Costs of Production (Ch 8)

8/2/2019 Costs of Production (Ch 8)

1/66

Cost of Production Short and Long Run

Chapter 8 and Week 7


2/66

Costs

Why do we care about them so much?Costs determine:

Firm supply function

Structure of industry (competitive,monopoly,)

Profits

Costs are determined by: Production technology

Price of inputs

2


3/66

Copyright 2012 John Wiley & Sons, Inc. 3

Learning Objectives

Delineate the nature of a firms cost explicit as wellas implicitOpportunity Cost.

Outline how cost is likely to vary with output in theshort run and various measures of short-run cost.

Detail the typical shapes of a firms short-run costcurves.

See how a firm will choose to combine inputs in itsproduction process in the long run when all inputs

are variable. Show how input price changes affect a firms cost

curves.(continued)


4/66

Copyright 2012John Wiley & Sons, Inc. 4

Learning Objectives (continued)

Differentiate between a firms long-run and short-run cost curves.

Understand how the minimum efficient scale ofproduction is related to market structure.

Quick note on how cost functions can beempirically estimated through surveys andregression analysis.


5/66

Opportunity Cost

Opportunity cost: the cost of something is whatyou have to give up to get it.

Value of the highest forsaken alternative

What is the opportunity cost of

Coming to class?

Going to university? Male vs. Female ? (Groups)

5


6/66

Question

Connor is sitting at home studying microeconomicson Friday night. He says:

- If Id worked tonight, Id have made $100

- If I

d stayed at home and played on-line poker, I

dhave made $150.

- He concludes the opportunity cost of sitting athome studying is $100+$150 or $250.

Has he studied enough, or should he studysome more?

6


7/66

Official Slogan for O.C.


There is no such thing as a free lunch!


8/66

8

The Profits of a Firm

Accounting Profits

Total Revenues Total Costs*

* Explicit costs


9/66

9

Costs & the Profits of a Firm

Explicit Costs Expenses that business managers must take

account of because they must actually be paid outby the firm, e.g. purchase inputs from other parties,

wages paid to employees,

Implicit Costs

Expenses that business managers do not have topay out of pocket, e.g., cost of using own resourcesvs could have been used elsewhere.

Opportunity Cost

Reflects both explicit and implicit costs


10/66

9

Economic Profit and OptimalDecision Making

Economic Profit

The difference between total revenues and

the opportunity cost of all factors ofproduction.


11/66

Copyright 2012 Pearson Canada Inc.,Toronto, Ontario 11


Accounting Profits Versus Economic Profits

or

Economic profits = total revenues (explicit+implicit costs)

Economic profits = total revenues total opportunity cost of all inputs used


12/66

Copyright 2012 Pearson Canada Inc.,Toronto, Ontario 12


Total revenues(gross sales)

Economiccosts =

accounting

costs+normal rateof return oninvestment(opportunity

cost of capital)

+all otherimplicitcosts

Total revenues(gross sales)

Accounting

costs

Normal rate ofreturn on

investment=

opportunity costof capital +

any otherimplicit costs

Economic profit

Accountingprofit


13/66

Some Terminology

Sunk costs*: Once incurred, cannot berecovered.

Avoidable costs: Need not be incurred

Example: After getting 25% on your firsttest, you decide to drop ECON 2001.Which costs are sunk? Partiallyavoidable?

* unavoidable

13


14/66

14

Ignore sunk costs.

Economic Decision Making


15/66

More terminology

Fixed costs. Unavoidable. Have to beincurred regardless of level of outputproduced, e.g. safety testing for new

pharmaceuticals, rent paid per month

Variable costs. Avoidable. Only have toincur if you actually produce output, e.g.,

labour, raw materials

15


16/66

Short-Run Cost

To produce more output in the short run, thefirm must employ more labour, which meansthat it must increase its costs.

We describe the way a firms costs changeas total product changes by using three costconcepts and three types of cost curve:

Total cost Marginal cost

Average cost


17/66

Total Cost

A firms total cost(TC) is the cost of allresourcesused.

Total fixed cost(TFC) is the cost of the firm

s fixedinputs. Fixed costs do not change with output.

Total variable cost(TVC) is the cost of the firmsvariable inputs. Variable costs do change with output.

TC= TFC+ TVC

Short-Run Cost


18/66

Total fixed cost is the sameat each output level.

Total variable costincreases as outputincreases.

Total cost, which is the sumof TFCand TVCalsoincreases as outputincreases.

Short-Run Cost

25


19/66

Behind Cost Relationships

A firms costs are determined by itsproduction function: Input combinations (quantities)

Input prices

The shape of the TVC curve is determined bythe shape of the TP curve, which in turn

reflects diminishing marginal returns.



20/66

The TVC curve getsits shape from the TP

curve.

Notice that the TPcurvebecomes steeper at low outputlevels and then less steep athigh output levels.

In contrast, the TVCcurvebecomes less steep at lowoutput levels and steeper athigh output levels.

Short-Run Cost


21/66

To see therelationship betweenthe TVCcurve andthe TPcurve, lets look

again at the TPcurve.

But let us add a second x-axisto measure total variable cost.

1 worker costs $25; 2 workers cost

$50: and so on, so the two x-axesline up.

Short-Run Cost


22/66

We can replace thequantity of labour onthe x-axis with totalvariable cost.

When we do that, we mustchange the name of the curve. Itis now the TVCcurve.

But it is graphed with cost onthe x-axis and output on the y-

axis.

Short-Run Cost


23/66

Marginal Cost

Marginal cost(MC) is the increase in total cost thatresults from a one-unit increase in total product.

Over the output range with increasing marginalreturns, marginal cost falls as output increases.

Over the output range with diminishing marginalreturns, marginal cost rises as output increases.

Short-Run Cost


24/66

Average Cost

Average cost measures can be derived from each ofthe total cost measures:

Average fixed cost(AFC) is total fixed cost per unitof output.

Average variable cost(AVC) is total variable costper unit of output.

Average total cost(ATC) is total cost per unit ofoutput.

ATC = AFC + AVC

Short-Run Cost


25/66

The AFCcurve shows thataverage fixed cost falls asoutput increases.

The AVCcurve is U-shaped. As

output increases, average variablecost falls to a minimum and thenincreases.

Short-Run Cost


26/66

The ATCcurve isalso U-shaped.

The MCcurve is very special.

The outputs over which AVCisfalling, MCis below AVC.

The outputs over which AVCisrising, MCis above AVC.

The output at which AVC is attheminimum, MCequals AVC.

Short-Run Cost


27/66

Similarly, the outputs overwhich ATCis falling, MCis

below ATC.The outputs over whichATCis rising, MCis aboveATC.

At the minimum ATC, MCequals ATC.

Short-Run Cost


28/66

Product & CostRelationship


29/66


Table 8.1


30/66


Figure 8.2 - Short-Run Total and Per-UnitCost Curves


31/66

Shifts in Cost Curves

The position of a firms cost curves dependon two factors:

- Technology

- Prices of factors of production

Short-Run Cost


32/66

Technology Technological change influences both the productivity

curves and the cost curves.

An increase in productivity shifts the AP and MPcurves upward and the ATC and MC curvesdownward.

If a technological advance brings more capital andless labour into use, fixed costs increase and variable

costs decrease. In this case, ATC increases at low output levels and

decreases at high output levels.

Short-Run Cost


33/66

Prices of Factors of Production

An increase in the price of a factor of productionincreases costs and shifts the cost curves.

An increase in a fixedcost shifts the total cost (TC)and average total cost (ATC) curves upward butdoes notshift the marginal cost (MC) curve.

An increase in a variablecost shifts the total cost

(TC), average total cost (ATC), and marginal cost(MC) curves upward.

Short-Run Cost


34/66

Group Problem


No Pain No Gain Inc is a dental practice advocating a naturalapproach to dentistryspecializing in root canal operations noNovocain! If output is measured as # of root canals performed on a dailybasis, define the following measures of their SR cost: TFC, TVC, TC,MC, AFC, AVC & ATC., then fill in the spaces in the table below:

Output TFC TVC TC MC AFC AVC ATC

1 $100 $50

2 $30

3 $40

4 $270

5 $70


35/66

Answer


TFC is total fixed cost which consists of the costs incurred by thefirm that do not depend on how much output it produces.

TVC is total variable cost and consists of the costs incurred by thefirm that depend on how much output it produces.

TC (Total Cost) = TFC + TVC

MC (Marginal Cost) = the change in total cost that results from aone-unit change in output

AFC (Average Fixed Cost) = TFC/output.;AVC(Average Variable Cost) = TVC/output;ATC (Average Total Cost) = TC/output.ATC= AFC + AFC


36/66

Answer Contd


Output TFC TVC TC MC AFC AVC ATC

1 $100 $50 $150 $50 $100 $50 $150

2 $100 $80 $180 $30 $50 $40 $90

3 $100 $120 $220 $40 $33.3 $40 $73.3

4 $100 $170 $270 $50 $25 $42.5 $67.5

5 $100 $250 $350 $80 $20 $50 $70


37/66

44

http://www.youtube.com/watch?v=S3iLMfm6CGY&feature=related

Cost Curves in 60 seconds!
http://www.youtube.com/watch?v=S3iLMfm6CGY&feature=relatedhttp://www.youtube.com/watch?v=S3iLMfm6CGY&feature=related


38/66


Isocost LineLong Run

An isocost line is a line that identifies all thecombinations of capital and labor, two factorinputs, that can be purchased at a given totalcost.

The line intersects each axis at the quantityof that input that the firm could purchase ifonly that input were purchased.

Slope = - w (w = wage; r = rent)

r

Fi 8 4 I t Li d


39/66


Figure 8.4 - Isocost Lines andthe Long-Run Expansion Path

MRTS = - wr

The expansion path is a curve formed by connecting the points of tangency between isocost lines and the highestrespective attainable isoquants.

- wr


40/66


Least Costly Input Combination

A point of tangency between an isocostline and an isoquant show the leastcostly way of producing a given output

level. Alternatively, a point of tangency shows

the maximum output attainable at a

given cost as well as the minimum costnecessary to produce that output.


41/66


Interpreting the Tangency Points

Golden rule of cost minimization: Tominimize cost, the firm should employ inputsin such a way that the MP per dollar spentis equal across all inputs.

Pts A, B, C all symbolized by (5), (6), and (7).

If the firm is not prod cing at a


42/66


If the firm is not producing at atangency point

Whenever MPL/w > MPK/r, a firmcan increase output withoutincreasing production cost by

shifting outlays from capital to labor. Whenever MPL/w < MPK/r, a firm

can increase output without

increasing production cost byshifting outlays from labor to capital.


43/66

Moneyball

50

http://www.youtube.com/watch?v=AiAHlZVgXjk
http://www.youtube.com/watch?v=AiAHlZVgXjkhttp://www.youtube.com/watch?v=AiAHlZVgXjk


44/66


Is Production Cost Minimized?

Cost minimization is a necessary conditionfor but not the same as profitmaximization

Cost minimization occurs at all points on theexpansion path, but profit maximization

involves selecting the most profitable outputfrom among those on the expansion path.

T bl 8 2 Th P d ti it G i


45/66


Table 8.2 The Productivity Gainsfrom Privatization


46/66

Long-Run Cost Curves

LTC shows the minimum cost at which each rate ofoutput may be produced,just as the expansion pathdoes.

LMC and LAC are derived from the LTC in the sameway that the short-run marginal and average curvesare derived from the short-run total cost curve.

LAC is U-shapedwhy? Economies of scale

Diseconomies of scale



47/66

Figure 8.6 - Long-Run Cost Curves


Economies of Scale and


48/66


Economies of Scale andDiseconomies of Scale

Economies of scale a situation in which afirm can increase its output more thanproportionally to its total input cost

Reflects increasing returns to scale

Diseconomies of scale a situation inwhich a firms output increases less than

proportionally to its total input cost Reflects decreasing returns to scale


49/66

The Long Run and Short Run Revisited

Long-run average cost curve (LAC): thelowest average cost attainable when allinputs are variable.

Each point on the LAC is associated with adifferent short-run scale of operation thatthe firm could choose.



50/66

Copyright 2012 Pearson Canada Inc.,

Toronto, Ontario 57

Long Run Cost Curves

Output per Time Period

AverageCost(dollarsp

erunitofoutput)


A

verageCost(dollarsperunitofoutpu

t)

SAC1

SAC2

Q1

C2

C1

C3

C4

Q2

SAC3

Build plant 1 ifexpected output

at Q1.

Build plant 2 ifexpected output

at Q2.

SAC1

SAC2

SAC3SAC4

SAC5SAC6

SAC7SAC8

LAC


51/66

58


Long-Run Average Cost Curve

Differ among firms and industries.

The locus of points representing theminimum unit cost of producing any givenrate of output, given current technology andresource prices.


52/66


59

Output per Year

Long-RunAverageCosts

(dollarspe

runit)

LAC

Economies of scale are features of afirms technology that lead to fallinglong-run average cost as outputincreasese.g. specialization,

innovation,


53/66


60

Output per Year


(dollarsperunit)

LAC

Constant returns to scale arefeatures of a firms technology thatlead to constant long-run average costas output increases.


54/66


61

Output per


(dollarspe

runit)

LAC

Diseconomies of scale are features of afirms technology that lead to rising long-run

average cost as output increases


55/66


Toronto, Ontario 62


Reasons for Diseconomies of Scale

Limits to the efficient functioning of

management. A more than proportionate increase in

managers and staff people may be neededas plant size grows, because of increasing

costs of information and communication.


56/66


Toronto, Ontario 63




(dollarspe

ryear)

0 10 1,000

A B

Point A is the minimum efficientscale because it is the point at whichthe output reaches minimum costs.

Importance of Cost Curves to Market


57/66

Importance of Cost Curves to MarketStructure

Minimum efficient scale the scale ofoperations at which average cost per unitreaches a minimum

Impact on industry structure Number of firms

Proportion of industry output by each firm

Degree of competition


Figure 8 3 Minimum Efficient Plant


58/66

Figure 8.3 Minimum Efficient PlantScales



59/66

Group Problem


In the U.S., more than 50 firms produce textiles, but only3 produce automobiles. This statistic shows that theGovernment anti-monopoly policy has been applied moreharshly to the textile industry than to the automobile industry.

Can you give an alternative explanation for the differencein the number of firms in the 2 industries?

A


60/66

Answer


The minimum efficient scale is much larger for the

automobile industry than it is for textiles, so there is not

room for many car companies while a larger number of

textile companies can exist in the same market.

L i b D i


61/66

Learning by Doing

Learning by doing is associated with improvements inproductivity resulting from a firms cumulative outputexperience

Advantages of Learning by Doing to Pioneering Firms Attainment of lower production costs

Incentive to produce more in any given period

Limits to Advantages: Benefits spill over to other firms

New products can give newer firms a competitive advantage


Figure 8 8 - Learning by Doing Versus


62/66

Figure 8.8 Learning by Doing VersusEconomies of Scale



63/66


Estimating Cost Functions

Techniques: Surveys

New entrant/survivor technique method fordetermining the minimum efficient scale of

production in an industry based oninvestigating the plant sizes either being builtor used by firms in the industry

Econometric specification

A di


64/66

Appendix

71

Additional Info for you!

Th P fi f Fi


65/66


Opportunity Cost of Capital

The normal rate of return*, or theavailable return on the next-best

alternative investment.

*Normal Rate of Return: The amount that must be paid to aninvestor to induce investment in a

business.

E A P fi E l


66/66

Here is an example of how economic profits and accounting profits differ. Imagine that two years after receiving yourcollege degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000

yearly, and your financial assets generate $3,000 per year in interest. On New Years Day, after deciding to be your ownboss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop. At the end of the

year, your books tell the following story:

Salary $28,000Rent $10,000Interest $3,000

Total Implicit Costs$41,000;

Congratulations, your

bookkeeper pipes up, youmade aHold it just a moment, you say, I have studied economics. You forgot to subtract my implicit costs. Being in this

business caused me to lose as income:Salary $28,000Therefore, Ive had an

economic profit thatsnegative, a loss of $36,000This business is a loser!

Econ vs. Acctg Profit Example

Documents

Costs of Production (Ch 8)