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PAN African eNetwork Project

Masters of Finance and Control Managerial Economics


Semester - I
Ms. Sonia Singh
1

Costs and Production

The Production Process


We now turn to consider the other side of the market: the Producer side What will we do with this? We examine the production process, which will allow us to understand the costs faced by a firm, which in turn, provides us with an understanding of supply relationships Thus we consider, in sequence:
Production Theory Cost Theory

Central Actor: The Firm


What are firms?
A way of organizing resources to provide goods and services to a market An organization specializing in the production of some good or service

What do firms do?


They engage in production Production is a transformation process in which inputs are transformed into outputs

Why do they do it?


For profit

The Firms Objective


The economic goal of the firm is to maximize profits.

Total Revenue, Total Cost, and Profit


Total Revenue
The amount a firm receives for the sale of its output.

Total Cost
The market value of the inputs a firm uses in production.

Total Revenue, Total Cost, and Profit


Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Costs as Opportunity Costs


A firms cost of production includes all the opportunity costs of making its output of goods and services. Explicit and Implicit Costs
A firms cost of production include explicit costs and implicit costs.
Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm.

Economic Profit versus Accounting Profit Economists measure a firms economic profit as total revenue minus total cost, including both explicit and implicit costs. Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs.

Economic Profit versus Accounting Profit When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.

Economic Profit vs. Accounting Profit


If we calculate Profit = Revenue - Explicit Cost we have Accounting Profit If we calculate Profit = Revenue - Explicit Costs - Implicit Costs we have Economic Profit

Figure 1 Economic versus Accountants


How an Economist Views a Firm How an Accountant Views a Firm

Economic profit Accounting profit Revenue Implicit costs Total opportunity costs Revenue

Explicit costs

Explicit costs

Copyright 2004 South-Western

The difference between implicit and explicit is important when we compute the profit. When computing the profit accountants only consider the explicit cost and economist consider both implicit and explicit cost. Imagine a firm with the following costs and revenue: Implicit Cost = 50 Explicit Cost = 30 Revenue = 100 Accountant Profit = Revenue Explicit Cost = 100 30 = $70 Economic Profit = Revenue Explicit Cost Implicit Cost = 100- 50 -30 = $20

The difference is quite big between accountant and economic profit. For this class, whenever we talk about profit we are referring to the economic profit.

Before we continue with more definitions of costs we will talk about the technology of the firms. Why? Because the technology of the firm determines the way costs behave. For example, cars used to be very expensive at the beginning of the 1900s, this is because the technology they used. Back then only a handful of people could afford to buy cars. Nowadays, firms use a different type of technology so cars are cheaper. To summarize: We will study the firm and firms only concern is to maximize profits. Profits are composed of revenue and costs. The revenue = P x Q and it depends on the type of market the firms operates. The costs of the firm depend on the technology of the firm, so we will first cover technology and then move on to costs.

Profit= Total Revenue Total Cost

Revenue depends on the market structure

Costs depend on the technology or production

We will study market structures in the next slide

Study production or technology to understand cost

The Firm
What kinds of firms are there?
Sole proprietorships Partnerships Corporations

Why do firms exist?


Cheaper
Specialization arguments (firms, employees) Lower Transactions Costs Risk Reduction

Production
How do firms organize resources? The Production Process Dependent on the Technology available Can be translated into more precise terms: The Production Function--For a given production technology, the production function tells us how much output you can get from a particular combination of inputs

Production
An entrepreneur must put together resources -- land, labour, capital -- and produce a product people will be willing and able to purchase

PRODUCTION FUNCTION
THE RELATIONSHIP BETWEEN THE AMOUNT OF INPUT REQUIRED AND THE AMOUNT OF OUTPUT THAT CAN BE OBTAINED IS CALLED THE PRODUCTION FUNCTION

What can you say about Marginal Product ?


As the quantity of a variable input (labour, in the example) increases while all other inputs are fixed, output rises. Initially, output will rise more and more rapidly, but eventually it will slow down and perhaps even decline. This is called the LAW OF DIMINISHING MARGINAL RETURNS

LAW OF DIMINISHING RETURNS


IT HOLDS THAT WE WILL GET LESS & LESS EXTRA OUTPUT WHEN WE ADD ADDITIONAL DOSES OF AN INPUT WHILE HOLDING OTHER INPUTS FIXED. IT IS ALSO KNOWN AS LAW OF VARIABLE PROPORTIONS.

COMBINING RESOURCES
THERE ARE MANY COMBINATIONS OF RESOURCES THAT COULD BE USED CONSIDER THE FOLLOWING TABLE SHOWING DIFFERENT NUMBER OF MECHANICS AND AMOUNT OF CAPITAL THAT THE HYPOTHETICAL FIRM, INDIA INC., MIGHT USE

ALTERNATIVE QUANTITIES OF OUTPUT THAT CAN BE PRODUCED BY DIFFERENT COMBINATIONS OF RESOURCES


Number of Mechanics 0 1 2 3 4 5 6 7 CA PITA L 5 0 10 0 15 0 20 0 25 0 30 0 35 0 40 0

30 60 100 130 130 110 100

100 250 360 440 500 540 550

250 360 480 580 650 700 720

340 450 570 640 710 760 790

410 520 610 690 760 800 820

400 530 620 700 770 820 850

400 520 620 700 780 830 870

390 500 610 690 770 840 890

PRODUCTION IN THE SHORT RUN


THE SHORT RUN IS A PERIOD JUST SHORT ENOUGH THAT AT LEAST ONE RESOURCE (INPUT-INDUSTRIAL PLANT,MACHINES) CANNOT BE CHANGED -- IS FIXED OR INELASTIC. THUS IN THE SHORT RUN PROUDCTION OF A COMMODITY CAN BE INCREASED BY INCREASING THE USE OF ONLY VARIABLE INPUTS LIKE LABOUR AND RAW MATERIALS.

Quantities of Output that Can Be Produced When One Resource is Fixed


N umber of Mechanics 0 1 2 3 4 5 6 7 CAPITAL 5 0 10 0 15 0 20 0 25 0 30 0 35 0 40 0

30 60 100 130 130 110 100

100 250 360 440 500 540 550

250 360 480 580 650 700 720

340 450 570 640 710 760 790

410 520 610 690 760 800 820

400 530 620 700 770 820 850

400 520 620 700 780 830 870

390 500 610 690 770 840 890

LONG RUN
THE LONG RUN IS A PERIOD SUFFIECIENTLY LONG THAT ALL FACTORS INCLUDING CAPITAL CAN BE ADJUSTED OR ARE VARIABLE. THIS MEANS THAT THE FIRM CAN CHOOSE ANY COMBINATION ON THE MANUFACTURING TABLE -- NOT JUST THOSE ALONG COLUMN LABELLED 10

THREE STAGES OF PRODUCTION


No. of workers (N) Total product TPL Marginal Product (MPL) (tonnes) (1) 1 2 3 4 5 6 7 8 9 10 11 12 (2) 24 72 138 216 300 384 462 528 576 600 594 552 (3) 24 48 66 78 84 84 78 66 48 24 -6 -42 Average Product Stage of production (APL) (4) 24 36 46 54 60 64 66 66 64 60 54 46 III -VE RETURNS II DIMINISHING RETURNS I INCREASING AND CONSTANT RETURNS (5)

BEHAVIOUR OF TPP,MPP AND APP DURING THE THREE STAGES OF PRODUCTION


TOTAL PHYSICAL PRODUCT STAGE I INCREASES AT AN INCREASING RATE STAGE II INCREASES AT A DIMINISHING RATE TILL IT REACHES MAXIMUM STAGE III STARTS DECLINING MARGINAL PHYSICAL PRODUCT AVERAGE PHYSICAL PRODUCT INCREASES & REACHES ITS MAXIMUM STARTS DIMINISHING

INCREASES, REACHES ITS MAXIMUM & THEN DECLINES TILL MR = AP IS DIMINISHING AND BECOMES EQUAL TO ZERO

BECOMES NEGATIVE

CONTINUES TO DECLINE

FROM THE ABOVE TABLE ONLY STAGE II IS RATIONAL WHICH MEANS RELEVANT RANGE FOR A RATIONAL FIRM TO OPERATE. IN STAGE I IT IS PROFITABLE FOR THE FIRM TO KEEP ON INCREASING THE USE OF LABOUR. IN STAGE III, MP IS NEGATIVE AND HENCE IT IS INADVISABLE TO USE ADDITIONAL LABOUR. i.e ONLY STAGE I AND III ARE IRRATIONAL

Law of Variable Proportions a/k/a Law of Diminishing Returns


When total output (production) of a commodity is increased by adding units of variable input (labor, capital use, etc.) while quantities of other inputs are held constant, the increases in total production become, after some point, smaller and smaller. Total production increases but the size of the increases diminish.

TP Total Product

Units of Labor

As more units of the variable resource, labor, are used; the total product continues to increase. After a certain point, however, total product still increases but at a decreasing rate. Finally, total product actually begins to decrease.

The law of diminishing returns assumes all units of variable inputs, workers in this case, are of equal quality. As each additional worker is added, up to point C, TP continues to increase. After point C, TP declines. Total product goes through 3 phases: It rises initially at an increasing rate; then it increases but at a decreasing rate; finally it reaches a maximum and declines

TP
Total Product

2 1
A Product per unit B C

Units of Labor Marginal Product is the additional output added per additional unit of input
Marginal Product

Units of Labor

Marginal Product is geometrically the slope of the total product curve. Marginal product measures the changes in total product associated with each additional input, in this case workers. The three phases of total product are also reflected in marginal product. Where total product is increasing at an increasing rate, marginal product is also rising. Workers added are adding larger and larger amounts to total product.

TP
Total Product

2 1
A Product per unit B C

Units of Labor

3 MP is 0
Marginal Product

1
Units of Labor

Where total product is increasing but at a decreasing rate, marginal product is positive but falling. Each additional worker adds less to total product than did preceding workers. When total product is at a maximum, marginal product is zero. When total product declines, marginal product becomes negative. Each additional unit of input added actually takes away from total product.

Lets Plot the MPP Schedule Well place it on top of the APP schedule so we can compare the two

Marginal and Average


Average and 150 Marginal Product 125 100 75 50 25 0 1 2 3 4 5 6 7 8

MPP>APP
|----------| |-----------------------------|

MPP<APP

APP
MPP=APP

Number of Mechanics

MPP

TP

Negative Returns Total Product

Increasing Returns Diminishing Returns

A Product per unit


Increasing Returns

B
Diminishing Returns

Units of Labor

Negative Returns

MP is 0
Marginal Product

Units of Labor

ISOQUANT
AN ISOQUANT OR ISO PRODUCT CURVE OR EQUAL PRODUCT CURVE OR A PRODUCTION INDIFFERENCE CURVE SHOW THE VARIOUS COMBINATIONS OF TWO VARIABLE INPUTS RESULTING IN THE SAME LEVEL OF OUTPUT. IT IS DEFINED AS A CURVE PASSING THROUGH THE PLOTTED POINTS REPRESENTING ALL THE COMBINATIONS OF THE TWO FACTORS OF PRODUCTION WHICH WILL PRODUCE A GIVEN OUTPUT.

Isoquants
An isoquant is a curve or line that has various combinations of inputs that yield the same amount of output.

For example from the following table we can see that different pairs of labour and capital result in the same output.

Labour (Units) 1 2 3 4 5

Capital (Units) 5 3 2 1 0

Output (Units) 10 10 10 10 10

An Isoquant
Capital, K (machines rented)

12 10 8 6 4 2 0 1 2 j 3 4 5 6 i

Each point on a given isoquant represents different recipes for producing the same level of output.

Quantity of Soybeans = 1 (kg./hour)

Labor, L (worker-hours employed)

10

43

FOR EACH LEVEL OF OUTPUT THERE WILL BE A DIFFERENT ISOQUANT. WHEN THE WHOLE ARRAY OF ISOQUANTS ARE REPRESENTED ON A GRAPH, IT IS CALLED AN ISOQUANT MAP. IMPORTANT ASSUMPTIONS THE TWO INPUTS CAN BE SUBSTITUTED FOR EACH OTHER. FOR EXAMPLE IF LABOUR IS REDUCED IN A COMPANY IT WOULD HAVE TO BE COMPENSATED BY ADDITIONAL MACHINERY TO GET THE SAME OUTPUT.

An Isoquant Map
0 1 2 3 4 5 6 7 8 9 10
Capital, K (machines rented)

Different isoquants represents different levels of output.

m
Quantity of Soybeans = 2 (kg./hour)

k
Quantity of Soybeans = 1 (kg./hour)

9 10

Labor, L (worker-hours employed) 45

SLOPE OF ISOQUANT
THE SLOPE OF AN ISOQUANT HAS A TECHNICAL NAME CALLED THE MARGINAL RATE OF TECHNICAL SUBSTITUTION (MRTS) OR THE MARGINAL RATE OF SUBSTITUTION IN PRODUCTION. THUS IN TERMS OF CAPITAL SERVICES K AND LABOUR L MRTS = Dk/DL

Marginal Rate of Substitution


Capital slope = Change in K Change in L On the next slide I will refer to a change with the use of a triangle. Labor

MRS
The slope of the curve at a point is K/ L

Now, if the marginal product of an input is defined as the change in output divided by the change in the input, the slope can be manipulated to be: K Q and since L Q K = 1 Q MPK

So the slope is MPL/MPK and is called the MRS (in absolute value) and it is a measure of the rate at which inputs can be substituted and output remains the same.

TYPES OF ISOQUANTS
1. LINEAR ISOQUANT 2. RIGHT-ANGLE ISOQUANT 3. CONVEX ISOQUANT

LINEAR ISOQUANT
IN LINEAR ISOQUANTS THERE IS PERFECT SUBSTIUTABILTY OF INPUTS. FOR EXAMPLE IN A POWER PLANT EQUIPED TO BURN OIL OR GAS. VARIOUS AMOUNTS OF ELECTRICITY COULD BE PRODUCED BY BURNING GAS, OIL OR A COMBINATION. i.e OIL AND GAS ARE PERFECT SUBSITUTES. HENCE THE ISOQUANT WOULD BE A STRAIGHT LINE.

RIGHT-ANGLE ISOQUANT
IN RIGHT-ANGLE ISOQUANTS THERE IS COMPLETE NON-SUBSTIUTABILTY BETWEEN INPUTS. FOR EXAMPLE TWO WHEELS AND A FRAME ARE REQUIRED TO PRODUCE A BYCYCLE THESE CANNOT BE INTERCHANGED. THIS IS ALSO KNOWN AS LEONTIEF ISOQUANT OR INPUT-OUTPUT ISOQUANT.

CONVEX ISOQUANT
IN CONVEX ISOQUANTS THERE IS SUBSTIUTABILTY BETWEEN INPUTS BUT IT IS NOT PERFECT. FOR EXAMPLE (1) A SHIRT CAN BE MADE WITH LARGE AMOUNT OF LABOUR AND A SMALL AMOUNT MACHINERY. (2) THE SAME SHIRT CAN BE WITH LESS LABOURERS, BY INCREASING MACHINERY. (3) THE SAME SHIRT CAN BE MADE WITH STILL LESS LABOURERS BUT WITH A LARGER INCREASE IN MACHINERY.

WHILE A RELATIVELY SMALL ADDITION OF MACHINERY FROM M1(MANUAL EMBROIDERY) TO M2(TAILORING MACHINE EMBROIDERY) ALLOWS THE INPUT OF LABOURERS TO BE REDUCED FROM L1 TO L2. A VERY LARGE INCREASE IN MACHINERY TO M3 (COMPUTERISED EMBROIDERY) IS REQUIRED TO FURTHER DECREASE LABOUR FROM L2 TO L3. THUS SUBSTIUTABILITY OF LABOURERS MACHINERY DIMINISHES FROM M1 TO M2 TO M3. FOR

PROPERTIES OF ISOQUANTS
1. AN ISOQUANT IS DOWNWARD SLOPING TO THE RIGHT. i.e NEGATIVELY INCLINED. THIS IMPLIES THAT FOR THE SAME LEVEL OF OUTPUT, THE QUANTITY OF ONE VARIABLE WILL HAVE TO BE REDUCED IN ORDER TO INCREASE THE QUANTITY OF OTHER VARIABLE.

PROPERTIES OF ISOQUANTS

2. A HIGHER ISOQUANT REPRESENTS LARGER OUTPUT. THAT IS WITH THE SAME QUANTITY OF 0NE INPUT AND LARGER QUANTITY OF THE OTHER INPUT, LARGER OUTPUT WILL BE PRODUCED.

PROPERTIES OF ISOQUANTS

3. NO TWO ISOQUANTS INTERSECT OR TOUCH EACH OTHER. IF THE TWO ISOQUANTS DO TOUCH OR INTERSECT THAT MEANS THAT A SAME AMOUNT OF TWO INPUTS CAN PRODUCE TWO DIFFERENT LEVELS OF OUTPUT WHICH IS ABSURD.

PROPERTIES OF ISOQUANTS 4. ISOQUANT IS CONVEX TO THE ORIGIN. THIS MEANS THAT THE SLOPE DECLINES FROM LEFT TO RIGHT ALONG THE CURVE. THAT IS WHEN WE GO ON INCREASING THE QUANTITY OF ONE INPUT SAY LABOUR BY REDUCING THE QUANTITY OF OTHER INPUT SAY CAPITAL, WE SEE LESS UNITS OF CAPITAL ARE SACRIFICED FOR THE ADDITIONAL UNITS OF LABOUR.

A Cost Function: Two Resources


Assume that there are two resources, Labor (L) and Capital (K). The money payments to these resources are Wages (W) and Rent (R). An isocost line is similar to the budget line. Its a set of points with the same cost, C. Lets plot K on the y axis and L on the x axis.
WL + RK = C; solve for K by first subtracting WL from both sides. RK = C - WL; next divide both sides by R. K = C/R (W/R)L; note that C/R is the y intercept and W/R is the slope.
58

An isocost line
K (machines rented)

C/R

Absolute value of slope equals The relative price of Labor, W/R.

C/W Labor hours used in production

59

A Numerical Example
Bundles of: Labor Machine rental ($3 per machine hour) 10 8 6 4 2 0 with C = $30 ($6 per labor hour) a b c d e f 0 1 2 3 4 5

Points a through f lie on the isocost line for C = $30/hour.


60

The Isocost Line


Capital, K (machines rented)

10 8 6 4 2 0

a b c d e f 1 2 3 4 5
Labor, L (worker-hours employed)

10

61

The Isocost Line


Capital, K (machines rented)

10 8 6 4 2 0

a b

Cost = $30 R = $3/machine W = $6/hour

c d e f 1 2 3 4 5
Labor, L (worker-hours employed)

10

62

Cost Minimization
Capital, K (machines rented)

Choose the recipe where the desired isoquant is tangent to the lowest isocost.

12 10 8
C = $36

6 4 2
C = $18

equ.

W = $6; R = $3;C = $30

Labor, L (worker-hours employed)

10

63

From the Production Function to the Total-Cost Curve


The relationship between the quantity a firm can produce and its costs determines pricing decisions. The total-cost curve shows this relationship graphically.

Table 1 A Production Function and Total Cost: Hungry Helens Cookie Factory

Copyright2004 South-Western

Figure 3 Hungry Helens Total-Cost Curve


Total Cost $80 70 60 50 40 30 20 10 Total-cost curve

10 20 30 40 50 60 70

80 90 100 110 120 130 140 150

Quantity of Output (cookies per hour)


Copyright 2004 South-Western

THE VARIOUS MEASURES OF COST


Costs of production may be divided into fixed costs and variable costs.

Fixed and Variable Costs


Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do vary with the quantity of output produced.

Fixed and Variable Costs


Total Costs
Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC

Fixed and Variable Costs


Average Costs
Average costs can be determined by dividing the firms costs by the quantity of output it produces. The average cost is the cost of each typical unit of product.

Fixed and Variable Costs


Average Costs
Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC

Average Costs
A F F =C i x e d F cC o s t = Q u a n Q i t y t a r i o a sb t Vl e C c = Q u a n t Qi t y o Q t a l T c Co s t = u a n Qt i t y

V V = C

T T =C

Table 2 The Various Measures of Cost: Thirsty Thelmas Lemonade Stand

Copyright2004 South-Western

Fixed and Variable Costs


Marginal Cost
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

Marginal Cost

( c h a n t go et a i)l n c T o Cs t = C = ( c h a n q g u e a ni n t Q t y ) i

Marginal Cost Thirsty Thelmas Lemonade Stand

Quantity

Figure 4 Thirsty Thelmas Total-Cost Curves


Total Cost $15.00 14.00 13.00 12.00 11.00 10.00 9.00 8.00 7.00 6.00 5.00 4.00 3.00 2.00 1.00 0 1 2 3 4 5 6 7 Quantity of Output (glasses of lemonade per hour) 8 9 10
Copyright 2004 South-Western

Total-cost curve

Cost Curves and Their Shapes


Marginal cost rises with the amount of output produced.
This reflects the property of diminishing marginal product.

Cost Curves and Their Shapes


The average total-cost curve is U-shaped. At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially.

Cost Curves and Their Shapes


The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

Figure 5 Thirsty Thelmas Average-Cost and Marginal-Cost Curves


Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 0 1 2 3 4 5 6 7 8 Quantity of Output (glasses of lemonade per hour) 9 10
Copyright 2004 South-Western

ATC

Cost Curves and Their Shapes


Relationship between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising.

Cost Curves and Their Shapes


Relationship Between Marginal Cost and Average Total Cost
The marginal-cost curve crosses the averagetotal-cost curve at the efficient scale. scale
Efficient scale is the quantity that minimizes average total cost.

Typical Cost Curves

It is now time to examine the relationships that exist between the different measures of cost.

Big Bobs Cost Curves

Figure 6 Big Bobs Cost Curves


(a) Total-Cost Curve Total Cost $18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 0 2 4 6 8 10 12 14 TC

Quantity of Output (bagels per hour)


Copyright 2004 South-Western

Figure 6 Big Bobs Cost Curves


(b) Marginal- and Average-Cost Curves Costs $3.00 2.50 MC 2.00 1.50 1.00 0.50 AFC 0 2 4 6 8 10 12 14 Quantity of Output (bagels per hour)
Copyright 2004 South-Western

ATC AVC

Typical Cost Curves


Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity of output. The average-total-cost curve is U-shaped. The marginal-cost curve crosses the averagetotal-cost curve at the minimum of average total cost.

COSTS IN THE SHORT RUN AND IN THE LONG RUN


For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.
In the short run, some costs are fixed. In the long run, fixed costs become variable costs.

COSTS IN THE SHORT RUN AND IN THE LONG RUN


Because many costs are fixed in the short run but variable in the long run, a firms long-run cost curves differ from its shortrun cost curves.

Figure 7 Average Total Cost in the Short and Long Run


Average Total Cost ATC in short run with small factory ATC in short ATC in short run with run with medium factory large factory

$12,000

ATC in long run

1,200

Quantity of Cars per Day


Copyright 2004 South-Western

Economies and Diseconomies of Scale


Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases. Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases

Figure 7 Average Total Cost in the Short and Long Run


Average Total Cost ATC in short run with small factory ATC in short ATC in short run with run with medium factory large factory

ATC in long run

$12,000 10,000 Economies of scale Constant returns to scale

Diseconomies of scale Quantity of Cars per Day


Copyright 2004 South-Western

1,000 1,200

Summary
The goal of firms is to maximize profit, which equals total revenue minus total cost. When analyzing a firms behavior, it is important to include all the opportunity costs of production. Some opportunity costs are explicit while other opportunity costs are implicit.

Summary
A firms costs reflect its production process. A typical firms production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product. A firms total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.

Summary
Average total cost is total cost divided by the quantity of output. Marginal cost is the amount by which total cost would rise if output were increased by one unit. The marginal cost always rises with the quantity of output. Average cost first falls as output increases and then rises.

Summary
The average-total-cost curve is U-shaped. The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. A firms costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run.

Text & References: Text: Gupta, G.S. 2006, Managerial Economics, 2nd Edition,Tata McGraw Hill Peterson, H.C and Lewis, W.C. 2005, Managerial Economics, 4th Edition, Prentice Hall of India References: R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics Macmillan. Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co. Koutsoyiannis,A. Modern Economics, Third Edition. Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill. Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking. Salvatore,D, International Economics, 9th Edition, John Wiley & Sons. Salvatore, D, Managerial Economics, 5 the edition, Thomson-South

In this section of the semester, we will focus our attention to the behavior of the firm. That is, we want to know how firms behave and how firms determine how much to produce.

We first start by defining what is the firms only goal. The firm is in business to make the largest possible profit. In other words, the firm is in business to maximize profits. Since the firm is in business to maximize profits we need to have a definition of profits: Profit = Revenue - Costs Profits are composed of revenue and costs. The revenue is how much the firm receives from the sale of its good. The cost is how much the firm has to pay to produce the good. Since, revenue and costs determine profit we need to understand them to know how the firm behaves.

1)

Revenue

The firms revenue can be written as: Revenue = Price x Quantity That is, the revenue is the price charged for the good times the number of goods sold by the firm. Notice that the price is a price per unit. For example is the price for shirts is $4 and a firm sold 9 units of them, then the firms revenue is 4 x 9 = $36. Now lets set: Price = P and Quantity = Q

We can now re-write the revenue as: Revenue = P x Q The revenue will behave in different ways depending of the type of market that the firms operates. There are four types of markets: competitive, oligopoly, monopoly and monopolistic competition. Since we have not covered this markets yet we will leave the discussion of the revenue to when we cover each particular market. We now move to the other part of the profit: costs.

2) Costs All firms want to keep low costs because that increases their profit. However, we first need to define what we mean by costs. In general, there are two types of costs: explicit and implicit. Explicit Cost: costs that require a monetary payment from the firm (there is an outlay of money). The firm in this case is actually paying someone.

Implicit Cost: costs that DO NOT require a monetary payment from the firm. The firm in this case is not paying money for a good or service.

Costs = Explicit + Implicit From now whenever we talk about cost we are consider both implicit and explicit cost.

The difference between implicit and explicit is important when we compute the profit. When computing the profit accountants only consider the explicit cost and economist consider both implicit and explicit cost. Imagine a firm with the following costs and revenue: Implicit Cost = 50 Explicit Cost = 30 Revenue = 100 Accountant Profit = Revenue Explicit Cost = 100 30 = $70 Economic Profit = Revenue Explicit Cost Implicit Cost = 100- 50 -30 = $20

The difference is quite big between accountant and economic profit. For this class, whenever we talk about profit we are referring to the economic profit.

Before we continue with more definitions of costs we will talk about the technology of the firms. Why? Because the technology of the firm determines the way costs behave. For example, cars used to be very expensive at the beginning of the 1900s, this is because the technology they used. Back then only a handful of people could afford to buy cars. Nowadays, firms use a different type of technology so cars are cheaper. To summarize: We will study the firm and firms only concern is to maximize profits. Profits are composed of revenue and costs. The revenue = P x Q and it depends on the type of market the firms operates. The costs of the firm depend on the technology of the firm, so we will first cover technology and then move on to costs.

Profit= Total Revenue Total Cost

Revenue depends on the market structure

Costs depend on the technology or production

We will study market structures in the next slide

Study production or technology to understand cost

3) Technology The technology of the firm is how the firms uses inputs to produce and output. Inputs are defined as the resources that the firm uses to produce something else. Examples of inputs are: labor, electricity, raw materials, buildings and so on. Output is what the firm is actually producing (the final product). Examples of outputs are: cars, computers, watches, and so on. For example a firm uses the inputs cotton, labor and sewing machines to produce the output t-shirts. Economists divide inputs into three big categories: capital (K), labor (L) and natural resources (NR) Capital (K) = refers to physical machines, building and equipment used in production. Capital DOES NOT refer to the amount of money the firm has. Labor (L) = refers to the amount of workers. Natural Resources (NR) = refers to the raw material used in production such as oil, electricity, cotton, etc.

Firms use inputs to produce and output. The relationship between these two is called the production function. Production Function: the relationship between the inputs and output. That is, the production function tell us how many tons of cotton, labor, sewing machines and workers are necessary to produce certain amount of t-shirts. Thus, the production function represents the technology of production. The production function is usually written as follows: Q = f(K,L,NR) f(K,L,NR) can be read as depends on K,L,NR. Therefore, Q=f(K,L,NR) is read as the output (Q) depends on K, L and NR. Notice that f(K,L,NR) is NOT a multiplication or addition or anything like that, it just says that Q depends on L, K, and NR. In order to simplify things we are going to forget about NR, this is just to make our life easier. Therefore, we are going to re-write the production function as: Q=f(L,K) That is, output depends on labor and capital.

Production and Time Horizon


In the case of production the time horizon matters. Firms usually have more constraints in the long-run than in the short run. In fact, we can say that in long-run everything is possible for the firm while in the short-run only few things can happen. For example, imagine that you produce donuts and you get a huge order of donuts for next week (3 million donuts). Most likely you will not be able to do it. Why? Because you need more machinery more supplies and more workers. You can probably hire more people relatively easy, say in a couple of days. But bringing new machinery and equipment and having a bigger shop will take months if not years. Thus, we usually say that in the short-run some input are variable. This means that in the short-run this inputs some can be increased or reduced easily (Labor for example) while others (Capital) cannot be changed in the short-run. However, in the long-run (that is in the distant future) everything is possible. In that future you can hire more workers but you can also build a bigger factory with more equipment and machinery to make donuts.

Production and Time Horizon


This take us to the main distinction between short and long run: In the short-run at least one input (usually capital) is fixed (that is one input does not change). In the long-run ALL inputs are variable (all inputs can be increased or decreased). From now on, we are going to talk about production in the short-run unless otherwise is explicitly noted.

Now, that we understand the production function we are going to look at one numerical example and then we will expand it later to include costs. Example: Consider a firm that produces cars (Q) using capital (K) and Labor (L). Because it is the short-run we are going to have capital fixed. The following table show the different amount of labor and capital that yield the corresponding output.

K 1

Notice that when the firm has no Labor it produces nothing but still has one unit of capital because capital is fixed. When the firm has one unit of labor and one unit of capital the firm produces 1 unit of output (1 car). When the firm has two units of labor and one unit of capital the firm produces 3 units of output (3 cars) and so on.

In addition, notice that output increases from zero to 22 and then decreases as we increase the number of workers. MPL is the marginal product of labor. MPL is the amount of output that an extra unit of labor will produce. The formula for the MPL is the following

Change in Output MPL = Change in Labor

K 1

MPL tells the firm how much an extra worker will produce and therefore it is important information. If you are a firm owner and you are thinking about hiring someone you have to consider the MPL of that worker and compare it to how much you will pay the worker to see if it is worth it (we will talk about this in the topic, but you can see now how MPL is important). MPL increases reaches a high point and then decreases.

Why does MPL first increases and then decreases? This happens because of specialization. Consider the following example. You have a lemonade stand and you have all you equipment and a single table where you must prepare the lemonade. When you hire your first worker, he has to do everything: cut the lemons, squeeze them, pour the water, the sugar, stir, put ice, serve the individual cups and attend customers. Obviously having one worker is better than having no worker. If you hire a second worker the two workers can specialize a litle bit. One person will take care of cutting the lemons and squeeze them while other one will pour the water and the sugar and attend customers. This specialization makes the second worker more productive. In our previous example, the second worker produces 2 more units of output while the first worker produces only one unit. As you keep increasing the number of workers the specialize more and more so that each worker produces more than the previous worker and MPL keeps increasing.

However, at some point specialization reaches a limit. The limit is reached when you have a lot of people working in the same table. As you can tell when you have more and more workers working all in the same table and sharing the same equipment they will be in each others way and therefore they will not be as productive. When this happens the advantage of specialization start to decrease and MPL decreases. If you adding worker you will actually reach a point when adding an extra worker reduce output. This is a worker that makes everyone slow down and production decreases when you hire him. In our previous example, this will be the tenth worker and no rational firm will hire him. Why specialization reaches a limit? The reason is that capital is fixed. That is, you can only use one table to produce lemonade and only one set of equipment and machinery. However, if you cold have more tables and equipment MPL will never decrease. Therefore MPL will increase and later decrease in the short-run because in the short-run capital is fixed. Finally,the last column of the previous example shows APL which is the average product of labor. The a

Finally, the last column of the previous example shows APL. APL is the average product of labor. APL tells us what is typical amount that a worker will produce. The formula for APL is the following

Q APL = L

APL also increases and then decreases.

Costs
Now, that we understand the production process of the firm we can study the firms costs. We will resume with the previous example we mentioned before. In order to get the costs of the firm we need to know the price of the inputs. In this case, we need to know the price of labor and capital. We will assume that the price of labor is $50 and the price of capital is $20. Now we need to obtain some definitions of costs: 1) Fixed Cost (FC)= costs that do not vary with the quantity produced. Examples of fixed costs are buildings, expensive or heavy equipment, book keeping and so on. 2) Variable Cost (VC)= costs that vary with the quantity produced. Examples of variable costs are labor, raw materials, electricity, and so on 4) Total Cost (TC) = Fixed Cost + Variable Cost

Costs
5) Average Fixed Cost (AFC) = Fixed Cost / Output AFC is the typical fixed cost of one unit of output. 6) Average Variable Cost (AVC) = Variable Cost / Output AVC is the typical fixed cost of one unit of output. 7) Average Total Cost (ATC) = Total Cost / Output ATC is the typical fixed cost of one unit of output. Because the TC = VC + FV then ATC= AVC + AFC 8) Marginal Cost (MC) = the change in the total cost from producing one extra unit:

MC=

Change in Total Cost Change in Output

Using all these different definitions of costs and the price of labor and capital we obtain the table in the following slide

Costs
Price of Labor = $50 Price of Capital = $20

K
Production

L 1 1
Total Costs

Q 0 1
Per unit costs

The previous table can be divided into three parts. The production section, the total cost section and the per unit section. As it turns out all the relevant information can be obtained by looking at the per unit costs. Hence, we will graph the per unit cost and get a summary of the important results.

0 1

The graph of the per unit costs is the following

MC ATC AVC

AFC Q

Costs
The previous table has a lot of information. Lets have a summary of the main points: 1)AFC is always decreasing. 2)AVC decreases reaches a low point and then increases again. 3)ATC decreases reaches a low point and then increases again. 4)MC decreases reaches a low point and then increases again. 5)When MC > ATC then ATC is increasing When MC < ATC then ATC is decreasing 6) MC crosses ATC and AVC at their lowest point

An activity
Using only one or two sentences, describe the relationship between inputs, marginal product and total product.

What you need to do.


Explain the difference between fixed and variable costs. Describe the difference between the short-run and long-run. Compute the average and marginal physical product for a single input given data on total output at different input levels. Explain the Law of diminishing marginal returns Explain how total product, average product, and marginal product can be computed. Explain the relationship between total product, average product and marginal product curves. Explain the theory of production Describe the Three stages of production. Theory of production Law of variable proportions Short-run Long-run Production function Total product Marginal product Stages of production Diminishing returns

Thank You
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