Costs of Production PDF

Learning objectives In this chapter you will: examine what items are included in a firm’s costs of production The Costs of analyse the link between a firm’s production process Production and its total costs learn the meaning of av...

Learning objectives In this chapter you will: examine what items are included in a firm’s costs of production The Costs of analyse the link between a firm’s production process Production and its total costs learn the meaning of average total cost and marginal cost and how they are related consider the shape of a typical firm’s cost curves examine the relationship between short-run and long-run costs  ▪ The economy is made up of thousands of firms. ▪ Some firms are large; they employ thousands of workers The Costs of and have thousands of shareholders who share in the Production firms’ profits. ▪ Other firms, such as the local hairdresser or café, are small; they employ only a few workers and are owned by a small group of people  What are costs? ▪ John, the owner of the firm, buys flour, sugar and other The Costs of cake ingredients. Production ▪ He also buys the mixers and ovens, and he hires workers to run this equipment. ▪ He then sells the resulting cakes to consumers.  Total revenue, total cost and profit ▪ Economists normally assume that the goal of a firm is to maximize profit and they find that this assumption works well in most cases. ▪ What is a firm’s profit? The amount that the firm receives for the sale of its output (cakes) is called total revenue. The Costs of ▪ The amount that the firm pays to buy inputs (flour, Production sugar, workers, ovens and so on) is called total cost. ▪ John gets to keep any revenue that is not needed to cover costs. ▪ Profit is a firm’s total revenue minus its total cost. ▪ That is: Profit = Total revenue − Total cost ▪ John’s objective is to make his firm’s profit as large as possible  Costs as opportunity costs ▪ A firm’s opportunity costs of production are sometimes obvious and sometimes less so. ▪ When John pays $1000 for flour, that $1000 is an opportunity cost because John can no longer use that $1000 to buy something else. The Costs of ▪ Similarly, when John hires workers to make the cakes, the wages he pays are part of the firm’s costs. Production ▪ These costs are explicit. In contrast, some of a firm’s opportunity costs are implicit. ▪ Imagine that John is a skilled painter and could earn $100 per hour from her artwork. For every hour that John works at his cake factory he gives up $100 in income and this forgone income is also part of his costs. ▪ The total cost of John’s business is the sum of his explicit and implicit costs.  ▪ This distinction between explicit and implicit costs highlights an important difference between how economists and accountants analyse a business. ▪ Economists are interested in studying how firms make The Costs of production and pricing decisions, so they include all Production opportunity costs when measuring costs. ▪ In contrast, accountants have the job of keeping track of the money that flows into and out of firms. As a result, they measure the explicit costs but often ignore the implicit costs  The cost of capital as an opportunity cost ▪ An important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. ▪ Suppose, for instance, that John used $300 000 of her The Costs of savings to buy the cake factory from the previous owner. Production ▪ If John had instead left this money in a savings account that pays an interest rate of 5 per cent, he would have earned $15 000 per year. ▪ To own his cake factory, therefore, John has given up $15 000 a year in interest income. This $15 000 is one of the opportunity costs of John’s business.  ▪ Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. ▪ Once again, we consider John’s Cake Factory. In the analysis that follows, we make an important simplifying Production and assumption: we assume that the size of John’s factory is fixed and that John can vary the quantity of cake costs produced only by changing the number of workers. ▪ This assumption is realistic in the short run, but not in the long run. That is, John cannot build a larger factory overnight, but he could do so over the next year or two.  ▪ short run a period of time during which at least one Production and factor of production is fixed ▪ long run the period of time needed for all factors of costs production to become variable  ▪ One of the Ten Principles of Economics is that rational people think at the margin. ▪ As we will see in future chapters, this idea is the key to understanding how firms decide how many workers to hire and how much output to produce. ▪ To take a step towards these decisions, column (3) in Production and Table gives the marginal product of a worker. costs ▪ The marginal product of any input into production is the increase in the quantity of output obtained from an additional unit of that input. ▪ When the number of workers goes from one to two, cake production increases from 50 to 90, so the marginal product of the second worker is 40 cakes.  ▪ Diminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increases. ▪ At first, when only a few workers are hired, they have easy access to John’s kitchen equipment. ▪ As the number of workers increases, additional workers Production and have to share equipment and work in more crowded conditions. costs ▪ Eventually, the factory becomes so overcrowded that workers often get in each other’s way. Hence, as more workers are hired, each additional worker contributes fewer additional cakes to total production. ▪ That is, the slope of the production function measures the marginal product. Production and costs  ▪ George’s total cost can be divided into two types. ▪ Some costs, called fixed costs, do not vary with the quantity of output produced. They are incurred even if the firm produces nothing at all. ▪ George’s fixed costs include the rent he pays because this cost is the same regardless of how much coffee he The various produces. measures of ▪ Some of the firm’s costs, called variable costs, change as the firm alters the quantity of output produced. cost George’s variable costs include the cost of coffee beans, milk and sugar. ▪ The more coffee George makes, the more of these items he needs to buy. Similarly, if George has to hire more workers to make more coffee, the salaries of these workers are variable costs.  Average and marginal cost ▪ As the owner of his firm, George has to decide how much to produce. ▪ One issue he will want to consider when making this decision is how the level of production affects his firm’s costs. In making this decision, George might ask his production supervisor the following two questions Production and about the cost of producing coffee: costs ▪ How much does it cost to make the typical cup of coffee? ▪ How much does it cost to increase production of coffee by one cup? These two questions might seem to have the same answer, but they do not. Both answers are important for understanding how firms make production decisions  ▪ average total cost total cost divided by the quantity of output ▪ average fixed cost fixed costs divided by the quantity of output ▪ average variable cost variable costs divided by the Production and quantity of output costs ▪ Average total cost tells us the cost of the typical unit, but it does not tell us how much total cost will change as the firm alters its level of production ▪ Marginal cost the increase in total cost that arises from an extra unit of production  ▪ Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units Production and produced. Marginal cost tells us the increase in total costs cost that arises from producing an additional unit of output. Quantity of T.C F.C V.C A.F.C A.V.C A.T.C M.C coffee(cups Per hour) 0 3.00 3.00 1 3.30 2 3.80 3 4.50 4 5.40 5 6.50 6 7.80 7 9.30 8 11.0 9 12.9 10 15.0