(2) Chpt 13 Costs of Production

Frida operates Frida's FroYo and spends $1,200 per week on frozen yogurt, $18 per week on cardboard bowls, $3 per week on spoons, $77 per week on candy and other toppings, and $2,300 on rent for the storefront and equipment. Frida sells her frozen yogurt for $4 per serving and she sells 1,500 servings per week. Frida's average variable cost is about

$0.87. [Average variable cost is total variable cost divided by quantity. Frida's total variable cost is the sum of the costs that change with changes in output, including frozen yogurt, bowls, spoons, and toppings. Frida's total variable cost is $1,200 + $18 + $3 + $77 = $1,298, so her average variable cost is $1,298/1,500 = $0.8653, about $0.87]

average fixed cost of producing 4 units is

$2.50 (FC/q) ($10/4)

Implicit costs example 2

Using $300,000 of savings to put toward the cookie factory instead of a savings account with interest of 5% = $15,000 per year. The foregone $15,000 is an implicit opportunity cost.

Average Variable Cost (AVC) Formula

Variable Cost/quantity of output (VC/Q)

Which of the following is a variable cost in the short run?

Wages paid to factory labor

Example of marginal product

When the number of workers goes from 1 to 2, cookie production increases from 50 to 90. The marginal product of the second worker is 40 cookies. (as number of workers increases, the marginal product decreases).

Whenever marginal cost is less than total cost, average total cost is falling.

Whenever marginal cost is greater than average total cost, average total cost is rising. [the marginal cost curve crosses the average total cost curve at its minimum]

Firms do not take into account fixed cost when deciding to stay open. Shutdown point is when

a firm experiences no benefit from continuing operations and will shut down. (fixed costs are not included when deciding to shutdown, only variable costs are examined)

AFC curve (average fixed cost curve)

always declines as output rises (because fixed cost is getting spread out over a larger number of units)

If, as the quantity produced increases, a production function first exhibits increasing marginal product and later diminishing marginal product, the corresponding marginal-cost curve will

be U-shaped

The marginal cost curve rises because of

diminishing marginal product. (MC increases as quantity of output increases). The upward slope reflects property of diminishing marginal product.

Total cost curve gets steeper at the end due to

diminishing marginal product; producing one additional unit of output requires a lot of additional units of inputs = very costly. (ex: kitchen crowded with workers = diminishing marginal product; producing additional cookies requires a lot of additional labor and is thus very costly)

If Boeing produces 9 jets per month, its long-run total cost is $9 million per month. If it produces 10 jets per month, its long-run total cost is $11 million per month. Boeing exhibits:

diseconomies of scale (increased quantity leads to increased ATC)

In the long run, if a very small factory were to expand its scale of operations, it is likely that it would initially experience

economies of scale

A higher level of production allows workers to specialize in particular tasks, a firm will likely exhibit _____ of scale and ______ average total costs.

economies of scale, and falling average total costs.

When the number of goods produced increases (2)....

fixed cost remains constant

Production function graph gets

flatter as production rises.

Average Total Cost (ATC) is

is the cost of a typical unit of output (if total cost is divided evenly over all the units produced).

Short-run cost curves

lie on or above the long-run cost curves.

Long-run cost curves (differ from short-run cost curves) are

much flatter than short-run cost curves.

When quantity produced is large, the total cost curve is

relatively steep.

When calculating long-run ATC from pre-existing short-run ATC cost curves, the ATC points are found by

taking the lowest average total cost curve at each level of output. (the LRATC (long-run ATC) is at the lowest points and will cover them in blue).

Assumption economists make about the goal of a firm

the goal of a firm is to maximize profit

The slope of the production function measures

the marginal product. As the number of workers increases (input), the marginal product declines, and the production function becomes flatter.

Diminishing marginal product explains why, as a firm's output increases

the production function gets flatter, AND the total-cost curve gets steeper.

AVC curve (average variable cost curve)

typically rises as output increases (because of diminishing marginal product)

When the number of goods produced increases...

variable cost increases [Variable cost and total cost have a positive relationship]

Production function graph axes

x-axis = number of inputs (number of workers). y-axis = quantity of output (cookies per hour)

Axes of total-cost curve

x-axis = quantity produced (output). y-axis = total cost

Madelyn owns a small pottery factory. She can make 1,000 pieces of pottery per year and sell them for $100 each. It costs Madelyn $20,000 for the raw materials to produce the 1,000 pieces of pottery. She has invested $100,000 in her factory and equipment: $50,000 from her savings and $50,000 borrowed at 10 percent (assume that she could have loaned her money out at 10 percent, too). Madelyn can work at a competing pottery factory for $40,000 per year. The economic profit at Madelyn's pottery factory is

$30,000 (Total rev - (explicit + implicit costs)). [100,000 - (20,000 + 5,000) + (5,000 + 40,000)] [100,000 - 70,000 = $30,000] The 20,000 +5,000 is from prior problem. The 5,000 and 40,000 is from interest could have been made from savings account and salary that could have been made from working at a competing factory.

A farmer gives banjo lessons for $20 per hour. One day he spends 10 hours planting $100 worth of seeds on his farm. What total cost has he incurred?

$300. (Total cost = explicit + implicit costs) ($20 × 10 hours = $200) ($200 + $100 = $300)

Madelyn owns a small pottery factory. She can make 1,000 pieces of pottery per year and sell them for $100 each. It costs Madelyn $20,000 for the raw materials to produce the 1,000 pieces of pottery. She has invested $100,000 in her factory and equipment: $50,000 from her savings and $50,000 borrowed at 10 percent (assume that she could have loaned her money out at 10 percent, too). Madelyn can work at a competing pottery factory for $40,000 per year. The accounting profit at Madelyn's pottery factory is

$75,000. (Total rev - explicit costs). [100,000 - (20,000 + 5,000) = $75,000]. The $5,000 comes from interest paid on borrowed $50,000 at 10% (0.1 × 50,0000 = 5,000) since money flows out of firm to pay for it.

The marginal cost of changing production from 3 units to 4 units is

$8 ($26 - $18 = $8)

The average total cost of producing 3 units is

$9.33 (TC/Q) ($10 + $18/3) = ($28/3)

MC < ATC then

(ATC) average total cost is falling

MC > ATC then

(ATC) average total cost is rising

3 properties of typical cost curves

1) Marginal cost eventually rises with quantity of output. 2) The average total cost curve is U-shaped. 3) The marginal cost curve crosses the ATC curve at the minimum of the average total cost.

Example of how the number of input (workers) increases, leads to a decrease in marginal product.

2nd worker added to a firm has a marginal product of 40 cookies; 3rd worker has marginal product of 30 cookies.... (gets smaller; is called diminishing marginal product).

The efficient scale of production is

4 units (at 0 units it is 10+0/0) (at 1 unit it is (10+5)/1 = 15) (at 2 units it is (10+11)/2 = 10.5) (at 3 units it is (10+18)/3 = 9.33) (at 4 units it is (10+26)/4 = 9) (at 5 units it is (10+36)/5 = 9.2) [At 4 units the ATC was the lowest = $9 which makes it the efficient scale]

Farmer faces diminishing marginal product. If he plants no seeds on his farm, he gets no harvest. If he plants 1 bag of seeds he gets 3 bushels of wheat; if he plants 2 bags of seeds he gets 5 bushels; if he plants 3 bags of seeds he gets

6 bushels (is not 7 ,8, or 9 because the marginal product is not increasing as much with each bag of seeds planted)

ATC Formulas (2)

ATC = TC/Q and ATC = AFC + AVC

The government imposes $1,000 per year license fee on all pizza restaurants. As a result, which cost curve shifts?

ATC and AFC

Example of why ATC responds to MC getting smaller or larger.

ATC is like cumulative grade point average and MC is like the grade you get in your next course. When MC (grade in next course) increases, then ATC (grade point average) increases. When MC (grade in next class) decreases, then ATC (grade point average) goes down.

A firm is producing 20 units with an ATC of $25 and a MC of $15. If it increases production to 21 units, which of the following occurs?

ATC will decrease.

Ellen opens a lemonade stand for 2 hours. She spends $10 for ingredients and sells $60 worth of lemonade. In the same 2 hours she could mow someone's lawn for $40. Ellen's earns an accounting profit of _______ and an economic profit of ______.

Accounting profit of $50. Economic Profit of $10. (Acct profit: total rev - explicit cost) ($60 - $10 = $50) [Econ profit: total rev - explicit and implicit cost] [$60 - ($10 + $40) = $10]

Total Revenue

Amount a firm receives for the scale of its outputs (quantity of output the firm produces times the price at which it sells its output)

Example of diminishing marginal product

As more workers are hired, each extra worker contributes fewer additional cookies to production. (due to over-crowding, less available equipment, ect)

At low levels of output (1-2 cups of coffee) AFC is high because fixed cost is spread over only a few units.

As output increases, fixed cost decreases as it is spread over more units (AFC declines rapidly at first then slows down). Tug of war btwn AFC and AVC generated U-shaped ATC curve.

Fixed Costs (FC)

Costs that do not vary with the quantity of output produced (are incurred even if a firm produces nothing at all) (ex: rent, cost of hiring a bookkeeper, etc.)

Variable costs (VC)

Costs that vary with the quantity of output produced (ex: cost of milk, sugar, cups, and worker salaries). [cost of sugar increases if you make more coffee; price of worker salaries increase if you hire more workers]

Chart of How accountants vs economists calculate economic/accounting profit

Economists: profit = total rev- explicit and implicit costs. Accountants: profit = total rev - explicit costs.

These properties of short-run and long-run cost curve graphs exist because firms have greater flexibility in the long-run. In the long-run, firms can choose which short-run curve it wants, but in the short-run it must use whatever short-run curve it has determined by decisions made in the past.

Ex: if ford wants to increase production, in short-run no choice but to hire more workers which leads to diminishing marginal product and increased ATC ($10,000 to $12,000). In long-run, Ford can expand workforce and factory size so ATC can return to $10,000.

Total Cost Formula (again)

Explicit cost + Implicit cost

2 types of opportunity costs for a firm

Explicit cost, implicit cost

Total Cost Formula

Explicit costs + implicit costs

Cost of financial capital as an opportunity cost (in-class)

Financial capital has an implicit cost (interest income not earned on financial capital) ex: owned as savings, invested in business. Is NOT shown as a cost by an accountant.

Total Cost Formula #2

Fixed Cost + Variable cost (FC + VC)

Average Fixed Cost (AFC) Formula

Fixed cost/quantity of output (FC/Q)

Many decisions are ______ in the short-run and are _______ in the long-run

Fixed in the short-run and variable in the long-run.

Because accountants ignore implicit costs, accounting profit is usually larger than economic profit.

For a business to be profitable from an economist's pov, total revenue must exceed all opportunity costs, both explicit and implicit.

Total Revenue example

Harry produces 10,000 cookies and sells them for $2 a piece. Total revenue is (p × q) ($2 × 10,000) = $20,000.

Example of financial capital opportunity cost between economists and accountants

Harry uses $100,000 in savings toward his business and borrows $200,000 from bank at 5% interest rate. An accountant (measures only explicit costs) will write down $10,000 interest paid to the bank loan every year as a cost (since money now flows out of the firm). An economist will say opt. cost of owning a business is still $15,000. Opt. cost = interest on bank loan (explicit cost of $10,000) plus foregone interest on savings (implicit cost of $5,000).

When one of your inputs is fixed it means a firm is in the short-run. Any kind of fixed cost present means the firm is in the short-run.

If a firm has no fixed cost, that means the firm is in the long-run.

Firm's cost of production

Includes all opportunity costs of making its output of goods and services (includes explicit and implicit costs)

Implicit costs

Input costs that do not require an outlay of money by the firm (ex: Could earn $100 per hour as a computer programmer. For every hour at the cookie factory you'd give up $100 in income which is part of her firm's implicit cost)

Explicit Costs

Input costs that require an outlay of money by the firm. (ex: money paid to buy inputs to make cookies (flour) and money paid out as wages to workers).

4 factors of production (needed to produce a good)

Labor, land, capital, and technology

Economics of Scale

Long-run ATC falls as the quantity of output increases (arises due to increasing specialization among workers) (Level of output increases and total cost decreases in the long-run).

Diseconomies of scale (when economics of scale gets too big)

Long-run ATC rises as the quantity of output increases (arises due to increasing coordination problems) (Level of output increases and total cost increases) = firm is too big

Constant Returns to scale

Long-run ATC stays the same as the quantity of output changes.

A firm is producing 1,000 units at a total cost of $5,000. When it increases production to 1,001 units, its total cost rises to $5,008. For this firm marginal cost is _____ and average total cost is ____

MC = $8. ATC = $5. [ATC = TC/Q = $5,000/1,000 = $5] [MC = ΔTC/ΔQ = ($5,008/$5,000)/(1,001-1,000) = 8/1 = $8].

Marginal Cost (MC) Formula

MC = ΔTC/ΔQ

MC, ATC, AVC, and AFC graph

MC rises with quantity of output. ATC is U-shaped. MC curve crosses ATC curve at the minimum average of total cost.

Typical Cost curve graph

Many firms experience increasing marginal product before diminishing marginal product. As a result, have cost curves like the graph. Notice that MC and AVC fall for a while before starting to rise.

Average total cost (ATC) tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced.

Marginal cost tells us the increase in total cost that arises from producing an additional unit of output.

Variable cost examples (changes with change in output(quantity))

Number of workers, number of inputs, utility costs (electric or water bill, etc.)

The cost of financial capital as an opportunity cost

Only includes implicit costs such as interest income earned on financial capital (from prior example). The money is owned as savings and is invested in the business. The added income from interest rates in a savings account ($15,000) was instead invested in the business, the lost $15,000 per year is not shown as a cost by an accountant (since no money flows out of the business to pay for it).

A fixed cost doesn't change with a change in output (quantity). Examples:

Paying $30 every month to buy a factory until you pay it off; or rent (paying $20 per day to rent an oven).

Total Revenue Formula

Price × Quantity

Total-cost Curve

Relationship between quantity produced and total costs (gets steeper as the amount of output rises).

Division of labor

Specialization of labor (increases productivity and hence increases output).

U-shaped average total-cost curve (ATC)

The bottom of the U-shaped ATC curve is at the quantity that minimizes average total cost.

Costs as opportunity costs

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

Marginal Product

The increase in output that arises from an additional unit of input (is the slope of the production function).

Marginal Cost

The increase in total cost that arises from an extra unit of production. (ex: increase in coffee production from 2 to 3 cups, total cost rises $3.80 to $4.50, so marginal cost of 3rd cup is $4.50 - $3.80 = $0.70)

Total Cost

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

Diminishing marginal product

The property whereby the marginal product of an input declines as the quantity of input decreases. (production function gets flatter as more inputs are being used; the slope of production function decreases)

Efficient Scale

The quantity of output that minimizes average total cost (located at bottom of U-curved ATC curve).

Production Function

The relationship between the quantity of inputs used to make a good and the quantity of output of that good. (ex: relationship btwn # of workers and # of cookies produced)

Industrial Organization

The study of how firms' decisions about prices and quantities depend on the market conditions they face.

When given a table, the fixed cost is the amount of money paid at 0 output (and will be the same down the entire column). Variable costs on a table are calculated by

Total Cost - Fixed cost = Variable cost (TC - FC = VC) [MC is incremental increase of TC between outputs]

Average Total Cost (ATC) Formula

Total Cost/quantity of output (TC/Q)

Economic Profit

Total Revenue minus total cost, including both explicit and implicit costs (measured by an economist)

Accounting Profit

Total Revenue minus total explicit cost (measured by an accountant).

Profit Formula

Total revenue - total cost