The Costs of Production
Principles of Microeconomics
Boris Nikolaev
It’s business time.
• Firms are in the business of making
profits.
max Profit = TR – TC
Sneak Preview
MR=MC
So it’s all about efficiency
Profits
• Are profits bad?
• What is the function of profits in a free market
economy?
• In a competitive market profits come not from
increase in price, but from decrease in the
cost of production.
• http://money.cnn.com/magazines/fortune/fortune500/2010/full_list/
(500 most profitable companies)
Corporate Profits after tax
CP/GDP
The Weed Trail [read here]
Marxist View
• The stagnating wages since the 1970s
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Technology
World war II
Outsourcing
Women in the labor force
Immigration
• Problem of effective demand
– Work more hours
– Borrowing binge (mortgage debt, credit cards)
• Greatest profit boom (in the history of the world)
– Marginal productivity, wages, and profits
Productivity vs Wages
What do you do with the profits?
• CEO salaries [Forbes list]
• Mergers & Acquisitions
• Lend to employees (e.g. GM, IBM, etc.)
Costs
• Resources are scarce, productive, and have
alternative uses.
Implicit cost is the opportunity cost of the resource
you own (the benefit you could have extracted
from it from its next best use).
Explicit costs are the direct cash payments you
make to use resources you don’t own such as
wages, rent, insurance, taxes, etc.
Economic vs Accounting Profit
Practice Question
Your current job pays $50K/year. You have $20K savings that earn you $3K
interest a year. You own a garage, which you rent for $12K/ year. You decide
to invest your savings and use your garage to start your own business.
Did you make a good economic decision?
Total Revenue
Explicit Costs
labor
food
Total Cost
$105K
$21K
$20K
$41K
Implicit Costs
salary
interest
rent
Total Implicit Cost
Accounting Profit
_____
Economic Profit / Loss______
_____
_____
_____
_____
Production in the Short Run
Q= f(L,K)
Class demonstration
The Law of Diminishing Marginal
Returns
Practice Question
# fishermen
Fish caught
1
15
2
35
3
58
4
80
5
95
6
105
7
108
8
105
Input (L)
TP = f(L)
MP of labor
Assume that only one input (L) is relevant in production.
The wage / worker = $175 and one pound of fish is selling for $10
MRP
What about costs?
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Short Run vs Long Run Costs
Fixed Costs (FC)
Variable Costs (VC)
Total Cost (TC) = FC + VC
Average Cost (AC) = TC/Q
AFC = FC/Q
AVC=VC/Q
AC = AFC + AVC
Total and Marginal Cost
Marginal and Average Cost
Cost in the Long Run
Diseconomies of scale
LR Average Cost Curve
Economies of Scale
Sources of Economies of Scale
• Spread of “overhead,” fixed cost over bigger
production.
• Labor specialization.
• Technology.
• Learning by doing
• Agglomeration economies.
LR Cost Curves
Note on International Trade
• What goods are produced and where?
• David Ricardo (1800’s) – comparative
advantage.
• Heckscher & Ohlin (1920-30’s) – differences in
factor endowments. Example: Developed
countries export more capital intensive goods
(cars, airplanes, etc…) and import from
developing countries more labor intensive
goods (clothing, agricultural products, etc…)
• Empirical studies.
Krugman’s Model
Uses economies of scale to explain
international trade.
1. Mass production decreases average
cost (ES)
2. Consumers prefer diversity of
products
Each country specializes and then trades. This is how countries
with similar factor endowments engage in trade (e.g. Japan
sells Toyota to US, US sells GM to Germany, etc…)