Chapter 4 - Costs of Production PDF

Chapter 4 Costs of Production  Learning Objectives After this chapter, you will be able to: 1. identify economic costs (explicit and implicit) of production and economic profit. 2. describe short-run (total, average, and marginal) products and explain the law of diminishing...

Chapter 4 Costs of Production  Learning Objectives After this chapter, you will be able to: 1. identify economic costs (explicit and implicit) of production and economic profit. 2. describe short-run (total, average, and marginal) products and explain the law of diminishing marginal returns 3. derive short-run (total, average, and marginal) costs 4. explain the long-run results of production(increasing returns to scale, constant returns to scale and decreasing returns to scale) and long-run costs  Chapter 4.1 Production, Costs, and Profit  Production ✘ Production is the process of transforming a set of resources into a good or service ✘ Inputs are the resources (land, labour, capital) used in production ✘ Output is the quantity of a good or service that results from production  Productive Efficiency Businesses can choose from different production processes. A labour-intensive process employs more labour and less capital. A capital-intensive process employs more capital and less labour. The lowest-cost process to produce a given quantity provides productive efficiency – making a given amount of output at the lowest cost  Productive Efficiency Different combination of workers and sewing machines to produce 250 t-shirts. Workers Sewing Machines (Labour) (Capital) Process A 4 2 Process B 3 3 The lowest-cost process results in productive efficiency: making a given quantity of output at the lowest cost Workers Cost of Sewing Machines Cost of Total Cost (Labour) Labour (Capital) Capital ($/woker) ($/machine) ($) Process A 4 100 2 25 450 Process B 3 100 3 25 375  Accounting Profits vs. Economic Profits  Accounting Profit = Total Revenue – Total Costs (explicit costs)  Accounting Profits vs. Economic Profits Firms make many decisions but they always consider the “bottom line” Economic costs include: explicit costs, which are payments for resources and supplies (accounting costs) + implicit costs, which are what owners give up by being involved in a business (opportunity cost) Economic profit = Total Revenue – Economic Costs  Accounting Profits vs. Economic Profits  Accounting Profit = Total Revenue – Total Costs (explicit costs) ✘ Because accounting profits consider only explicit costs, accounting profits are always greater than economic profits  Accounting Profits vs. Economic Profits ✘ Normal Profit is the minimum return necessary for owners to keep their money and skills in the business (this occurs when Economics Profits = 0) ✘ If a business is only operating at normal profit levels, then the owner is making the same money whether running the business or switching to whatever he/she gave up to own the business.  Chapter 4.2 Production in the Short Run  Theory Of The Firm assumes: Producers always want to maximize profit. Adam Smith’s “invisible hand” of self interest leads them to... - Increase revenue and decrease cost which leads to... - Increase in profits. Fixed and Variable Inputs Variable Inputs: inputs whose quantities can be adjusted in the short run (e.g. labour, materials) Fixed Inputs: inputs whose quantities cannot be adjusted in the short run (e.g. land, capital)  Short Run and Long Run ✘ Short Run: max capacity becomes fixed because of a shortage of at least one resource (there is at least one fixed inputs- e.g. land) ✘ Long Run: all inputs can be varied. (e.g. lease eventually ends – can find new place to rent, or can build a new facility)  Law of Diminishing Marginal Returns Cultivated Labour Force Total Production Marginal Product Year Land (bushels of corn) (extra bushels) 0 0 0 0 1000 1 10 1 1000 1200 2 10 2 2200 1100 3 10 3 3300 800 4 10 4 4100 300 5 10 5 4400 0 6 10 6 4400 The law of diminishing marginal returns states that marginal product will increase when a variable input is increased, but only to a point. After this, increasing variable inputs will not have a positive effect on output because of decreasing efficiency in the use of the fixed inputs. Total, Average, & Marginal Product  Total Product (TP) = Q The total quantity produced with a given workforce  Average Product (AP) = TP/L the quantity of output produced per worker Marginal Product (MP) = ∆Q/∆L is the extra output produced by one more unit of an input (for instance, the difference in output when a firm's labour is increased from five to six workers)  The Three Stages of Production The relationship: When MP is increasing, TP is increasing rapidly (steep slope). When MP peaks and starts to Average decrease, Marginal product product TP is still peaks peaks at increasing twoslowly when but workers the second worker (flattening slope). As the number of workers increases, total product isWhen hiredMPand becomes becomes negative negative, at the TP starts same point to decrease. AP increases until the fifth that total product begins to drop peaks when it equals MP. worker is hired T-Shirts Produced per Day 300 Labour Total Marginal Average 250 TP (L) Product Product Product 200 (q) (Δq/ΔL) (q/L) 150 (workers (T-shirts (T-shirts (T-shirts 100 per day) per day) per day) per day) 50 0 1 2 3 4 5 6 0 0 -- Number of Workers Employed per Day 80 1 80 80 T-Shirts Produced per Day Diminishing 120 120 returns set in 2 200 100 100 50 80 3 250 83.3 20 60 4 270 67.5 40 AP 10 5 280 56 20 -10 0 6 270 45 -20 1 2 3 4 5 6 MP Number of Workers Employed per Day  Chapter 4.3 Costs in the Short Run The Theory Of The Firm The economic relationship between profit, revenue and cost, can be expressed in simple equation: Total Profit = Total Revenues – Total Costs  Fixed Cost and Variable Cost ✘ Fixed Costs: costs that remain the same at all levels of output. ○ example: rent, property taxes, interest on loans. ✘ Variable Costs: costs that change with the levels of output. ○ example: labour, fuel, raw materials, and power.  Total, Average, & Marginal Costs Total Costs: Total Costs: TC = FC + VC Average (per-unit costs): Average Fixed Cost: AFC = FC/Q Average Variable Cost: AVC = VC/Q Average Cost: AC = TC/Q or AVC + AFC Marginal cost is the extra cost of producing an additional unit of output Marginal Cost MC = ∆TC/∆Q  Short-Run Costs for Pure ‘n’ Simple T- Shirts 1 2 3 4 5 6 7 8 9 10 Labour Total Margin Fixed Variable Total Marginal Average Average Average Product al Costs Costs Cost Cost Fixed CostsVariable Cost (L) (q) Produc (FC) (VC) (TC) (MC) (AFC) Costs (AC) t (MP) (FC + VC) (ΔTC/Δq) (FC/q) (AVC) (AFC + AVC) (VC/q) 0 0 $825 $0 $825 100/80 80 $1.25 1 80 825 100 925 $10.31 $1.25 $11.56 100/120 120 0.83 2 200 825 200 1025 4.13 1.00 5.13 100/50 50 2.00 3 250 825 300 1125 3.30 1.20 4.50 100/20 20 5.00 4 270 825 400 1225 3.06 1.48 4.54 100/10 10 10.00 5 280 825 500 1325 2.95 1.79 4.74 Columns 4 and 5 represent fixed costs of $825 and variable costs ($100/worker) Total costs in column 6 is the sum of the fixed and variable costs Marginal cost in column 7 is found by dividing the change in total cost by the change in total product (quantity). Columns 8 and 9 are derived by dividing fixed and variable costs by total product. Average cost in column 10 is the sum of the average fixed and the average variable costs. Short-Run Costs WITH 2 VARIABLE COSTS 1 2 3 4 5 6 7 8 9 10 Labour Total Margin Fixed Variable Total Marginal Average Average Average Product al Costs Costs Cost Cost Fixed CostsVariable Cost (L) (q) Produc (FC) (VC) (TC) (MC) (AFC) Costs (AC) t (MP) (FC + VC) (ΔTC/Δq) (FC/q) (AVC) (AFC + AVC) (VC/q) 0 0 $825 $0 $825 140/80 80 $1.75 1 80 825 140 965 $10.31 $1.75 $12.06 160/120 120 1.33 2 200 825 300 1125 4.13 1.50 5.63 125/50 50 2.50 3 250 825 425 1250 3.30 1.70 5.00 110/20 20 5.50 4 270 825 535 1360 3.06 1.98 5.04 105/10 10 10.50 5 280 825 640 1465 2.95 2.29 5.24 Columns 4 and 5 represent fixed costs of $825 and variable costs ($100/worker and $0.50/per shirt) Total costs in column 6 is the sum of the fixed and variable costs Marginal cost in column 7 is found by dividing the change in total cost by the change in total product (quantity). Columns 8 and 9 are derived by dividing fixed and variable costs by total product. Average cost in column 10 is the sum of the average fixed and the average variable costs.  $ Marginal Cost Cost/ Revenue MC MP Output - MC curve us shaped like a “J” because of the law of diminishing returns - MC is essentially the mirror image of MP... Cool!...because of the law of DMR  The Family of Short-Run Cost Curves 12 MC 10 8 $ per T-Shirt 6 AC b 4 AFC 2 AVC a 0 50 100 150 200 250 300 Quantity of T-Shirts Produced Per Day The relationship: - As output rises, AFC curve falls. - AVC curve falls until it reaches its minimum where it meets the MC curve, then it starts to rise. - AC curve also falls and rises again after it reaches its minimum at the MC curve.  Chapter 4.4 Production in the Long Run Costs in the Long Run Recall that in the short run, some input resources are fixed (e.g. machinery, building, cultivated land) But…in the long run, these can be adjusted (all inputs become variable) Also…. Recall that in the short run the law of diminishing marginal returns applies But….in the long run this does not apply. Instead there is a new situation that arises  Recall…. Cultivated Labour Force Total Production Marginal Production Year Land (bushels of corn) (extra bushels) 0 0 0 0 1000 1 10 1 1000 1200 2 10 2 2200 1100 3 10 3 3300 800 4 10 4 4100 300 5 10 5 4400 0 6 10 6 4400 Law of Diminishing Marginal Returns occurs in the short run when at least one input is fixed (cannot be increased – i.e. cultivated land)  Law of Increasing Returns to Cultivated Labour Force Total Production Marginal Production Year Scale Land (bushels of corn) (extra bushels) 0 0 0 0 1000 1 10 1 1000 1400 2 20 2 2400 1800 3 30 3 4200 2200 4 40 4 6400 3600 5 50 5 10,000 5000 6 60 6 15,000 - The law of increasing returns to scale occurs when all productive resources are increased simultaneously. e.g. farmer has increased the scale of operations. - Since in the real world productive resources are limited, eventually the availability of productive resources will end and the law of diminishing returns will once again prevail. Increasing Returns to Scale ✘ All inputs can be changed by the same proportion in the long run. ○ Increasing returns to scale means: % change in output > the % change in inputs. ○ Increasing returns to scale are caused by: division of labour specialized capital specialized management. Constant Returns to Scale ○ Constant returns to scale means : % change in output = the % change in inputs. ○ Constant returns to scale arise whenever making more of a product means repeating exactly the same tasks. Decreasing Returns to Scale Decreasing returns to scale means: % change in output < the % change in inputs Decreasing returns to scale are caused by: management difficulties limited natural resources.  Costs in the Long Run Long-Run Average Costs AC4 AC1 Long-Run AC $ per Magazine AC2 AC3 Range A Range B Range C Quantity of Magazines per Week - initial range of increasing returns to scale - middle range of constant returns to scale - final range of decreasing returns to scale - Long-run average cost is the minimum short-run average cost at every output. - The long-run average cost curve is saucer-shaped because of various Costs in the Long Run Long-Run Average Costs in Different Industries Extended Range of Extended Range of Extended Range of Increasing Returns Constant Returns Decrease Returns to Scale to Scale to Scale – Manufacturing – Craft Industries - Primary Industries Industries Long-Run AC $ per Unit $ per Unit $ per Unit Long-Run AC Long-Run AC Quantity of Output Quantity of Output Quantity of Output