Module 5 Chapter 7

Resource Costs

-The production function is just the starting point for supply decisions. To decide how much output to produce with that function, a firm must next examine the costs of production. A production function tells us how much output a firm can produce with its existing plant and equipment. We can see that this firm could produce up to 51 pairs per day by employing 6 workers (= capacity). But the previous graph and table doesn't tell us how much the firm will want to produce. -The most desirable rate of output is the one that maximizes total profit—the difference between total revenue and total costs. And there is no reason to expect maximum profit to coincide with maximum output. We must combine the production function with the cost of the inputs.

Average Costs

Average total cost (ATC) is total cost divided by the quantity produced in a given time period ATC = Total Cost / Total Output At 15 units of output, ATC = $245/15 jeans = $16.33 per pair of jeans Average fixed cost (AFC) is the total fixed cost divided by the quantity produced in a given time period. AFC= Fixed Cost / Total Output At 15 units of output, AFC = $120/15 jeans = $8 per pair of jeans Average variable cost (AVC) is the total variable cost divided by the quantity produced in a given time period. AVC= Variable Cost / Total Output At 15 units of output, AVC = $125/15 jeans = $8.33 per pair of jeans

Dollar Costs

Dollar costs are the most likely basis of production decisions, not technical notions of things like MPP. The dollar costs, however, are directly related to the underlying production function.Let's look at some of the costs in our example related to our jeans business. Total cost is the market value of all resources used to produce a good or service. The total cost of producing a good equals the market value of all the resources used in its production. In this case, the production of 15 pairs of jeans per day requires resources worth $245. Total costs will change of course as we alter the rate of production but not all costs increase as we produce more. This idea, then links back to our concepts of time—short run and long run. Fixed Costs are costs of production that don't change when the rate of output is altered (e.g., the cost of basic plant and equipment). = $100 + $20 = $120 per day to produce any quantity of jeans There is no way to avoid fixed costs in the short run. The lowest cost possible (when output is zero) is equal to the fixed costs. When output is zero, you still have to pay your fixed cost in the short run! For instance, you still have to pay rent for your factory. Variable Costs are costs of production that change when the rate of output is altered (e.g., labor and material costs). = $80 + $45 = $125 per day to produce 15 pairs of jeans How fast total costs rise depends on variable costs only. Because they are the ones that change with output in the short run.

We can make some observations about the relationships among the different components of average costs:

Falling AFC: As the rate of output increases, AFC decreases as the fixed cost is spread over more output. Rising AVC: As the rate of output increases, AVC will eventually rise. AVC rises because of diminishing returns in the production process. U-Shaped ATC: The initial dominance of falling AFC, combined with the later resurgence of rising AVC, is what gives the ATC curve its characteristic U shape. Minimum Average Cost: The bottom of the "U" is important as it represents the minimum average total costs. It represents the lowest possible opportunity costs to produce the product. However, the goal of producers is to maximize profit and that might not happen at this point.

Chapter 7 THE COSTS OF PRODUCTION

In this chapter, we begin to look into producer decision-making. Remember that the goal of firms is to maximize their profits. The key questions addressed in this chapter are: How much output can a firm produce? How do the costs of production vary with the rate of output? Do larger firms have a cost advantage over smaller firms?

What causes increasing marginal costs?

Increasing marginal cost is the direct result of diminishing returns. These increasing marginal costs aren't the fault of any worker or business; they simply reflect the resource constraints found in any production setting (i.e., existing and limited plants and equipment). In the short run, the quantity and quality of land and capital are fixed, and a firm can only squeeze more output by hiring workers. These additional workers add to output but at a diminishing rate. So additional output not only add to costs, it adds to costs at an increasing rate.

Marginal Resource Cost

Marginal Cost (MC) refers to the increase in total costs required to get one additional unit of output. More generally Marginal Cost (MC) = Change in Total Cost / Change in Output

Diminishing Marginal Returns

Marginal productivity can increase initially (from a to c on the green MPP line). We assume that every worker is identical so it is not due to the second worker being really good at sewing. Instead, it has a lot to do with specialization. When there are two workers, one worker can focus on sewing and the other worker can cut the material and piece the clothing together. But marginal productivity eventually diminishes and can eventually go negative (where the green MPP lines goes below the horizontal axis). This is called "diminishing returns" and it has to do with the limited availability of other inputs (like capital—in this example, sewing machines). Remember that in the short run, this jeans factory only has 1 sewing machine! So, they hire the 1st They cut the cloth, use the machine to sew the pieces together, and inspect for defects at the end of the line. With the employment of the second worker, the 1stcan specialize in cutting the cloth while the second specializes in sewing and inspecting. With the employment of the third worker, each worker can specialize in a step in the jeans making process. BUT, with the 4thworker, things start to get crowded. They add a bit to the overall level of output. Maybe they assist each of the 1st3 with their jobs. BUT, their contribution isn't as large as the previous 3. The return to hiring another worker is starting to diminish. Often times, you'll hear the expression "too many cooks in the kitchen" to explain the phenomena of diminishing returns to inputs. Law of Diminishing Returns is the marginal physical product of a variable input eventually declines as more of it is employed with a given quantity of other (fixed) inputs. As more labor is hired, each unit of labor has less capital and land to work with. Note: In the graph above, diminishing returns set in when the third worker is hired. Notice the relationship between the(blue) Total Output line and the (green) MPP line If the MPP of labor (MPPL) > 0, then total output will increase. If the MPP of labor (MPPL) < 0, then total output will decrease. If the MPP of labor (MPPL) = 0, then total output will not change.

Short-Run Constraints

So... if the firm wants to maximize profits... how many sewing machines and workers should the firm hire? We have to think about time to answer this question. Here, we consider time as a function of production. There are different production time horizons that limit a firm's choices. -Short-run is the period in which the quantity (and quality) of some inputs can't be changed. -Long-run is the period in which the quantity (and quality) of all inputs can be changed. The short and long run are not set times (like 1 week or 2 years), instead they depend on the specific production process for each firm. For example, for this clothing manufacturer it is probably really easy to vary labor hours. They could ask one of their workers to stay late or come in on their day off. On the other hand, it may be a few days before they are able to get a new sewing machine because they probably have to order it from a specialized manufacturer. It would take even longer to change the physical size of the manufacturing facility, perhaps 1-2 years. You can imagine other firms that would have shorter short-runs (food truck) and longer short-runs (nuclear power plant, Colorado State University). Note: The general assumption is that, in the short-run, labor can change while capital is held constant in the short-run. In the short run, as the amount of labor used increases, the output will also increase [until diminishing returns sets in (more on this soon!)]. Let's assume that the firm is a small shop and only has one sewing machine. The firm narrows their production capabilities in the short run to the row with 1 sewing machine (fixed input in the short run). This firm can vary their labor input. The following is the graphical representation of this short run production function. This is the limit to output in the short run for this firm.

Economic vs. Accounting Costs

The cost curves we observe are based on real production relationships. The dollar costs computed are a direct reflection of underlying resource costs: the land, labor, and capital used in the production process. Not everyone counts this way. On the contrary, accountants and business-people typically count dollar costs only and ignore any resource use that doesn't result in an explicit dollar cost. Explicit Cost is a payment made for the use of a resource. Implicit cost is the value of resources used, for which no direct payment is made. The essential economic question is how many resources are used in production. Economic and accounting costs will diverge whenever any factor of production is not paid an explicit wage (or rent, etc.) Economic cost is the value of all resources used to produce a good or service; the opportunity cost of production. Economic Cost = Explicit Costs + Implicit Costs Accounting cost is the costs that have an explicit dollar cost attached to them. Accounting Cost = Explicit Costs only Whenever we talk about costs, we mean economic costs.

Marginal Cost

The economic cost of a particular quantity of output is measured by the value of the resources needed to produce it. How do input costs change when output increases? When we focus on the additional costs incurred from increasing production, we're talking about marginal costs. Marginal Cost (MC) is the increase in total cost associated with a one-unit increase in production. MC = Change in Total Cost / Change in Output Marginal cost and MPP are also connected! As we have to pay the workers we hire! Whenever MPP is increasing, the marginal cost of producing a good must be falling. Likewise, if MPP declines, marginal cost increases.

A Cost Summary

The output decision has to be based not only on the capacity to produce (the production function) but also on the costs of production (the cost functions). The following is a graph of the cost curves where the curves are "smoothed." CostSummary Cost curves have a predictable shape "U-shaped" ATC and AVC Continually diminishing AFC "Nike Swoosh" MC All firms will have similarly shaped cost curves. Some firms may have higher or lower costs based on their individual productivity or resource costs. Firms with higher costs would have cost curves represented graphically as higher on the cost curve graph. Firms with lower costs would have cost curves represented graphically as lower on the cost curve graph. The marginal cost curve always intersects the ATC and AVC curves at their lowest point. If MC > ATC, ATC is increasing. If MC < ATC, ATC is decreasing. If MC > AVC, AVC is increasing. If MC < AVC, AVC is decreasing.

Efficiency

The production function shows us the maximum output that can be attained from a given level of inputs, in other words, it represents maximum technical efficiency. Efficiency (technical) is the maximum output of a good from the resources used in production. It is possible to produce inefficiently. This means getting less output than possible for the inputs used (which isn't a desirable situation). But we assume that a firm is producing efficiently - that they are doing the best that they can given available resources, technology, and management. If there is an advancement in technology, or if the firm has better management, then there would be increased productivity leading to a change in the production.

THE PRODUCTION FUNCTION

The production function tells us how a firm uses different levels of resources and available technology to produce an output. Factors of Production are resource inputs used to produce goods and services, such as land, labor, capital, and entrepreneurship. Production function is a technological relationship expressing the maximum quantity of a good attainable from different combinations of factor inputs. There is a great South Park episode about underpants-stealing gnomes. They steal underpants (inputs) but they don't know how to turn those underpants into something that will earn them profit. Below is the short clip (one bad word) and a picture of their business plan. From a firm's perspective, they really want to know how best to produce. What is the smallest amount of resources needed to produce a specific product? or, What is the maximum amount of output attainable from a given quantity of resources? The purpose of a production function is to tell us just how much output we can produce with varying amounts of factor inputs.

Long-Run Costs

The short-run is characterized by fixed costs. These costs (factory, equipment, etc.) cannot be changed in the short-run. In the long-run, new sites can be leased, new equipment can be installed, and new buildings can be constructed. Consequently, there are no fixed costs in the long-run. It is a moment in time where anything about the production process can be changed. In the long run, the business could build or lease any size factory and could lease as many machines as desired. The firm can change or choose the size of operation at this point in time. But once you choose to enter into a new lease, or to buy that equipment, the business moves into another short run time period. Long run is a period of time long enough for all inputs to be varied—i.e. there are no fixed costs in the Long Run! Think about this example about Mexican food: There could be a small business (taco truck)TacoTruck.png There could be a medium business (family Mexican restaurant)FamilyRestraurant.png There could be a HUGE business (Casa Bonita (Links to an external site.)Links to an external site.) Each of these businesses are "locked" into a particular production process in the short run (i.e., taco truck only has their one truck, etc.). But in the LR, each firm can change their scale of operation to meet business needs best. For example, the Tribeca Taco Truck can expand its fleet or go out of business. But... each firm strives to minimize their costs in the long run. Long-Run Average Costs are the long-run cost curve is just a summary of our best short-run cost possibilities, using existing technology and facilities. The long-run cost curve is just a summary of our best short-run cost possibilities, using existing technology and facilities. Long-Run Marginal Costs are the long-run marginal cost curve intersects our long-run cost curve at its lowest point.

Marginal Productivity

The short-run production function not only defines the limit to output but also shows how much each worker contributes to that unit. -Marginal Physical Product (MPP) is the change in the total output associated with one additional unit of input. MPP= Change in total Output / Change in Input Quantity For example, the MPP of the third worker can be calculated by looking at the table OR the corresponding graph, specifically we are interested in changes in total output and changes in the number of workers. The MPP of the third worker is the change in total output between having 2 workers working and having 3. Change in Total Output: Specifically, when there are 2 workers, the firm can produce 34 jeans. When there are 3 workers, they can produce 44. Change in Input Quantity: The change in inputs, in this case, is the change in the number of workers - we have moved from a total of 2 workers to a total of 3. So, we can now calculate the MPP MPP = Change in Total Output / Change in Input Quantity = [44 jeans - 34 jeans] / [3 workers - 2 workers] = 10 / 1 = 10 jeans In other words, the marginal physical product of the 3rdworker is 10 jeans day, which corresponds to the point (d) on the MPP (green) line in the graph.

Economies of Scale

There's really no reason we couldn't build a factory to any desired size. In the long run, we face an infinite number of scale choices, not just three. There are many options available in long-run production. One option is the decision to use one large plant or several smaller plants to produce a given amount of output. -Constant Return In some cases, it is no more efficient to produce in large scale plants than in small plants. In such cases, the production process is characterized by constant returns to scale. With constant returns, long run average costs do not change as output increases. Constant Returns to Scale: Increases in plant size do not affect minimum average cost: minimum per-unit costs are identical for small plants and large plants. -Economies of Scale Large plants may be able to achieve greater efficiencies than smaller plants. Economies of scale occur when an increase in plant size results in increasing operating efficiency. With economies of scale, long run average costs decrease as output increases. Economies of Scale are reductions in minimum average costs that come about through increases in the size (scale) of plant and equipment. -Diseconomies of Scale Although large plants may be able to achieve greater efficiencies than smaller plants, there's no assurance that they actually will. Diseconomies of scale occur when an increase in plant size results in reducing operating efficiency. With diseconomies of scale, long run average costs increase as output increases. Diseconomies of Scale- Increases in minimum average costs that come about through increases in the size (scale) of plant and equipment. Note that efficiency and size don't necessarily go hand in hand.

Varying Input Levels

This table shows the output attainable from various levels of inputs. Output = pairs of jeans per day Inputs = Capital input (sewing machines per day) and Labor input (workers per day) The productivity of any factor of production depends on the amount of other resources available to it. Productivity is output per unit of input, for example, output per labor-hour. In general, any word related to "product" in economics is related to output. Production, productivity, marginal product, all are concepts related to output. We can observe that by varying input levels, output will increase or decrease. For example, if this firm has one sewing machine and one worker, this firm can produce 15 pairs of jeans per day. If this firm has more inputs, say 2 sewing machines and 4 workers, it can produce 72 pairs of jeans per day. Question: How many jeans can be produced if we have 3 sewing machines but no workers? 0 pairs of jeans. If there is no one to operate the machine, nothing can get produced.