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
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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 employeesSlide10Slide11
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
$10Slide37Slide38Slide39Slide40
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. Slide47Slide48
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 benefitsSlide57Slide58
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.