I.
Production
A.Economic Profit
B. Short-run vs Long-run
C. Total Product (Q), MPL and APL
II. Marginal Reasoning for the firm
A. Marginal Revenue
B. Marginal Cost
C.
III.
The Decision Rule for the firm
Short Run costs and the Family of cost Curves.
A. Formulas
B. Calculate
C. Graph
D.Interpret (6 points of interest)
Production and the Cost of Production
Economic Profit vs Accounting Profit
Explicit costs – costs that require an outlay of $.
Ex: wages, rent, utility bills
Implicit costs – the opportunity costs of resources the
firm uses in production that requires no direct outlay
of $.
Ex: Value of entrepreneurs labor.
Ex: Interest that could have been earned with
owner’s assets that were tied-up in the business.
- Accountants and Economists agree that:
π = TR – TC
- However, they disagree on how to define TC (total costs).
Economists  include explicit and implicit costs.
Accountants  include only explicit costs.
Ex: Balance sheet of economist vs accountant
You quit your job that paid $23,000/year and opened up a
health food store.
Accountant:
Total Revenue
From food sold
$ 130,000
Costs
Cost of food
85,000
Wages
20,000
Utilities and taxes
10,000
Rent
10,000
125, 000
π = TR – TC
= 130,000 – 125,000 = 5,000
Economist:
Total Revenue
From food sold
$ 130,000
Explicit Costs
Cost of food
85,000
Wages
20,000
Utilities and taxes
10,000
Rent
10,000
125, 000
Implicit Costs
Forgone salary
23,000
Economists Total Costs = Explicit Costs + Implicit Costs
TC = 125, 000 + 23,000 = 148,000
Economic π = TR – (Explicit Costs + Implicit Costs)
= 130,000 – 148,000 = -18,000 → loss
What are the opportunity costs of an item with explicit
costs?
The amount of $ you pay for it.
Therefore,
Economic π = TR – (opportunity costs of all inputs)
Or
Economic π = TR – (Explicit Costs + Implicit Costs)
Short-run vs Long-run
Short-run - a period of time in which the plant capacity
cannot be changed.
Note: Other resources are variable, except
capacity. Therefore, output can vary in the
short-run by varying say, labor.
Long-run – a period of time in which all resources used in
production can be changed (including plant capacity).
Production
Assume there are 2 inputs to production, capital (K) and
labor (L).
Total Product (TP) – the maximum output (Q) that is
attainable as labor (L) increases and capital (K) is fixed.
Note: TP is a short-run curve, since K is fixed.
Marginal Product of labor (MPL) – shows the change in
output from a one unit change in labor.
MPL =
Average Product of labor (APL) – total output divided by
the total number of workers employed.
APL
Table Ex:
Labor (L)
Total
Product (Q)
Marginal
Product (MPL)
0
0
-
1
10
10
2
22
12
3
33
11
4
42
9
5
48
6
6
50
2
General Graph:
- As long as MPL > APL  APL is ↑’ing
- As long as MPL < APL  APL is ↓’ing
Why?
Aside:
Basketball player averages 10 points/game for 1st ten
games. During the 11th game, the player only scores 8
points. If she scores (on the margin) less than 10
points  her average will fall.
The Bottom Line:
- If what you add on the margin is above the
average average will increase.
- If what you add on the margin is below the
average average will decrease.
Note: MPL= APL at maximum of APL
Marginal Reasoning for the Firm:
How do we make decisions?
Marginal Reasoning
-
weighing the marginal benefit of a decision
to the marginal cost.
Goal of firm: Maximize profit
- We will show how firms use marginal reasoning to
maximize π (profit).
Total Revenue (TR)product
Total receipts for the sale of a
TR = Price x Quantity Sold
TR = P x Q
Marginal Revenue (MR) - Marginal benefit for the firm.
-The addition to revenue of selling an additional unit of
output.
MR = TR/Q
Ex: Lumber Yard (firms sells lumber at $270 a bundle)
Output (Q)
0
1
2
3
4
5
6
7
8
9
10
TR = PQ
MR = TR/Q
Costs
Total Costs (TC)- The total outlays of a firm in
producing its output
Fixed Costs: Costs that do not vary with the quantity
produced.
Ex:
Variable Costs: Costs that vary with the quantity
produced.
Ex:
TC = Fixed Costs + Variable Costs
Marginal Costs (MC)- The addition to cost of producing
another unit of output.
MC = TC/Q
Profit (π) = Total Revenue – Total Costs
π = TR - TC
Recall the lumber company example. The Lumber Yard
sells lumber at $270 a bundle. Calculate MC and π for the
previous example:
Output TR =
(Q)
PQ
0
0
MR =
TC
TR/Q
180
1
270
270
445
2
540
270
685
3
810
270
895
4
1,080
270
1,075
5
1,350
270
1,285
6
1,620
270
1,525
7
1,890
270
1,795
8
2,160
270
2,125
9
2,430
270
2,515
10
2,700
270
2,965
MC =
π = TR-TC
TC/Q
Why does MC start high then drop, then rise again?
1. At low levels of Q  MC is high
2. MC is dropping
3. MC is increasing
The Firms’ Decision Rule:
- Goal of a firm is to maximize π.
- Specifically, we want to find the optimal level of output
(Q*) that maximizes π.
How? Weigh the marginal benefits to the marginal costs.
Recall, for the firm: MR is the marginal benefit.
MC is the marginal cost.
Profit:
π = TR-TC
Rule to find Q* (the level of output that maximizes π):
Continue to produce as long as the marginal benefit
exceeds MC.
- Specifically: If MR > MC ↑ Q
If MR < MC ↑ Q
Graph: (Go back to chart)
(Optimal Level of output) Q* = 7
Note: Q* does not  the firm is making π.
But if the firm operates at loss  minimizing the loss.
Short Run Costs
Total Fixed Costs (TFC):
costs that do not vary with output.
Total Variable Costs (TVC):
costs that do vary with output.
Total Costs:
TC = TFC + TVC
Lets define our average costs:
Average Total Costs: (ATC)
ATC = TC / Q
Average Variable Costs: (AVC)
AVC = TVC / Q
Average Fixed Costs: (AFC)
AFC = TFC / Q
Calculate the following from the information given:
Output TFC
(Q)
0
180
TVC
TC
0
180
1
450
2
690
3
900
4
1080
5
1290
6
1530
7
1800
8
2130
9
2520
10
2970
AFC = AVC =
TFC/Q TVC/Q
ATC =
TC/Q
Graph TC, TVC, TFC Curves:
Graph MC, ATC, AVC, AFC Curves:
6 Points Of Interest
1. ATC is always above AVC
2. MC is decreasing, then increasing
3. MC intersects ATC at the minimum of ATC
Recall:
- If what you add on the margin is above the
average average will increase.
- If what you add on the margin is below the
average average will decrease.
On Our Curve:
At low Q, MC is below the ATC  ATC is
decreasing
After the point of intersection (of MC and ATC) 
MC is above ATC  ATC increases.
4. MC intersects AVC at the minimum of AVC
(same reasons as number 3)
5. AFC is decreasing as output increases.
6. Distance between ATC and AVC is large on the left
and small on the right.
Why?