of a variable input are combined with fixed inputs, eventually, the marginal physical product of the variable input will decline. PRODUCTION IN THE SHORT RUN Capital Labor Total Marginal Average Stages of (Fixed (Variable Product Product Product Production input) input) (TP) (MP) (AP) 10 0 0 0 0 10 1 8 8 8 10 2 20 12 10 STAGE I 10 3 33 13 11 10 4 44 11 11 10 5 50 6 10 10 6 54 4 9 STAGE II 10 7 56 2 8 10 8 56 0 7 10 9 54 -2 6 STAGE III 10 10 50 -4 5 MP = 54 - 56 AP = 56 9-8 8 = -2 = 7 PRODUCTION IN THE SHORT RUN Product Curves Product curves show how the firm’s total product, marginal product, and average product change as the firm varies the quantity of labor employed.  PRODUCTION IN THE SHORT RUN RELATIONSHIP BETWEEN TP AND MP RELATIONSHIP BETWEEN AP AND MP When MP is increasing, TP increase at an increasing rate. When MP is above AP , AP is increasing When MP is decreasing, TP increase at a decreasing rate. When MP is below AP, AP is decreasing. When MP is zero, TP at its maximum. When MP equals to AP, AP is at maximum. When MP is negative, TP declines. 60 TP MAX STAGE I STAGE II STAGE III 50 40 30 TP MP 20 AP MAX; AP =MP AP 10 MP=0 0 1 2 3 4 5 6 7 8 9 10 -10 PRODUCTION IN THE SHORT RUN Stage I Stage II  Proportion of fixed factors are  Called law of diminishing marginal returns greater than variable factors  The most efficient stage of production  Under utilization of fixed factor because the combinations of inputs are fully  Operation involves a waste of resources utilized STAGES OF PRODUCTION Stage III  Proportion of fixed factors is lower than variable factors  Increase in variable factors decline the TP because of overcrowding  A producer would not like to operate at this stage  PRODUCTION IN THE SHORT RUN STAGES OF PRODUCTION PRODUCTION IN THE SHORT RUN STAGES OF PRODUCTION PRODUCTION IN THE SHORT RUN STAGES OF PRODUCTION PRODUCTION IN THE SHORT RUN Total Product Curve The figure shows a total product curve. The total product curve shows how total product changes with the quantity of labor employed. PRODUCTION IN THE SHORT RUN The total product curve is similar to the PPF. It separates attainable output levels from unattainable output levels in the short run. PRODUCTION IN THE SHORT RUN Marginal Product Curve The figure shows the marginal product of labor curve and how the marginal product curve relates to the total product curve. The first worker hired produces 4 units of output. PRODUCTION IN THE SHORT RUN The second worker hired produces 6 units of output and total product becomes 10 units. The third worker hired produces 3 units of output and total product becomes 13 units. And so on. PRODUCTION IN THE SHORT RUN The height of each bar measures the marginal product of labor. For example, when labor increases from 2 to 3, total product increases from 10 to 13, so the marginal product of the third worker is 3 units of output. PRODUCTION IN THE SHORT RUN To make a graph of the marginal product of labor, we can stack the bars in the previous graph side by side. The marginal product of labor curve passes through the mid-points of these bars. PRODUCTION IN THE SHORT RUN Almost all production processes are like the one shown here and have:  Increasing marginal returns initially  Diminishing marginal returns eventually PRODUCTION IN THE SHORT RUN Increasing Marginal Returns Initially, the marginal product of a worker exceeds the marginal product of the previous worker. The firm experiences increasing marginal returns. PRODUCTION IN THE SHORT RUN Diminishing Marginal Returns Eventually, the marginal product of a worker is less than the marginal product of the previous worker. The firm experiences diminishing marginal returns. PRODUCTION IN THE SHORT RUN Increasing marginal returns arise from increased specialization and division of labor. Diminishing marginal returns arises because each additional worker has less access to capital and less space in which to work. Diminishing marginal returns are so pervasive that they are elevated to the status of a “law.” The law of diminishing marginal returns states that: As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes. PRODUCTION IN THE SHORT RUN Average Product Curve Figure 11.3 shows the average product curve and its relationship with the marginal product curve. When marginal product exceeds average product, average product increases. PRODUCTION IN THE SHORT RUN When marginal product is below average product, average product decreases. When marginal product equals average product, average product is at its maximum. SHORT-RUN COST To produce more output in the short run, the firm must employ more labor, which means that it must increase its costs. Three cost concepts and three types of cost curves are  Total cost (TC/TFC/TVC)  Marginal cost (MC)  Average cost (AVC/AFC/AFC) SHORT-RUN COST Total Cost A firm’s total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC SHORT-RUN COST The figure shows a firm’s total cost curves. Total fixed cost is the same at each output level. Total variable cost increases as output increases. Total cost, which is the sum of TFC and TVC also increases as output increases. SHORT-RUN COST The AVC curve gets its shape from the TP curve. Notice that the TP curve becomes steeper at low output levels and then less steep at high output levels. In contrast, the TVC curve becomes less steep at low output levels and steeper at high output levels. SHORT-RUN COST To see the relationship between the TVC curve and the TP curve, lets look again at the TP curve. But let us add a second x-axis to measure total variable cost. 1 worker costs $25; 2 workers cost $50; and so on, so the two x-axes line up. SHORT-RUN COST We can replace the quantity of labor on the x-axis with total variable cost. When we do that, we must change the name of the curve. It is now the TVC curve. But it is graphed with cost on the x-axis and output on the y-axis. SHORT-RUN COST Redraw the graph with cost on the y-axis and output on the x-axis, and you’ve got the TVC curve drawn the usual way. Put the TFC curve back in the figure, and add TFC to TVC, and you’ve got the TC curve. SHORT-RUN COST Marginal Cost Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. MC = ∆TC/ ∆Q Over the output range with increasing marginal returns, marginal cost falls as output increases. Over the output range with diminishing marginal returns, marginal cost rises as output increases.  Total Variable Cost and Marginal Cost for a SHORT-RUN COST Typical Firm Total Variable Cost and Marginal Cost Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit. Thus, the marginal cost curve shows how total variable cost changes with single-unit increases in total output. SHORT-RUN COST Average Cost Average cost measures can be derived from each of the total cost measures: Average fixed cost (AFC) is total fixed cost per unit of output. AFC = TFC/Q Average variable cost (AVC) is total variable cost per unit of output. AVC = TVC/Q Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC @ ATC = TC/Q SHORT-RUN COST The figure shows the MC, AFC, AVC, and ATC curves. The AFC curve shows that average fixed cost falls as output increases. The AVC curve is U-shaped. As output increases, average variable cost falls to a minimum and then increases. SHORT-RUN COST The ATC curve is also U-shaped. The MC curve is very special. For outputs over which AVC is falling, MC is below AVC. For outputs over which AVC is rising, MC is above AVC. For the output at minimum AVC, MC equals AVC. SHORT-RUN COST Similarly, for the outputs over which ATC is falling, MC is below ATC. For the outputs over which ATC is rising, MC is above ATC. For the output at minimum ATC, MC equals ATC. SHORT-RUN COST Why the Average Variable Cost Curve Is U- Shaped Initially, MP exceeds AP, which brings rising AP and falling AVC. Eventually, MP falls below AP, which brings falling AP and rising AVC. The ATC curve is U-shaped for the same reasons. In addition, ATC falls at low output levels because AFC is falling quickly. SHORT-RUN COST Why the Average Total Cost Curve Is U-Shaped The ATC curve is the vertical sum of the AFC curve and the AVC curve. The U-shape of the ATC curve arises from the influence of two opposing forces: 1. Spreading total fixed cost over a larger output—AFC curve slopes downward as output increases. 2. Eventually diminishing returns—the AVC curve slopes upward and AVC increases more quickly than AFC is decreasing. SHORT-RUN COST SHORT-RUN COST SHORT-RUN COST Cost Curves and Product Curves The shapes of a firm’s cost curves are determined by the technology it uses. We’ll look first at the link between total cost and total product and then … at the links between the average and marginal product and cost curves. SHORT-RUN COST Total Product and Total Variable Cost Figure 11.6 shows when output is plotted against labor, the curve is the TP curve. When output is plotted against variable cost, the curve is the TVC curve … but it is flipped over. SHORT-RUN COST Average and Marginal Product and Cost The firm’s cost curves and product curves are linked:  MC is at its minimum at the same output level at which MP is at its maximum.  When MP is rising, MC is falling.  AVC is at its minimum at the same output level at which AP is at its maximum.  When AP is rising, AVC is falling. SHORT-RUN COST The figure shows these relationships. SHORT-RUN COST Average-Marginal Rule When the marginal magnitude is above the average magnitude, the average magnitude rises; when the marginal magnitude is below the average magnitude, the average magnitude falls. SHORT-RUN COST Average-Marginal Rule SHORT-RUN COST Relationship Between Cost and Productivity W = Wages (variable cost) MPP = Marginal Physical Product MC = Marginal Cost SHORT-RUN COST SHORT-RUN COST How MPP Affects MC LONG-RUN COST In the long run, all inputs are variable and all costs are variable. The Production Function The behavior of long-run cost depends upon the firm’s production function. The firm’s production function is the relationship between the maximum output attainable and the quantities of both capital and labor. LONG-RUN COST Table 11.3 shows a firm’s production function. As the size of the plant increases, the output that a given quantity of labor can produce increases. But for each plant, as the quantity of labor increases, diminishing returns occur. LONG-RUN COST Diminishing Marginal Product of Capital The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labor employed. A firm’s production function exhibits diminishing marginal returns to labor (for a given plant) as well as diminishing marginal returns to capital (for a quantity of labor). For each plant, diminishing marginal product of labor creates a set of short run, U-shaped cost curves for MC, AVC, and ATC. LONG-RUN COST Short-Run Cost and Long-Run Cost The average cost of producing a given output varies and depends on the firm’s plant. The larger the plant, the greater is the output at which ATC is at a minimum. The firm has 4 different plants: 1, 2, 3, or 4 knitting machines. Each plant has a short-run ATC curve. The firm can compare the ATC for each output at different plants. LONG-RUN COST ATC1 is the ATC curve for a plant with 1 knitting machine. LONG-RUN COST ATC2 is the ATC curve for a plant with 2 knitting machines. LONG-RUN COST ATC3 is the ATC curve for a plant with 3 knitting machines. LONG-RUN COST ATC4 is the ATC curve for a plant with 4 knitting machines. LONG-RUN COST The long-run average cost curve is made up from the lowest ATC for each output level. So, we want to decide which plant has the lowest cost for producing each output level. Let’s find the least-cost way of producing a given output level. Suppose that the firm wants to produce 13 sweaters a day. LONG-RUN COST 13 sweaters a day cost $7.69 each on ATC1. LONG-RUN COST 13 sweaters a day cost $6.80 each on ATC2. LONG-RUN COST 13 sweaters a day cost $7.69 each on ATC3. LONG-RUN COST 13 sweaters a day cost $9.50 each on ATC4. LONG-RUN COST The least-cost way of producing 13 sweaters a day is to use 2 knitting machines. LONG-RUN COST Long-Run Average Cost Curve The long-run average cost curve is the relationship between the lowest attainable average total cost and output when both the plant and labor are varied. The long-run average cost curve is a planning curve that tells the firm the plant that minimizes the cost of producing a given output range. Once the firm has chosen its plant, the firm incurs the costs that correspond to the ATC curve for that plant. The LRATC curve is not scalloped because it is assumed that there are so many plant sizes that the LRATC curve touches each SRATC curve at only one point.  LONG-RUN COST The figure illustrates the long-run average cost (LRAC) curve. LONG-RUN COST Economies and Diseconomies of Scale Economies of scale exist when inputs are increased by some percentage and output increases by a greater percentage, causing unit costs to fall. Diseconomies of scale exist when inputs are increased by some percentage and output increases by a smaller percentage, causing unit costs to rise. Constant returns to scale exist when inputs are increased by some percentage and output increases by an equal percentage, causing unit costs to remain constant. LONG-RUN COST The figure illustrates economies and diseconomies of scale. LONG-RUN COST Why Economies of Scale? Up to a certain point, long-run unit costs of production fall as a firm grows. There are two main reasons for this: Growing firms offer greater opportunities for employees to specialize. Growing firms can take advantage of highly efficient mass production techniques and equipment that ordinarily require large setup costs and thus are economical only if they can be spread over a large number of units. LONG-RUN COST Why Diseconomies of Scale? In very large firms, managers often find it difficult to coordinate work activities, communicate their directives to the right persons in satisfactory time, and monitor personnel effectively. LONG-RUN COST Minimum Efficient Scale A firm experiences economies of scale up to some output level. Beyond that output level, it moves into constant returns to scale or diseconomies of scale. Minimum efficient scale is the smallest quantity of output at which the long-run average cost reaches its lowest level. If the long-run average cost curve is U-shaped, the minimum point identifies the minimum efficient scale output level. LONG-RUN COST Minimum Efficient Scale Think for a moment.