Engineering

110 Week 1 handout TA: Ravi Ramakrishnan 04/05/2013 Production and Cost Structure: A goal of businesses is to maximize profit. To do this they need to figure out how to structure themselves and determine the optimal level of production. In order to do this they must define their inputs and the various costs associated with them. Sunk Costs Are costs that are incurred before we make decisions about our business. Since they occurred in the past they do not affect decisions we make in the present. For example if we spent a billion dollars on a project our decision to continue the project only depends on the revenues and costs we will incur not the prior investment (sunk costs). Opportunity Costs Any resources we use on a project will be diverted from another project. The profit lost from not pursuing the alternative project is opportunity cost. That is if I go to college I cannot simultaneously work a fulltime job. The lost wages from my decision are an opportunity cost. Short Run vs. Long Run the short run is defined by the fact that some factors of production cannot be increased or decreased. That is heavy equipment, factories, etc, take time to become operational. This time interval is the short run. The long run is defined by the ability to change all factors of production. Fixed Costs Any cost that does not depend on production level. It typically does not exist in the long run. For example if I lease factory space my lease payments become a fixed cost until the term of lease ends. Variable Costs Any cost that depends on production. If I want to produce more shirts I would need to purchase more fabric. Thus fabric cost is variable. Total Cost - is the sum of variable and fixed costs. Remember that opportunity costs are imbedded in total cost. Law of Diminishing Returns Initially additional resources will bring more and more benefit after a certain point they bring less benefit per unit of resource. For example if I buy fries for lunch each fry will bring me happiness after awhile though the taste (benefit) per fry begins to diminish. Economies of Scale As we increase the scale of production (i.e. increase factory size) the minimum average total cost (total cost/quantity) decreases. Marginal Cost Additional cost that is incurred by producing one more unit of good.

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