Week 7 Class Output and Costs (3) PDF

Output & Costs ECON 1000: Microeconomics for Managers Week 7 Professor Irene Henriques Learning outcomes:  Explain and distinguish between the economic and accounting measures of a firm’s cost of production and profit  Explain and illustrate a firm’s short-run product curves ...

Output & Costs ECON 1000: Microeconomics for Managers Week 7 Professor Irene Henriques Learning outcomes:  Explain and distinguish between the economic and accounting measures of a firm’s cost of production and profit  Explain and illustrate a firm’s short-run product curves  Explain and derive a firm’s short-run cost curves © 2025 Pearson Education  Economic Cost and Profit A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. The Firm’s Goal A firm’s goal is to maximize profit. If the firm fails to maximize its profit, the firm is either eliminated or taken over by another firm that seeks to maximize profit. © 2025 Pearson Canada  Economic Cost and Profit Accounting Profit Accountants measure a firm’s profit to ensure that the firm pays the correct amount of tax and to show it investors how their funds are being used. Profit equals total revenue minus total cost. Accountants use Revenue Canada rules based on standards established by the accounting profession. © 2025 Pearson Canada  Economic Cost and Profit Economic Accounting Economists measure a firm’s profit to enable them to predict the firm’s decisions, and the goal of these decisions is to maximize economic profit. Economic profit is equal to total revenue minus total cost, with total cost measured as the opportunity cost of production. © 2025 Pearson Canada  Economic Cost and Profit A Firm’s Opportunity Cost of Production A firm’s opportunity cost of production is the value of the best alternative use of the resources that a firm uses in production. A firm’s opportunity cost of production is the sum of the cost of using resources  Bought in the market  Owned by the firm  Supplied by the firm's owner © 2025 Pearson Canada  Economic Cost and Profit Explicit costs are the input costs that require an outlay of money by the firm. Implicit costs are the input costs that do not require an outlay of money by the firm. Resources Bought in the Market – an explicit cost The amount spent by a firm on resources bought in the market is an opportunity cost of production because the firm could have bought different resources to produce some other good or service. © 2025 Pearson Canada  Economic Cost and Profit Resources Owned by the Firm – an implicit cost If the firm owns capital and uses it to produce its output, then the firm incurs an opportunity cost. The firm incurs an opportunity cost of production because it could have sold the capital and rented capital from another firm. The firm implicitly rents the capital from itself. The firm’s opportunity cost of using the capital it owns is called the implicit rental rate of capital. © 2025 Pearson Canada  Economic Cost and Profit The implicit rental rate of capital is made up of 1. Economic depreciation 2. Interest forgone Economic depreciation is the change in the market value of capital over a given period. Interest forgone is the return on the funds used to acquire the capital. © 2025 Pearson Canada  Economic Cost and Profit 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. Irene used $300 000 of her savings to buy her factory. If Irene had instead left this money in a savings account that pays an interest rate of 5 percent, she would have earned $15 000 per year. This forgone $15 000 is one of the implicit © 2025 Pearson Canada  Economic Cost and Profit Resources Supplied by the Firm’s Owner The owner might supply both entrepreneurship and labour. The return to entrepreneurship is profit. The profit that an entrepreneur can expect to receive on average is called normal profit. Normal profit is the cost of entrepreneurship and is an opportunity cost of production. © 2025 Pearson Canada  Economic Cost and Profit In addition to supplying entrepreneurship, the owner might supply labour but not take a wage. The opportunity cost of the owner’s labour is the wage income forgone by not taking the best alternative job. Economic Accounting: A Summary Economic profit equals a firm’s total revenue minus its total opportunity cost of production. The example in Table 10.1 on the next slide summarizes the economic accounting. © 2025 Pearson Canada Economic Cost and Profit © 2025 Pearson Canada  Economists versus Accountants Explicit costs are the input costs that require an outlay of money by the firm. Implicit costs are the input costs that do not require an outlay of money by the firm.  Economic Cost and Profit Decision Time Frames The firm makes many decisions to achieve its main objective: profit maximization. Some decisions are critical to the survival of the firm. Some decisions are irreversible (or very costly to reverse). Other decisions are easily reversed and are less critical to the survival of the firm, but still influence profit. All decisions can be placed in two time frames:  The short run  The long run © 2025 Pearson Canada  Economic Cost and Profit The Short Run The short run is a time frame in which the quantity of one or more resources used in production is fixed. For most firms, the capital, called the firm’s plant, is fixed in the short run. Other resources used by the firm (such as labour, raw materials, and energy) can be changed in the short run. Short-run decisions are easily reversed. © 2025 Pearson Canada  Economic Cost and Profit The Long Run The long run is a time frame in which the quantities of all resources—including the plant size—can be varied. Long-run decisions are not easily reversed. A sunk cost is a cost incurred by the firm and cannot be changed. If a firm’s plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are irrelevant to a firm’s current decisions. © 2025 Pearson Canada  Short-Run Technology Constraint To increase output in the short run, a firm must increase the amount of labour employed. Three concepts describe the relationship between output and the quantity of labour employed: 1. Total product 2. Marginal product 3. Average product © 2025 Pearson Canada  Short-Run Technology Constraint Product Schedules Total product is the total output produced in a given period. The marginal product of labour is the change in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same. The average product of labour is equal to total product divided by the quantity of labour employed. © 2025 Pearson Canada  Short-Run Technology Constraint Table 10.1 shows a firm’s product schedules. As the quantity of labour employed increases:  Total product increases.  Marginal product increases initially … but eventually decreases.  Average product decreases. © 2025 Pearson Canada  Short-Run Technology Constraint Product Curves Product curves show how the firm’s total product, marginal product, and average product change as the firm varies the quantity of labour employed. © 2025 Pearson Canada  Short-Run Technology Constraint Total Product Curve Figure 10.1 shows a total product curve. The total product curve shows how total product changes with the quantity of labour employed. © 2025 Pearson Canada  Short-Run Technology Constraint It separates attainable output levels from unattainable output levels in the short run. © 2025 Pearson Canada  Short-Run Technology Constraint Marginal Product Curve Figure 10.2 shows the marginal product of labour curve and how the marginal product curve relates to the total product curve. The first worker hired produces 4 units of output. © 2025 Pearson Canada  Short-Run Technology Constraint 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. © 2025 Pearson Canada  Short-Run Technology Constraint The height of each bar measures the marginal product of labour. For example, when labour increases from 2 to 3, total product increases from 10 to 13 sweaters, so the marginal product of the third worker is 3 sweaters. © 2025 Pearson Canada  Short-Run Technology Constraint To make a graph of the marginal product of labour, we can stack the bars in the previous graph side by side. The marginal product of labour curve passes through the mid-points of these bars. © 2025 Pearson Canada  Short-Run Technology Constraint Almost all production processes are like the one shown here and have:  Increasing marginal returns initially  Diminishing marginal returns eventually © 2025 Pearson Canada  Short-Run Technology Constraint 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. © 2025 Pearson Canada  Short-Run Technology Constraint Increasing marginal returns arise from increased specialization and division of labour. Diminishing marginal returns arise 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 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. © 2025 Pearson Canada  Short-Run Technology Constraint Average Product Curve Figure 10.3 shows the average product curve and its relationship with the marginal product curve. When marginal product exceeds average product, average product increases. © 2025 Pearson Canada  Short-Run Technology Constraint When marginal product is below average product, average product decreases. When marginal product equals average product, average product is at its maximum. © 2025 Pearson Canada  Short-Run Cost To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs. Three cost concepts and three types of cost curves are  Total cost  Marginal cost  Average cost © 2025 Pearson Canada  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 © 2025 Pearson Canada  Short-Run Cost Let’s draw total costs per day. Put the TFC curve back in the figure, and add TFC to TVC, and you’ve got the TC curve. © 2025 Pearson Canada  Short-Run Cost Marginal Cost Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. 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. © 2025 Pearson Canada  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 = FC/Q) Average variable cost (AVC) is total variable cost per unit of output. (AVC = AC/Q) Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC or simply © 2025 Pearson Canada  Short-Run Cost Figure 10.5 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. © 2025 Pearson Canada  Short-Run Cost The ATC curve is also U-shaped. The MC curve is very special. The outputs over which AVC is falling, MC is below AVC. The outputs over which AVC is rising, MC is above AVC. The output at which AVC is at the minimum, MC equals AVC. © 2025 Pearson Canada  Short-Run Cost Similarly, the outputs over which ATC is falling, MC is below ATC. The outputs over which ATC is rising, MC is above ATC. At the minimum ATC, MC equals ATC. © 2025 Pearson Canada  Short-Run Cost The AVC curve is U-shaped because: 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. © 2025 Pearson Canada  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. © 2025 Pearson Canada  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. © 2025 Pearson Canada  Short-Run Cost Average and Marginal Product and Cost The shapes of a firm’s cost curves are determined by the technology it uses:  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. © 2025 Pearson Canada  Short-Run Cost Figure 10.7 shows these relationships. © 2025 Pearson Canada  Short-Run Cost Shifts in the Cost Curves The position of a firm’s cost curves depend on two factors:  Technology  Prices of factors of production © 2025 Pearson Canada  Short-Run Cost Technology Technological change influences both the product curves and the cost curves. An increase in productivity shifts the product curves upward and the cost curves downward. If a technological advance results in the firm using more capital and less labour, fixed costs increase and variable costs decrease. In this case, average total cost increases at low output levels and decreases at high output levels. © 2025 Pearson Canada  Short-Run Cost Prices of Factors of Production An increase in the price of a factor of production increases costs and shifts the cost curves. An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve. An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves upward. © 2025 Pearson Canada Next week – Perfect Competition READ: C H A P TER 1 1 – MI CH AEL PAR K I N AND ROBI N BADE ( 2 0 2 5 ). MI CROE CONOMI C S : CANADA I N T HE GL OBAL ENV I RONMEN T , PEARSON CANADA.