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Costs of Production - PPT Presentation

AP Microeconomics UHS Barnett Total Revenue Total Cost Profit We assume that the firms goal is to maximize profit Profit Total revenue Total cost the amount a firm receives from the sale of its output ID: 614704

cost 000 costs atc 000 cost atc costs 100 total output profit rises scale marginal product explicit avc production

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Slide1

Costs of Production

AP MicroeconomicsUHSBarnettSlide2

Total Revenue, Total Cost, Profit

We assume that the firm’s goal is to maximize profit

.

Profit

=

Total revenue – Total cost

the amount a firm receives from the sale of its output

the market value of the inputs a firm uses in production

0Slide3

Costs: Explicit vs. Implicit

Explicit costs require an outlay of money,

e.g., paying wages to workers.

Implicit costs

do not require a cash outlay,

e.g., the opportunity cost of the owner’s time.Remember one of the Ten Principles: The cost of something is what you give up to get it

. This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.

0Slide4

Explicit vs. Implicit Costs: An Example

You need $100,000 to start your business.

The interest rate is 5%.

Case 1: borrow $100,000

explicit cost = $5000 interest on loan

Case 2: use $40,000 of your savings, borrow the other $60,000explicit cost = $3000 (5%) interest on the loanimplicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.

0

In both cases, total (exp

+

imp) costs are $5000.Slide5

Economic Profit vs. Accounting Profit

Accounting profit

= total revenue minus total explicit costs

Economic profit

= total revenue minus total costs (including explicit and implicit costs)Accounting profit ignores implicit costs, so it’s higher than economic profit.

0Slide6

Using the information below, compute the explicit and implicit costs, the accounting and economic profits.  Then explain what will happen in this industry and why.

Total Revenue  $600,000Cost of materials  $200,000Wages to employees  $250,000Foregone wage      $100,000

Foregone rent and interest    $

80,000

The explicit costs would be the out-of-pocket expenses of materials and employee wages: 200,000 + 250,000 = $450,000.

The implicit costs are the foregone opportunities, $100,000 + $80,000 = $180,000.  The accounting profit is $150,000 computed by taking the total revenue $600,000 less the explicit costs $450,000.  Subtracting

the additional $180,000 of implicit costs leaves an economic profit of negative $30,000. Thus

if this loss continues, we would anticipate the owner would exit this business.Slide7

ACTIVE LEARNING

2

Economic profit vs. accounting profit

The equilibrium rent on office space has just increased by $500/month.

Determine the effects on accounting profit and economic profit if

a.

you rent your office space

b.

you own your office space

© 2012 Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Slide8

ACTIVE LEARNING

2

Answers

The rent on office space increases $500/month.

a.

You rent your office space.

Explicit costs increase $500/month.

Accounting profit & economic profit each fall $500/month.

b. You own your office space.

Explicit costs do not change,

so accounting profit does not change.

Implicit costs increase $500/month (opp. cost

of using your space instead of renting it),

so economic profit falls by $500/month.

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Slide9

Think about an airliner like Southwest Airlines. What are their fixed costs and what are their variable

costs in the

short run

?

Fixed – Insurance, depreciation of equipment (capital), taxes, interest on loans, contract employees

Variable – jet fuel, food (peanuts), wages to hourly employeesSlide10
Slide11

Using the information below, compute the explicit and implicit costs, the accounting and economic profits.  Then explain what will happen in this industry and why.

Total Revenue  $600,000Cost of materials  $200,000Wages to employees  $250,000Foregone wage      $100,000

Foregone rent and interest    $

80,000

The explicit costs would be the out-of-pocket expenses of materials and employee wages: 200,000 + 250,000 = $450,000.

The implicit costs are the foregone opportunities, $100,000 + $80,000 = $180,000.  The accounting profit is $150,000 computed by taking the total revenue $600,000 less the explicit costs $450,000.  Subtracting

the additional $180,000 of implicit costs leaves an economic profit of negative $30,000. Thus

if this loss continues, we would anticipate the owner would exit this business.Slide12

The Production Function

A

production function

shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good.

It can be represented by a table, equation, or graph.

Example 1:Farmer Jack grows wheat. He has 5 acres of land. He can hire as many workers as he wants.

0Slide13

0

500

1,000

1,500

2,000

2,500

3,000

0

1

2

3

4

5

No. of workers

Quantity of output

EXAMPLE 1:

Farmer Jack’s Production Function

3000

5

2800

4

2400

3

1800

2

1000

1

0

0

Q

(bushels

of wheat)

L

(no. of workers)

0Slide14

Marginal Product

If Jack hires one more worker, his output rises by the

marginal product of labor

.

The

marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. Notation: ∆ (delta) = “change in…” Examples:

∆Q = change in output, ∆

L = change in labor Marginal product of labor (MPL) =

0

Q

LSlide15

3000

5

2800

4

2400

3

1800

2

1000

1

0

0

Q

(bushels

of wheat)

L

(no. of workers)

EXAMPLE 1:

Total & Marginal Product

200

400

600

800

1000

MPL

0

Q

= 1000

L

= 1

Q

= 800

L

= 1

Q

= 600

L

= 1

Q

= 400

L

= 1

Q

= 200

L

= 1Slide16

MPL equals the

slope of the production function.

Notice that

MPL diminishes

as

L increases.This explains why the production function gets flatter as L

increases.

0

500

1,000

1,500

2,000

2,500

3,000

0

1

2

3

4

5

No. of workers

Quantity of output

EXAMPLE 1:

MPL = Slope of Prod Function

3000

5

200

2800

4

400

2400

3

600

1800

2

800

1000

1

1000

0

0

MPL

Q

(bushels

of wheat)

L

(no. of workers)

0Slide17

Why MPL Is Important

Recall one of the Ten Principles:

Rational people think at the margin.

When Farmer Jack hires an extra worker, his costs rise by the wage he pays the workerhis output rises by MPLComparing them helps Jack decide whether he should hire the worker. Slide18

Why MPL Diminishes

Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why?

As Jack adds workers, the average worker has less land to work with and will be less productive.

In general,

MPL

diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.). Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things

equa)Slide19

EXAMPLE 1:

Farmer Jack’s CostsFarmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.

The market wage for a farm worker is $2000 per month.

So Farmer Jack’s costs are related to how much wheat he produces….Slide20

EXAMPLE 1:

Farmer Jack’s Costs

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

Total

Cost

3000

5

2800

4

2400

3

1800

2

1000

1

$10,000

$8,000

$6,000

$4,000

$2,000

$0

$1,000

$1,000

$1,000

$1,000

$1,000

$1,000

0

0

Cost of labor

Cost of land

Q

(bushels

of wheat)

L

(no. of workers)

0Slide21

EXAMPLE 1:

Farmer Jack’s Total Cost Curve

Q

(bushels

of wheat)

Total

Cost

0

$1,000

1000

$3,000

1800

$5,000

2400

$7,000

2800

$9,000

3000

$11,000Slide22

Marginal Cost

Marginal Cost (MC

)

is the increase in Total Cost from

producing one more unit:

TC

Q

MC

=Slide23

EXAMPLE 1:

Total and Marginal Cost

$10.00

$5.00

$3.33

$2.50

$2.00

Marginal Cost (

MC

)

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

Total

Cost

3000

2800

2400

1800

1000

0

Q

(bushels

of wheat)

Q

= 1000

∆TC

= $2000

Q

= 800

∆TC

= $2000

Q

= 600

∆TC

= $2000

Q

= 400

∆TC

= $2000

Q

= 200

∆TC

= $2000Slide24

MC

usually rises

as

Q

rises,

as in this example.EXAMPLE 1: The Marginal Cost Curve

$11,000

$9,000

$7,000

$5,000

$3,000

$1,000

TC

$10.00

$5.00

$3.33

$2.50

$2.00

MC

3000

2800

2400

1800

1000

0

Q

(bushels

of wheat)Slide25

Why MC Is Important

Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more or less wheat?

To find the answer, Farmer Jack needs to

“think at the margin.”

If the cost of additional wheat (

MC) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more. Slide26

Fixed and Variable Costs

Fixed costs

(

FC

)

do not vary with the quantity of output produced. For Farmer Jack, FC = $1000 for his landOther examples: cost of equipment, loan payments, rentVariable costs (VC

) vary with the quantity produced.

For Farmer Jack, VC = wages he pays workersOther example: cost of materials

Total cost (TC) = FC + VC

0Slide27

EXAMPLE 2

Our second example is more general, applies to any type of firm

producing any good with any types of inputs. Slide28

EXAMPLE 2:

Costs

7

6

5

4

3

2

1

620

480

380

310

260

220

170

$100

520

380

280

210

160

120

70

$0

100

100

100

100

100

100

100

$100

0

TC

VC

FC

Q

$0

$100

$200

$300

$400

$500

$600

$700

$800

0

1

2

3

4

5

6

7

Q

Costs

FC

VC

TC

0Slide29

Recall,

Marginal Cost (

MC

)

is the change in total cost from producing one more unit:Usually, MC

rises as Q rises, due to diminishing marginal product.

Sometimes (as here), MC falls before rising.

(In other examples, MC may be constant.)

EXAMPLE 2: Marginal Cost

620

7

480

6

380

5

310

4

260

3

220

2

170

1

$100

0

MC

TC

Q

140

100

70

50

40

50

$70

TC

Q

MC

=Slide30

EXAMPLE 2:

Average Fixed Cost

100

7

100

6

100

5

100

4

100

3

100

2

100

1

14.29

16.67

20

25

33.33

50

$100

n/a

$100

0

AFC

FC

Q

Average fixed cost (

AFC

)

is fixed cost divided by the quantity of output:

AFC

=

FC

/

Q

Notice that

AFC

falls as

Q

rises: The firm is spreading its fixed costs over a larger and larger number of units.

0Slide31

EXAMPLE 2:

Average Variable Cost

520

7

380

6

280

5

210

4

160

3

120

2

70

1

74.29

63.33

56.00

52.50

53.33

60

$70

n/a

$0

0

AVC

VC

Q

Average variable cost (

AVC

)

is variable cost divided by the quantity of output:

AVC

=

VC

/

Q

As

Q

rises,

AVC

may fall initially. In most cases,

AVC

will eventually rise as output rises.

0Slide32

EXAMPLE 2:

Average Total Cost

88.57

80

76

77.50

86.67

110

$170

n/a

ATC

620

7

480

6

380

5

310

4

260

3

220

2

170

1

$100

0

74.29

14.29

63.33

16.67

56.00

20

52.50

25

53.33

33.33

60

50

$70

$100

n/a

n/a

AVC

AFC

TC

Q

0

Average total cost (

ATC

)

equals total cost divided by the quantity of output:

ATC

=

TC

/

Q

Also,

ATC

=

AFC

+

AVCSlide33

Usually, as in this example, the

ATC curve is U-shaped.

$0

$25

$50

$75

$100

$125

$150

$175

$200

0

1

2

3

4

5

6

7

Q

Costs

EXAMPLE 2:

Average Total Cost

88.57

80

76

77.50

86.67

110

$170

n/a

ATC

620

7

480

6

380

5

310

4

260

3

220

2

170

1

$100

0

TC

Q

0Slide34

EXAMPLE 2:

The Various Cost Curves Together

0

AFC

AVC

ATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0

1

2

3

4

5

6

7

Q

CostsSlide35

ACTIVE LEARNING

3

Calculating costs

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Fill in the blank spaces of this table.

210

150

100

30

10

VC

43.33

35

8.33

260

6

30

5

37.50

12.50

150

4

36.67

20

16.67

3

80

2

$60.00

$10

1

n/a

n/a

n/a

$50

0

MC

ATC

AVC

AFC

TC

Q

60

30

$10Slide36

ACTIVE LEARNING

3

Answers

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Use

AFC

=

FC

/

Q

Use

AVC

=

VC

/

Q

Use relationship between

MC

and

TC

Use

ATC

=

TC

/

Q

First, deduce

FC

= $50 and use

FC

+

VC

=

TC

.

210

150

100

60

30

10

$0

VC

43.33

35

8.33

260

6

40.00

30

10.00

200

5

37.50

25

12.50

150

4

36.67

20

16.67

110

3

40.00

15

25.00

80

2

$60.00

$10

$50.00

60

1

n/a

n/a

n/a

$50

0

MC

ATC

AVC

AFC

TC

Q

60

50

40

30

20

$10Slide37
Slide38
Slide39
Slide40

EXAMPLE 2:

The Various Cost Curves Together

0

AFC

AVC

ATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0

1

2

3

4

5

6

7

Q

CostsSlide41

$0

$25

$50

$75

$100

$125

$150

$175

$200

0

1

2

3

4

5

6

7

Q

Costs

EXAMPLE 2:

Why ATC Is Usually U-Shaped

0

As

Q

rises:

Initially,

falling

AFC

pulls

ATC

down.

Eventually,

rising

AVC

pulls

ATC

up.

Efficient scale

:

The quantity that minimizes ATC. Slide42

EXAMPLE 2:

ATC and MC

0

ATC

MC

$0

$25

$50

$75

$100

$125

$150

$175

$200

0

1

2

3

4

5

6

7

Q

Costs

When

MC

<

ATC

,

ATC

is falling.

When

MC

>

ATC

,

ATC

is rising.

The

MC

curve crosses the

ATC

curve at

the

ATC

curve’s minimum. Slide43

Total Cost = ATC*Q = $15*10 = $150

Total Variable Cost = AVC*Q = $8*10 = $80

The vertical distance between ATC and AVC is AFC, so TFC = AFC*Q = $7*10 = $70

If the total fixed cost is $70 then at 20 units of output, the vertical distance between ATC and AVC which is the AFC would be $3.50.Slide44

Similar mirror-image relationship between AP & AVCSlide45

Costs in the Short Run & Long Run

Short run: Some inputs are fixed (e.g.

,

factories, land).

The costs of these inputs are

FC.Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones).In the long run, ATC

at any Q is cost per unit using the most efficient mix of inputs for that

Q (e.g., the factory size with the lowest ATC).Slide46

EXAMPLE 3:

LRATC with 3 factory sizes

ATC

S

ATC

M

ATC

L

Q

Avg

Total

Cost

Firm can choose from

three

factory sizes:

S

,

M

,

L

.

Each size has its own

SRATC

curve.

The firm can change to a different factory size in the long run, but not in the short run. Slide47
Slide48

EXAMPLE 3:

LRATC with 3 factory sizes

ATC

S

ATC

M

ATC

L

Q

Avg

Total

Cost

Q

A

Q

B

LRATC

To produce less than

Q

A

, firm will choose size

S

in the long run.

To produce between

Q

A

and

Q

B

, firm will choose size

M

in the long run.

To produce more than

Q

B

, firm will choose size

L

in the long run.Slide49

Long

run average cost curve

(LRATC) shows

the

minimum

average cost of producing any given level of outputSlide50

A Typical LRATC Curve

Q

ATC

In

the real world, factories come in many sizes,

each with its own

SRATC

curve.

So a typical

LRATC

curve

looks like this

:

Different industries have different shaped LRATC’s

LRATCSlide51

How ATC Changes as

the Scale of Production Changes

Economies of scale

:

ATC

falls as Q increases.

Constant returns to scale:

ATC stays the same as

Q increases.Diseconomies of scale: ATC rises

as

Q increases.

LRATC

Q

ATCSlide52

The AC curve is broken into three

areas    Increasing Returns to Scale (economies of scale) - For instance doubling the inputs leads to a more than doubling of output    Constant Returns to Scale - Doubling of inputs leads to a doubling of

output

    Decreasing Returns to Scale (diseconomies of scale) - Doubling of inputs leads to less than doubling of output.Slide53

How ATC Changes as

the Scale of Production Changes

Economies of scale occur when increasing production allows greater specialization:

workers more efficient when focusing on a narrow task.

More common when

Q is low. Spreading out of design and development costs (Movie Industry)Purchasing inputs in bulk – lower per unit cost (railway industry)more

intensive use of highly skilled personnelmore

intensive use of capital (for instance, with shifts)ability to utilize by-products rather than discard them.Slide54

How ATC Changes as

the Scale of Production Changes

Diseconomies of scale are due to coordination problems in large organizations.

E.g., management becomes stretched, can’t control costs.

More common when

Q is high.- difficulties in control and supervision,- slow decision making due to excessive size of administration,- lack of employee motivation.Slide55

The minimum efficient

scale: is the smallest output that a plant (or firm) can produce such that its 

long run average costs

 are

minimized.

Beyond this level of production, as this firm continues to grow, it will see no further cost benefitsSlide56

The minimum efficient

scale: is smallest output that a plant (or firm) can produce such that its 

long run average costs

 are

minimized.

Beyond this level of production, as this firm continues to grow, it will see no further cost benefitsSlide57
Slide58

Difference between short-run ATC & LRATC curves

Economies of Scope:

Lower

the

per unit cost as the range of products produced increasesSlide59

Discussion Questions:

1. What does it mean that a firm can become “too big for its own good”? Can you think of any other organizations (economic or otherwise) that have gotten so big that they’ve failed?2. Why

does your hometown have only one electricity company? Why aren’t 

utility

 industries such as water, natural gas, and garbage collection more competitive? How does the concept of economies of scale lead to certain industries being “natural monopolies”?

3. Why don’t more companies make jumbo jets?Slide60

SUMMARY

Implicit costs do not involve a cash outlay,

yet are just as important as explicit costs

to firms’ decisions.

Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs.

The production function shows the relationship between output and inputs.

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Slide61

SUMMARY

The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly.

Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper.

Variable costs vary with output; fixed costs do not.

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Slide62

SUMMARY

Marginal cost is the increase in total cost from an extra unit of production. The

MC

curve is usually upward-sloping.

Average variable cost is variable cost divided by output.

Average fixed cost is fixed cost divided by output.

AFC

always falls as output increases.

Average total cost (sometimes called “cost per unit”) is total cost divided by the quantity of output. The ATC curve is usually U-shaped.

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.Slide63

SUMMARY

The

MC

curve intersects the

ATC

curve

at minimum average total cost.

When MC < ATC, ATC

falls as Q rises. When MC > ATC, ATC rises as

Q rises.

In the long run, all costs are variable. Economies of scale: ATC falls as

Q rises. Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises.

© 2012

Cengage

Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.