Chapter 6: Production and Costs
• economic costs & profits
• short run
• long run
big picture
• understand behavior of firm
• understand & measure
 production
 costs
I. economic costs & profits
• firm’s goal:
•
maximize profit
look at factors that affect firm’s
decision
economic costs
• opportunity cost of resources used
• explicit costs
•
 paid in money
 wages, rent, material, etc.
implicit costs
 opportunity cost of resources
used
example: smoothie shop
• explicit costs:
 wages
 interest on loan
 rent on store
 fruit, blenders
• implicit costs
 forgone interest on funds used to
buy capital
 owner’s forgone wages
 owner’s forgone profit from other
venture
accounting profit
• total revenue – explicit costs
• ignores opportunity cost
economic profit
• includes opp. costs
= total revenue - total costs
= (price)(quantity)
- (explicit + implicit costs)
normal profit
• occurs when
• amount of accounting profit
•
= opportunity costs of resources
if earning a normal profit,
 economic profit = 0
Short Run vs. Long Run
• Short Run (SR)
 time frame where some resources
are fixed
-- plants, equipment
 some inputs variable
-- labor
 SR decisions are reversible
• Long Run (LR)
 time frame where all inputs are
variable
--build a bigger plant
 LR decisions are hard to reverse
-- cannot easily get rid of capital
-- sunk cost
II. SR Production
• measures of output
 total product
 marginal product
 average product
total product (TP)
• total quantity of good produced
•
in a given period
at first, increases with labor,
then falls
TP: gal. of smoothies per hour
# workers
0
1
2
3
4
5
6
7
TP
0
1
3
6
8
9
9
8
TP
9
56
# workers
marginal product (MP)
• change in TP due to one more
worker
change in TP
=
change in labor
At first MP rises with workers
• add more workers
• greater specialization
• MP of each worker added is larger
•
than previous worker
increasing marginal returns
then, MP falls with more workers
• keep adding workers
• but same amount of capital
• so eventually get in the way
• MP of more workers smaller than
•
MP of previous workers
decreasing marginal returns
TP, MP: gal. of smoothies
# workers
TP
0
1
2
3
4
5
6
7
0
1
3
6
8
9
9
8
MP
1
2
3
2
1
0
-1
MP
3
0
3
Q = # workers
law of decreasing returns
• As firm uses more labor
 with capital fixed,
 MP of labor will eventually fall
Average Product (AP)
TP
=
labor
= productivity
# workers
TP
0
1
2
3
4
5
6
7
0
1
3
6
8
9
9
8
MP
1
2
3
2
1
0
-1
AP
1
1.5
2
2
1.8
1.5
1.1
MP
3
0
AP
3
# workers
MP & AP
• MP intersects AP at max of AP
• why?
• MP > AP
•
 AP is rising
MP < AP
 AP is falling
III. SR cost
• measure cost 3 ways:
 total cost
 marginal cost
 average cost
Total Cost (TC)
• cost of all factors used
• total fixed cost (TFC)
•
•
 cost of land, capital, etc.
 does not change in SR
total variable cost (TVC)
 cost of labor
 changes in SR
TC = TFC + TVC
example : yogurt
• labor = $6/ hour
• TFC = $10/ hour
workers
TP
TFC
TVC
TC
0
1
1.6
2
0
1
2
3
10
10
10
10
0
6
9.6
12
10
16
19.6
22
4
5
8
9
10
10
24
30
34
40
TC
TC
TVC
10
TFC
Q = output
Marginal Cost
• change in TC due to one-unit
increase in output (Q)
change in TC
=
change in Q
TP
TFC
TVC
TC
MC
0
1
2
3
10
10
10
10
0
6
9.6
12
10
16
19.6
22
6
3.6
2.4
8
9
10
10
24
30
34
40
6
Average Cost (ATC)
• = TC/Q
• average fixed cost (AFC)
•
•
 (TFC/Q)
average variable cost (AVC)
 (TVC/Q)
ATC = AFC + AVC
TP
TFC
TVC
TC
0
1
2
3
10
10
10
10
0
6
9.6
12
10
16
19.6
22
8
9
10
10
24
30
34
40
AFC
AVC
AC
10
5
3.33
6
4.8
4
16
9.8
7.33
1.25
1.11
3
3.33
4.25
4.44
AC, MC
MC
ATC
AVC
AFC
Q = output
MC & AC
• MC intersects AC at its minimum
• MC < AC
•
 AC is falling
MC > AC
 AC is rising
AC is U-shaped
• why?
• AFC falls with Q
• AVC falls then rises
•
 decreasing marginal returns
so ATC falls, then rises
cost & product curves
• when MP is at maximum,
•
MC is at minimum
when AP is at maximum,
AVC is at minimum
what shifts cost curves?
• technology
 make more with same inputs
 shifts TP, MP, AP up
 changes ATC curve
• changes in factor prices
 increase fixed costs
-- TFC, AFC shift up
-- TC shift up
 increase wages (variable)
-- TVC, AVC, MC shift up
-- TC shift up
IV. LR costs
• all inputs (and costs) are variable
• what happens if increase plant
AND labor by 10%?
 ATC fall?
 ATC rise?
 ATC stay same?
Economies of scale
• increase inputs 10%
•
 output increase > 10%
 ATC falls
why?
 gains from specialization
-- labor
-- capital
Diseconomies of scale
• increase inputs 10%
•
 output increase < 10%
 ATC rises
why?
 too hard to control large firm
Constant returns to scale
• increase inputs 10%
 output increase = 10%
 ATC stays same
LR Average Cost (LRAC)
• lowest average cost when all inputs
•
are variable
SRAC curves from different plant
sizes
AC
ATC1
ATC2
ATC3
ATC4
LRAC
Q = output
AC
ATC1
ATC2
ATC3
ATC4
economies
of scale
constant diseconomies
of scale
returns
to
scale
Q = output
summary:
• costs = implicit + explicit
• SR, only labor variable
• LR, all inputs variable
• Production & costs
 total, marginal, average
 fixed, variable