Econ11 Module 5: The Cost of Production PDF

MODULE 5: THE COST OF PRODUCTION ECON11 CLASS LECTURE Image source...

MODULE 5: THE COST OF PRODUCTION ECON11 CLASS LECTURE Image source: https://www.betterteam.com/images/production-worker-job-description-2455x3679-2020123.jpeg?crop=2:1,smart&width=1200&dpr=2  ACCORDING TO THE LAW OF SUPPLY… firms are willing to produce and sell a greater quantity of a good when the price of the good is higher. This response leads to a supply curve that slopes upward. INDUSTRIAL ORGANIZATIONS the study of how firms’ decisions about prices and quantities depend on the market conditions they face  THE BEHAVIOR OF PROFIT- MAXIMIZING FIRMS 1. How much output to supply (quantity of product) 2. How to produce that output (which production technique/technology to use) 3. How much of each input to demand  WHAT ARE COSTS? total revenue the amount a firm receives for the sale of its output TOTAL REVENUE= P X Q total cost the market value of the inputs a firm uses in production profit total revenue minus total cost ECONOMIC PROFIT= Total Revenue –Total Costs SCENARIO: Caroline owns a cookie factory. Her main objective is to make large profit as possible. When Caroline pays $1,000 for flour, that $1,000 is an opportunity cost because Caroline can no longer use that $1,000 to buy something else. Similarly, when Caroline hires workers to make the cookies, the wages she pays are part of the firm’s costs. EXPLICIT COSTS Imagine that Caroline is skilled with computers and could earn $100 per hour working as a programmer. For every hour that Caroline works at her cookie factory, she gives up $100 in income, and this forgone income is also part of her costs. IMPLICIT COSTS ECONOMIC PROFIT VS. ACCOUNTING PROFIT economic profit total revenue minus total cost, including both explicit and implicit costs accounting profit total revenue minus total explicit cost Rate of return is the annual flow of net income generated by an investment expressed as a percentage of the total investment. A normal rate of return is the rate that is just sufficient to keep owners and investors satisfied. If the rate of return were to fall below normal, it would be difficult or impossible for managers to raise resources needed to purchase new capital. When a firm earns a positive level of profit, it is earning more than is sufficient to retain the interest of investors. When a firm suffers a negative level of profit—that is, when it incurs a loss—it is earning at a rate below that required to keep investors happy. The Bases of Decisions: Market Price of Output, Available Technology, and Input Prices In the language of economics, a firm needs to know three things: 1. The market price of output 2. The techniques of production that are available 3. The prices of inputs DETERMINING THE OPTIMAL METHOD OF PRODUCTION optimal method of production The production method that minimizes cost  SHORT RUN VS. LONG RUN DECISION short run The period of time for which two conditions hold: The firm is operating under a fixed scale (fixed factor) of production, and firms can neither enter nor exit an industry. Example: -manufacturing firm: size of the plant; physician: size of the clinic; farmer: land long run That period of time for which there are no fixed factors of production: Firms can increase or decrease the scale of operation, and new firms can enter and existing firms can exit the industry.  The Production Process production technology The quantitative relationship between inputs and outputs. Labor intensive technology Capital-intensive technology Technology that relies heavily on human Technology that relies heavily on capital instead labor instead of capital. of human labor. Image source: http://2.bp.blogspot.com/-oeKCTPnG-Z4/USH- Image source: https://www.therobotreport.com/wp-content/uploads/2017/08/Capital_intensive.jpg H_kpc4I/AAAAAAAABTg/ZcrPNI5mXuo/s1600/Labou+intensive+farming.bmp PRODUCTION AND COSTS Number of Output Marginal Cost of Cost of Total costs Workers Product of Factory Workers Labor 0 0 $30 $0 $30 50 1 50 30 10 40 40 2 90 30 20 50 30 3 120 30 4 140 20 30 5 150 30 6 155 30  PRODUCTION AND COSTS ANSWER: production function Number of Output Marginal Cost of Cost of Total costs the relationship between Workers Product of Factory Workers the quantity of inputs Labor used to make a good and 0 0 - $30 $0 $30 the quantity of output of 50 that good 1 50 30 10 40 40 2 90 30 30 20 50 3 120 30 30 60 20 marginal product 4 140 30 40 70 10 5 150 30 50 80 the increase in output 5 that arises from an 6 155 30 60 90 additional unit of input diminishing marginal product the property whereby the marginal product of an input declines as the quantity of the input increases TOTAL COST TC = FC + VC Fixed costs are expenses that must be paid even if the firm produces zero output. Variable costs do vary as output changes. Examples include materials required to produce output (such as steel to produce automobiles), production workers to staff the assembly lines, power to operate factories, and so on. MARGINAL COST Marginal cost ( MC ) denotes the extra or additional cost of producing 1 extra unit of output. average total cost total cost divided by the quantity of output ATC= TC/Q average fixed cost fixed cost divided by the quantity of output AFC= FC/Q average variable cost variable cost divided by the quantity of output AVC= VC/Q marginal cost the increase in total cost that arises from an extra unit of production MC= ΔTC/ΔQ  THE VARIOUS MEASUREMENTS OF COSTS Quantity of Total Cost Fixed Costs Variable Average Average Average Marginal Output ($) Costs (TC- Fixed Costs Variable Total cost Costs (per hour) FC) (FC/Q) cost (VC/Q) (TC/Q) ( TC/ Q) 0 3.00 3.00 0.00 -- -- -- 0.30 1 3.30 3.00 0.30 3.00 0.30 3.30 0.50 2 3.80 3.00 0.80 1.50 0.40 1.90 0.70 3 4.50 3.00 ? 4 5.40 3.00 ? 5 6.50 3.00 ? 6 7.80 3.00 ? 7 9.30 3.00 ? 8 11.00 3.00 ? 9 12.90 3.00 ? 10 15.00 3.00  THE VARIOUS MEASUREMENTS OF COSTS Quantity of Total Cost Fixed Costs Variable Average Average Average Marginal Output ($) Costs (TC- Fixed Costs Variable Total cost Costs (per hour) FC) (FC/Q) cost (VC/Q) (TC/Q) ( TC/ Q) 0 3.00 3.00 0.00 -- -- -- 0.30 1 3.30 3.00 0.30 3.00 0.30 3.30 0.50 2 3.80 3.00 0.80 1.50 0.40 1.90 0.70 3 4.50 3.00 1.50 1.00 0.50 1.50 0.90 4 5.40 3.00 2.40 0.75 0.60 1.35 1.10 5 6.50 3.00 3.50 0.60 0.70 1.30 1.30 6 7.80 3.00 4.80 0.50 0.80 1.30 1.50 7 9.30 3.00 6.30 0.43 0.90 1.33 1.70 8 11.00 3.00 8.00 0.38 1.00 1.38 1.90 9 12.90 3.00 9.90 0.33 1.10 1.43 2.10 10 15.00 3.00 12.00 0.30 1.20 1.50  CONCLUSIONS 1. Rising Marginal Cost This upward slope reflects the property of diminishing marginal product. When the quantity of coffee produced is already high, the marginal product of an extra worker is low, and the marginal cost of an extra cup of coffee is large and vice versa.  CONCLUSIONS 2. U-Shaped average total costs Average fixed cost always declines as output rises because the fixed cost is getting spread over a larger number of units. Average variable cost usually rises as output increases because of diminishing marginal product. Efficient scale: the quantity of output that minimizes average total cost  CONCLUSIONS 3. The relationship between marginal cost and average total costs. Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. The marginal-cost curve crosses the average-total-cost curve at its minimum. Why?  Costs in the Short Run and in the Long Run Average Total Costs ATC in short run For many firms, the with small ATC in the long run ATC in short run division of total costs factory ATC in with large between fixed and variable short run factory costs depends on the time with medium horizon. factory $12,000 10,000 1,000 1,200 Quantities of cars per day.  Costs in the Short Run and in the Long Run Average Total ATC in ATC in the long run Costs short run with small ATC in factory short run ATC in with large short run factory with medium factory Diseconomies of scale $12,000 10,000 Economies of scale Constant return to scale 1,000 1,200 Quantities of cars per day.  Production Functions with Two Variable Factors of Production Additional capital increases the productivity of labor. Because capital— buildings, machines, and so on—is of no use without people to operate it, we say that capital and labor are complementary inputs. Capital and labor are at the same time complementary and substitutable inputs. Capital enhances the productivity of labor, but it can also be substituted for labor.  Choice of Technology If labor becomes expensive, firms can adopt labor-saving technologies; that is, they can substitute capital for labor. If capital becomes relatively expensive, firms can substitute labor for capital. Two things determine the cost of production: (1) technologies that are available and (2) input prices. Profit-maximizing firms will choose the technology that minimizes the cost of production given current market input prices.  Isoquants and Isocost law of diminishing marginal returns 1 A graph that shows all the combinations of states that adding an additional factor of production capital and labor that can be used to produce a results in smaller increases in output. given amount of output is called an isoquant. 1: https://www.investopedia.com/terms/l/lawofdiminishingmarginalreturn.asp The ratio of MPL to MPK is called the marginal A graph that shows all the combinations of capital rate of technical substitution (MRTS). It is the and labor that are available for a given total cost is rate at which a firm can substitute capital for called an isocost line. labor and hold output constant MPL = (Wage/Price of the output) or ( TP/ L) MPK = (Rental price of capital/Price of output) or ( TP/ K) Here, the MRTSLK indicates the rate at which additional units of labour (∆L) can be substituted for fewer units of capital (–∆K) while keeping output (TP) constant. When much capital and little labour are used, the marginal productivity of labour is relatively great and the marginal productivity of capital is relatively small, so one unit of labour will substitute for a relatively large amount of capital. Properties of Isoquants: Let us summarize the main properties of isoquants: Isoquants further from the origin represent greater levels of output. Isoquants slope downward. Isoquants never intersect. Isoquants tend to be convex — that is, bowed towards the origin. Isocost line An isocost line identifies all combinations of capital and labour the firm can hire for a given total cost. Again, iso is from the Greek word meaning ‘equal’, so an isocost line is a line representing equal total cost to the firm Assume a unit of labour costs the firm $15 000 per year, and the cost for each unit of capital is $25 000 per year. The total cost (TC) of production is: TC = (w x L) + (r x K) = $15 000 L + $25 000 K The Costs Minimizing Equilibrium Pk= $1; PL=$1 Capital (K) TC=PkxK + PLXL MPL > MPk PL Pk A TC= $ 5 B Qx= 200 pairs of pants MPk = MPL MPk > MPL Pk PL C Pk PL TC= $ 4 Labor (L)  CONCLUSION Firms vary in size and internal organization, but they all take inputs and transform them into outputs through a process called production. A positive profit level occurs when a firm is earning an above-normal rate of return on capital. Two assumptions define the short run: (1) a fixed scale or fixed factor of production and (2) no entry to or exit from the industry. In the long run, firms can choose any scale of operations they want and firms can enter and leave the industry. Profit equals total revenue minus total cost. Total cost (economic cost) includes (1) out-of-pocket costs and (2) the opportunity cost of each factor of production, including a normal rate of return on capital. The relationship between inputs and outputs (the production technology) expressed numerically or mathematically is called a production function or total product function.  CONCLUSION The marginal product of a variable input is the additional output that an added unit of that input will produce if all other inputs are held constant. According to the law of diminishing returns, when additional units of a variable input are added to fixed inputs, after a certain point, the marginal product of the variable input will decline. CONCLUSION