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The Costs of Production

The Costs of Production

E

conomics

P R I N C I P L E S O FP R I N C I P L E S O F

N. Gregory

N. Gregory

Mankiw

Mankiw

Premium PowerPoint Slides by Ron Cronovich

13

You run General Motors.

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List 3 different costs you have.

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List 3 different business decisions that are affected by your costs.

A C T I V E L E A R N I N G

A C T I V E L E A R N I N G 11

Brainstorming costs

Brainstorming costs

1

In this chapter,

In this chapter,

look for the answers to these questions:

look for the answers to these questions:

§

What is a production function? What is marginal product? How are they related?

§

What are the various costs, and how are they related to each other and to output?

§

How are costs different in the short run vs. the long run?

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What are “economies of scale”?

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THE COSTS OF PRODUCTION 3

Total Revenue, Total Cost, Profit

§

We assume that the firm’s goal is

Profit = Total revenue – Total cost

the amount a firm receives from the sale of its output

THE COSTS OF PRODUCTION 4

Costs: Explicit vs. Implicit

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Explicit costsrequire an outlay of money,

e.g., paying wages to workers.

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Implicit costs

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Remember one of the Ten Principles:

The cost of something is what you give up to get it.

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

THE COSTS OF PRODUCTION 5

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 =

§

Case 2: use $40,000 of your savings, borrow the other $60,000

§explicit cost = $3000 (5%) interest on the loan

§implicit cost =

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THE COSTS OF PRODUCTION 6

Economic Profit vs. Accounting Profit

§

Accounting profit

= total revenue minus

§

Economic profit

= total revenue minus

§

Accounting profit ignores implicit costs, so it’s higher than economic profit.

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

Compare the effects on accounting profit and economic profit if

a.you rent your office space b.you own your office space

A C T I V E L E A R N I N G

A C T I V E L E A R N I N G 22

Economic profit vs. accounting profit

Economic profit vs. accounting profit

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THE COSTS OF PRODUCTION 9

The Production Function

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A production function

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

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Example 1:

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Farmer Jack grows wheat.

§

He has 5 acres of land.

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THE COSTS OF PRODUCTION 10

No. of workers

Q

Example 1: Farmer Jack’s Production Function

3000 (bushels of wheat) L

(no. of workers)

THE COSTS OF PRODUCTION 11

M arginal Product

§

If Jack hires one more worker, his output rises by the marginal product of labor.

§

The marginal productof any input is

§

Notation:

Examples: Q=

§

Marginal product of labor (MPL) =

THE COSTS OF PRODUCTION 12

3000 (bushels of wheat) L

(no. of workers)

EXAM PLE 1:

Total & M arginal Product

1000 MPL

Q= 1000

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THE COSTS OF PRODUCTION 13 MPL equals the

slope of the production function.

Notice that MPL diminishes as Lincreases. This explains why the production function gets flatter as 0Lincreases.

500 1,000 1,500 2,000 2,500 3,000

0 1 2 3 4 5

No. of workers

Q

u

a

n

ti

ty

o

f

o

u

tp

ut

EXAM PLE 1: M PL = 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)

THE COSTS OF PRODUCTION 14

W hy M PL Is Important

§

Recall one of the Ten Principles:

Rational people think at the margin.

§

When Farmer Jack

§

Comparing them helps Jack decide whether he would benefit from hiring the worker.

THE COSTS OF PRODUCTION 15

W hy M PL Diminishes

§

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

§

As Jack adds workers,

§

In general, MPLdiminishes as Lrises

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THE COSTS OF PRODUCTION 16

EXAM PLE 1: Farmer Jack’s Costs

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Farmer 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….

THE COSTS OF PRODUCTION 17

EXAM PLE 1: Farmer Jack’s Costs

$11,000

(bushels of wheat) L

(no. of workers)

THE COSTS OF PRODUCTION 18

EXAM PLE 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 $11,000

$0

0 1000 2000 3000

Quantity of wheat

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THE COSTS OF PRODUCTION 19

M arginal Cost

§

Marginal Cost(MC)

THE COSTS OF PRODUCTION 20

EXAM PLE 1: Total and M arginal Cost

$2.00 Marginal Cost (MC) (bushels of wheat)

Q= 1000 ∆TC= $2000

THE COSTS OF PRODUCTION 21

MCusually rises as Qrises, as in this example.

EXAM PLE 1: The M arginal Cost Curve (bushels of wheat)

$0

0 1,000 2,000 3,000

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THE COSTS OF PRODUCTION 22

W hy M C 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.”

THE COSTS OF PRODUCTION 23

Fixed and Variable Costs

§

Fixed costs (FC)

§

For Farmer Jack,

§

Other examples:

§

Variable costs (VC)

§

For Farmer Jack, VC=

§

Other example:

§

Total cost (TC) =

THE COSTS OF PRODUCTION 24

EXAM PLE 2

§

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

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THE COSTS OF PRODUCTION 25 EXAM PLE 2: Costs

7

THE COSTS OF PRODUCTION 26

Recall, Marginal Cost (MC)

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

Usually, MCrises as Qrises, due to diminishing marginal product.

Sometimes (as here), MCfalls before rising.

(In other examples, MCmay be constant.)

EXAM PLE 2: M arginal Cost

620

THE COSTS OF PRODUCTION 27

EXAM PLE 2: A verage Fixed Cost

100

is fixed cost divided by the quantity of output:

AFC= FC/Q

Notice that AFCfalls as Qrises: The firm is spreading its fixed costs over a larger and larger number of units.

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THE COSTS OF PRODUCTION 28 EXAM PLE 2: A verage Variable Cost

520

Q Average variable cost (AVC)

is variable cost divided by the quantity of output:

AVC= VC/Q

As Qrises, AVCmay fall initially. In most cases, AVCwill eventually rise as output rises.

$0

THE COSTS OF PRODUCTION 29

EXAM PLE 2: A verage Total Cost

88.57

Q Average total cost

(ATC)

Also,

THE COSTS OF PRODUCTION 30

Usually, as in this example, the ATCcurve is U-shaped.

$0

EXAM PLE 2: A verage Total Cost

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THE COSTS OF PRODUCTION 31 EXAM PLE 2: The Various Cost Curves Together

AFC Calculating costs Calculating costs

32

Fill in the blank spaces of this table.

210

THE COSTS OF PRODUCTION 34

$0

EXAM PLE 2: W hy ATC Is Usually U-Shaped

As Qrises: Initially,

Eventually,

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THE COSTS OF PRODUCTION 35 EXAM PLE 2: A TC and MC

ATC MC

$0 $25 $50 $75 $100 $125 $150 $175 $200

0 1 2 3 4 5 6 7 Q

C

o

s

ts

When MC< ATC,

When MC> ATC,

The MCcurve crosses the

ATCcurve at

THE COSTS OF PRODUCTION 36

Costs in the Short Run & Long Run

§

Short run:

§

Long run:

§

In the long run,

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

THE COSTS OF PRODUCTION 37

EXAM PLE 3: LRA TC with 3 factory Sizes

Q

Avg Total Cost Firm can choose from 3 factory sizes: S, M, L.

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THE COSTS OF PRODUCTION 38 EXAM PLE 3: LRA TC with 3 factory Sizes

ATCS ATCM

ATCL

Q

Avg Total Cost

QA QB

To produce less than QA, firm will choose

To produce between QA

and QB, firm will choose

To produce more than QB, firm will choose

THE COSTS OF PRODUCTION 39

A Typical LRA TC Curve

Q

ATC

In the real world, factories come in many sizes, each with its own

SRATCcurve.

So a typical

LRATCcurve looks like this:

THE COSTS OF PRODUCTION 40

Q

ATC

How ATC Changes as the Scale of Production Changes

Economies of scale:

Constant returns to scale:

Diseconomies of scale:

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THE COSTS OF PRODUCTION 41

How ATC Changes as the Scale of Production Changes

§

Economies of scale occur when

§

Diseconomies of scale are due to

THE COSTS OF PRODUCTION 42

CONCLUSION

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Costs are critically important to many business decisions, including production, pricing, and hiring.

§

This chapter has introduced the various cost concepts.

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