Dr.

Katie Sauer Principles of Microeconomics

The Costs of Production (Ch 13) Basic economic assumption: firms attempt to ____________________. It is possible for firm owners to have different goals. The one motive that makes the most accurate prediction about how firm managers behave is the assumption of profit maximization. I. Profit The goal of a firm is to maximize profit. _________ = Total Revenue Total Cost = TR TC Total ___________ = price x quantity Total ___________ = market value of all inputs used in production To an economist, the costs of producing an item must include all of the ___________________costs of inputs used in production. Costs include both implicit and explicit costs. explicit costs: input costs that require an outlay of money by the firm ex: wages, electricity, raw materials implicit costs: input costs that do not require an outlay of money by the firm ex: forgone interest earned on money spent ________________________________________________________________ Ex: Caroline uses $300,000 of her savings to start her firm. It was in a savings account paying 5% interest. When she takes the money out of savings, she no longer earns interest on it. forgone interest = Because Caroline could have earned $15,000 per year on this savings, we should include this in her total cost. implicit cost=forgone interest = explicit cost = total cost = _________________________________________________________________ Ex: If Caroline had instead borrowed $200,000 from a bank at 7% interest and used $100,000 from her savings: Forgone interest = Implicit Costs = Explicit cost = $__________________________ from savings + $_________________________ borrowed + $ _________________________interest payments Total cost =

The inclusion of all opportunity costs in calculating profits is the major way in which accountants and economists _________________________in analyzing the performance of a business. Accountants focus on explicit costs. Economists examine both explicit and implicit costs. Economic Profit vs Accounting Profit = total revenue explicit costs E = total revenue explicit costs implicit costs
A

Accounting profit will always __________________ economic profit. (as long as there are implicit costs) ________________________________________________________ Ex: Wages $10,000 Supplies $20,000 Forgone interest $1,500 Utilities $2,000 Price of Product $33 Quantity sold 1000 Calculate Accounting profit and economic profit. Total Revenue = Explicit Costs = Implicit Costs =
A

= ______________________________________________________________ II. Production and Costs in the Short Run Short Run = one or more inputs are fixed Long Run = all inputs are variable

A. Production Production function = the relationship between the quantity of inputs used and the quantity of output that results Total Product = TP = Output = Q

Ex: Lets grow some rice. Number Amount Average amount of Produced produced per Workers worker (average product)

Additional amount produced from each extra worker (marginal product)

Trends we notice: As the number of workers rises, what happens to total output?

0 1 2 3 4 5 6 7 8 As the number of workers rises, what happens to marginal product? As the number of workers rises, what happens to average product?

Graph the resulting production function:

Graph the resulting output per worker curves:

________________________________________________________________________ Recap: Total Product (TP) is the amount produced. aka output, quantity(Q) Average Product of Labor = total output = AP # workers Marginal Product of Labor = change in output = MP change in labor 3

In general, marginal product is the increase in output that arises from an additional unit of input. As the amount of labor used increases, the marginal product of labor falls. __________________________________________ is the property whereby the marginal product of an input declines as the quantity of the input increases. - the more of an input used, output will increase by less and less - output increases at a decreasing rate ___________________________________________________________________________ Ex: Consider the short-run production of a small firm that makes sweaters. These sweaters are made using a combination of labor and knitting machines. In the short run, the firm has signed a lease to rent one machine. Therefore, in the short run, the firm cannot vary the amount of knitting machines it uses. The firm can vary the amount of labor it employs. Labor (#workers) 0 1 2 3 4 5 Total Output 0 4 10 13 15 16 Average Product Marginal Product

Trends we notice: As the number of workers rises, what happens to total output? As the number of workers rises, what happens to average product? As the number of workers rises, what happens to marginal product? Here are the shapes of typical Total Product, Average Product, and Marginal Product curves:

The Average-Marginal Rule: If MP > AP then AP is rising. If MP < AP then AP is falling. If MP = AP then AP is at its maximum. _________________________________________________________ Example: Suppose triplets are enrolled in Principles of Microeconomics. They each had a B average (GPA = 3.0) before taking the class. Triplet One gets a C in the course. What happens to her GPA? Triplet Two gets an A in the class. What happens to her GPA? Triplet Three gets a B in the class. What happens to her GPA? When the additional grade (marginal grade) is higher the overall GPA (average grade) ___________. When the additional grade (marginal grade) is lower the overall GPA (average grade) ____________. When the additional grade (marginal grade) is the same the overall GPA (average grade) __________. __________________________________________________________ B. Costs Inputs are not free. The more output a firm produces, the more inputs it needs to acquire. Intuitively, we understand that as total output rises, so do total costs of production. There are two types of costs: 1. ____________costs: costs that do not vary with the quantity of output produced. ex: warehouse lease, payments on a loan 2. ____________ costs: costs that do vary with the quantity of output produced. ex: raw materials, electricity

Consider the sweater manufacturer again. Suppose the firm is currently renting one machine for $25 per day. Each worker is also paid $25 per day. Labor Total Fixed Variable Total (#workers) Output Cost Cost Cost 0 0 1 4 2 10 3 13 4 15 5 16 Trends we notice: What happens to fixed costs as output increases? What happens to variable costs as output increases? What happens to total cost as output increases? 5

total cost = fixed costs + variable costs. TC = FC + VC

Because fixed costs dont vary with the amount produced, the fixed cost curve is a horizontal line at the value of the fixed cost. Even if the firm produces nothing, it will incur the fixed cost. Variable costs increase as output increases, so the variable cost curve is upward sloping. If the firm produces nothing, then it incurs no variable cost. - curve starts at zero Since total cost is the sum of fixed cost and variable cost, it slopes up and has an intercept equal to the value of fixed cost. In addition to total costs, firms are interested in the cost per unit of output produced: average total cost: total cost divided by the quantity of output

average fixed cost: fixed costs divided by the quantity of output

average variable cost: variable costs divided by the quantity of output

marginal cost: the increase in total cost that arises from an extra unit of production

Labor (#workers) 0 1 2 3 4 5

Total Output 0 4 10 13 15 16

Fixed Cost 25 25 25 25 25 25

Variable Cost 0 25 50 75 100 125

Total Cost 25 50 75 100 125 150

Average Average Average Fixed Variable Total Marginal Cost Cost Cost Cost

Trends we notice: What happens to Average Fixed Cost as output increases? What happens to Average Variable Cost as output increases? What happens to Average Total Cost as output increases? What happens to Marginal Cost as output increases?

Here are the shapes of typical average fixed cost, average variable cost, average total cost, and marginal cost curves.

Focus for a moment on the relationship between average cost and marginal cost: The Average-Marginal Rule applies here: If MC > AC then AC rising. If MC < AC then AC falling. If MC = AC then AC is at its minimum. The quantity that corresponds to the minimum of Average Total Cost has a special name: efficient scale

Note the relationship between marginal product and marginal cost:

III. Production and Cost in the Long Run A. Production In the long run, all inputs are variable. B. Costs In the long run, there are no fixed costs. The __________________________________________ is found by tracing out the minimums of all of the Short Run Average Total Cost curves.

For a given firm, its LRAC is usually a flat u-shape. - range of output where average costs are falling as output rises - range of output where average costs are rising as output rises

_______________________ of Scale often occur when a firm has high overhead and large fixed costs. - automobile manufacturer needs to make a high volume of vehicles to make up for the factory costs _______________________ of Scale often occur when a firm is so big that it is experiencing coordination and communication issues. - different branches of Sony have sued each other not realizing they were both part of Sony _________________________ to Scale = average costs stay constant as output increases. ___________________________________________________________________ Chapter Summary: The goal of firms is to maximize profit (total revenue minus total cost). When calculating profits, it is important to include all the opportunity costs of production. A firms costs reflect its production process. - diminishing marginal product - total cost curve gets steeper as the quantity rises

A firms total costs can be divided between fixed costs and variable costs. - Fixed costs are costs that do not change when the firm changes the quantity of output. - Variable costs are costs that do change when the firm changes the quantity of output.

Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost rises if output increases by one unit. For a typical firm, marginal cost rises with the quantity of output. Average total cost first falls as output increases and then rises as output increases further. The marginal-cost curve always crosses the average total cost curve at the minimum of average total cost.

A firms costs often depend on the time horizon being considered. - many costs are fixed in the short run but variable in the long run