ECON 211: Chp. 14 Production and Cost

interest

- interest is another cost of capital - when the firm's owner provides the funds used to buy capital, the opportunity cost of those funds is the interest income forgone by not using them in the best alternative way - interests are an implicit cost

increasing marginal returns

- occur when the marginal product of an additional worker exceeds the marginal product of the previous worker - the source of increasing marginal return is increased specialization and greater division of labor in the production process - the marginal product of the second worker is greater than the marginal product of the first worker - most production processes experience increasing marginal returns initially

decreasing marginal returns

- occur when the marginal product of an additional worker is less than the marginal product of the previous worker - arises from the fact that more and more workers use the same equipment and work space - as more workers are employed, there is less and less that is productive for the additional worker to do - by hiring more workers continues to increase output but by successively smaller amounts until a point at which total product stops rising - all production eventually reach a point of decreasing marginal returns

total product (TP)

- the total quantity of a good produced in a given period - total product is an output rate (the number of units produced per unit of time) - changes as the quantity of labor employed increases

average variable cost (AVC)

- the total variable cost per unit of output

average cost (AC)

- there are three average cost concepts: average fixed cost, average variable cost, average total cost

Short Run Production

- to increase the output of a fixed plant, a firm must increase the quantity of labor it employs - the relationship between output and the quantity of labor employed is described by: total product, marginal product, average product

The Firm's Goal

- to maximize profit - a firm that doesn't seek to maximize profit is either eliminated or bought by firms that do - to calculate a firm's profit, we must determine its total revenue and total cost - the decisions that a firm makes to maximize its profit depends on opportunity cost and economic profit

opportunity cost of the firm

- to produce its output, a firm employs factors of production: land, labor, capital, entrepreneurship - the highest valued alternative forgone is the opportunity cost of a firm's production - it is the amount that the firm must pay the owners of the factors of production it employs to attract them from their best alternative (so a firm's opportunity cost of production is the cost of the factors of production it employs)

Short Run Cost

- to produce more output (total product) in the short run, a firm must employ more labor, which means that it must increase its cost - we describe the relationship between output and cost using three concepts: total cost, marginal cost, average cost

marginal cost (MC)

- total cost and total variable cost increase at a decreasing rate at small levels of output and then begin to increase at an increasing rate as output increases - marginal cost is the change in total cost that results from a one unit increase in output - marginal cost is located midway between the total costs, showing that it is the result of changing outputs

total cost curves (TC, TFC, TVC)

- total fixed cost curve (TFC) is horizontal because total fixed cost does not change when output changes (constant) - total variable cost curve (TVC) and the total cost curve (TC) both slope upward because variable cost increases as output increases - the vertical distance between the total cost curve and total variable cost curve is the total fixed cost

Economies and Diseconomies of Scale

- when economies of scale are present, the long run average cost curve (LRAC) slopes downwards

law of decreasing returns

As a firm uses more of a variable factor of production, with a given quantity of fixed factors of production, the marginal product of the variable factor eventually decreases

long run average cost curve (LRAC)

- a curve that shows the lowest average total cost at which it is possible to produce each output when the firm has had sufficient time to change both its plant size and labor employed

Cost Curves and Product Curves

- a firm's cost curves and product curves are linked - AP and MP Curves: as labor increases, output increases: marginal product and average product rise, marginal cost and average variable cost fall. At the maximum marginal product, marginal cost is at a minimum. - AVC and MC Curves: as labor increases, output increases. Marginal product falls and marginal cost rises, but average product continues to rise and average variable cost continues to fall. At the point of maximum average product, average variable cost is at a minimum. As labor increases further, output increases. Average product diminishes and average variable cost increases.

economic profit

- a firm's total revenue minus total cost - the amount received from the sale of the product - it is the price of the output multiplied by the quantity sold - the total cost is the sum of explicit costs and implicit costs and is the opportunity cost of production - if a firm incurs an economic loss, the entrepreneur receives less than normal profit

Prices of Factors of Production

- an increases in the price of a factor of production increases costs and shifts the cost curves. But how the curves shift depends on which resource price changes. - an increase in fixed costs (ex: rent) shifts the fixed cost curves (TFC and AFC) upwards and shifts the total cost curve (TC) upwards but leaves variable cost curves (TVC and AVC) and the marginal cost curve (MC) unchanged. - an increase in variable costs (ex: wages): shifts variable cost curves (TVC and AVC) and the marginal cost curve (MC) upwards but leaves the fixed cost curves (TFC and AFC) unchanged.

economic depreciation

- an opportunity cost of a firm using capital that is owns - measured as the change in the market value of capital over a given period (market price of the capital at the beginning minus market price at the end of the period)

average cost curves (AC, AFC, AVC)

- average fixed cost curve (AFC) slopes downwards: as output increases, the same constant total fixed cost is spread over a larger output - average total cost curve (ATC) and average variable cost curve (AVC) are U-shaped: the vertical distance between the AVC and ATC is equal to AFC, the distance shrinks as output increases because AFC decreases with increasing output

Why the average total cost curve is U-shaped

- average total cost (ATC) is the sum of average fixed cost (AFC) and average variable cost (AVC): so ATC curve combines the shapes of the AFC and AVC curves - the U-shape of the ATC arises from the influence of two opposing forces: spreading total fixed cost over a larger output, decreasing marginal returns - when output increases, the firm spreads it total costs over a larger output and its average fixed cost decreases (its average fixed cost curve slopes downwards) - decreasing marginal returns means that as output increases, ever larger amounts of labor are needed to produce an additional unit of output. So average variable cost eventually increases, and AVC curve eventually slopes upwards - initially, average total cost decreases and curve slopes downwards, but as as output increases further, and decreasing marginal returns set in, average variable cost begins to increase - eventually, average variable cost increases more quickly than average fixed cost decreases, and ATC curve slopes upwards

Two Views of Cost and Profit

- both economists and accountants measure a firm's total revenue by price multiplied by the quantity sold of each item BUT: - Economists: measure economic profit as total revenue minus opportunity cost (opportunity cost includes implicit and explicit costs, normal profit is an implicit cost) - Accountants: measure profit as total revenue minus explicit costs and depreciation

constant returns to scale

- features of a firm's technology that keep average total cost constant as output increases - constant returns to scale occur when a firm is able to replicate its existing production facility including its management system

diseconomies of scale

- features of a firm's technology that make average total cost rise as output increases - diseconomies of scale arise from the difficulty of coordinating and controlling a large enterprise (the larger the firm, the greater is the cost of communicating both up and down the management hierarchy and among managers) - management complexity brings rising average total cost - diseconomies of scale occur in all production processes but in some perhaps only at a very large output rate

economies of scale

- features of a firm's technology that makes average total cost fall as output increases - main source of economies of scale is greater specialization of both labor and capital

fixed vs. variable

- fixed resources that a firm uses are its fixed factors of production - the resources that it can vary are its variable factors of production

Long Run Cost

- in the long run, a firm can vary both the quantity of labor and the quantity of capital - all costs are variable in the long run

total product curve

- shows how the quantity of a good produced changes (by unit of time) as the quantity of labor employed changes - like the PPF, the total product curve separates attainable outputs from unattainable outputs - points below the total product curve are inefficient (using more labor than is necessary to produce a given output) - points above the total product curve are unattainable - points on the total product curve are efficient

Technology

- technological changes that increase productivity: shifts the total product curve upwards, shifts marginal product curve and average product curve upwards

Explicit Costs and Implicit Costs

- the amount that a firm pays to attract resources from their best alternative use is either an explicit or implicit cost - explicit cost: a cost paid in money (an opportunity cost because the money could have been spent on something else, ex: wages for labor, interest to the bank, expenditure on resources) - implicit cost: an opportunity cost when a firm uses a factor of production for which it does not make a direct money payment - two categories of implicit costs: depreciation and the cost of resources of the firm's owner

marginal product (MP)

- the change in total product that results from a one-unit increase in the quantity of labor employed - tells us the contribution to total product of adding one additional worker - when the quantity of labor increases by more than one worker, we calculate marginal product as: MP= change in total product / change in quantity of labor - the steeper the slope of the TP, the greater the MP - when TP curve turns downwards, MP is negative - TP and MP curves incorporate feature that is shared by all production processes in firms: increasing marginal returns initially, decreasing marginal returns eventually

total fixed cost (TFC)

- the cost of a firm's fixed factors of production: land, capital, and entrepreneurship - in the short run, the quantities of these inputs don't change as output changes, so total fixed cost doesn't change as output changes

total variable cost (TVC)

- the cost of a firm's variable factor of production: labor - to change its output in the short run, a firm must change the quantity of labor it employs, so total variable cost changes as output changes

total cost (TC)

- the cost of all the factors of production used by the firm - total cost divides into two parts: total fixed cost and total variable cost - total cost is the sum of total fixed cost and total variable cost: TC=TFC+TVC

depreciation

- the fall in the value of the firm's capital - accountants calculate it by using the Internal Revenue Standards Board

Short Run vs. Long Run

- the key influence on cost is the quantity of output that the firm produces per period - the greater the output rate, the higher the total cost of production. But the effect of a change in production on cost depends on how soon the firm wants to act. - a firm that plans to change its output rate tomorrow has fewer options than a firm that plans ahead and intends to change its production six months from now. - to study the relationship between a firm's output decision and its costs, we distinguish between two decision time frames: short run and long run

marginal cost curve (MC)

- the marginal cost curve (MC) is U-shaped because of the way in which marginal product changes - by increasing labor, marginal product increases and output increases. Over this output, marginal cost decreases as output increases - but at a point, increasing labor results in decreasing marginal product as output increases. Over this output, marginal cost increases as output increases.

Relationship between Marginal Cost Curve and Average Cost Curve

- the marginal cost curve intersects the average variable cost curve and the average total cost curve at their minimum points: - when marginal cost is less than average cost, average cost is decreasing - when marginal cost exceeds average cost, average cost is increasing

Shifts in the Cost Curves

- the position of a firm's short run cost curves depends on two factors: technology and price of factors of production

normal profit

- the return to entrepreneurship - part of a firm's opportunity cost because it is the cost of not running another firm (ex: instead of running a smoothie store, you could've run a flower shop) - implicit cost

long run

- the time frame in which the quantities of all resources can be varied - to increase output in the long run: a firm can increase the size of its plant - long run decisions are not easily reversed (ex: once a firm buys a new plant, its resale value is usually much less than the amount the firm paid for it) - the fall in value is economic depreciation, it is a sunk cost to emphasize that it is irrelevant to the firm's decisions - only the short run cost of changing its labor inputs and the long run cost of changing its plant size are relevant to firm's decisions

shortrun

- the time frame in which the quantities of some resources are fixed - for most firms, the fixed resources are the firm's technology and capital, its equipment and buildings, its management organization is also fixed in the short run - in the short run, a firm can usually change the quantity of labor it uses but not its technology and quantity of capital (equipment and buildings) - to increase output in the short run: a firm must increase the quantity of variable factors it uses (labor is usually the variable factor of production) - short run decisions are easily reversed - a firm can increase or decrease output in the short run by increasing or decreasing the number of labor hours it hires

average total cost (ATC)

- the total cost per unit of output - calculated from the total cost concepts: TC=TFC+TVC - TC/Q = TFC/Q +TVC/Q - ATC = AFC+AVC

average fixed cost (AFC)

- the total fixed cost per unit of output

average product (AP)

- the total product per worker employed - calculated by: AP = TP / Quantity of labor - another name for average product is productivity - average product is largest when average product and marginal product are equal - points at which marginal product exceeds average product, the average product curve slopes upwards (average product increases as more labor is employed) - points at which marginal product is less than the average product, the average product curve slopes downwards (average product decreases as more labor is employed)