The Costs of Production: An Introduction

The Costs of Production: An Introduction

Production & Costs AP Microeconomics Unit 3, Days 1 & 2 Stater A few key terms: Firm: an organization that utilizes resources to produce a good or service that it hopes to sell profitably Explicit costs: direct, purchased, outof-pocket costs. Examples? Implicit costs.

costs: indirect, non-purchased Includes the costs of the next-best alternatives that have been forgone the opportunity costs! Lemonade Stand Carly runs a lemonade stand and sold 1000 cups this month at a price of $1 per cup. What is her total revenue? TR = $1 x 1000 cups = $1000 She had the following explicit costs this month: $75 to rent a table; $300 on lemons, sugar, and cups; and $25 for a vendors permit.

How might we determine her profit? Profit = TR Explicit Costs = $1000 - $75 - $300 - $25 = $600 But wait! What we just determined is called the accounting profit. We need to know something called the economic profit. Economic profit = TR Explicit cost Implicit cost Carly chose to give up working part-time at a bank for $1000/month an opportunity cost, or an implicit cost.

What is her economic profit? $1000 - $75 - $300 - $25 - $1000 = -$400 (a loss!) Nothing is free; it is just nonpriced. Economists always considers opportunity costs! We will use: Economic costs: both explicit & implicit costs. Economic profit: TR explicit costs implicit costs

Production Functions vs. Cost Functions Production functions look at relationships between inputs & output Cost functions look at relationship between output and costs Labor Capital Production Function Output

Two Types of Inputs Fixed inputs: resources that go into the production process that cant be changed in the short run Variable inputs: resources that can be adjusted in the short run to meet changes in demand Ex: The firm cant change the factory size in the short run, but it can add or reduce labor units (employees). Relationship between Productivity & Cost High

productivity implies low cost! Inefficiency leads to high production costs a competitive disadvantage 3 Short-Run Production Measures Index Card #1 Total Product (TP) The total quantity/output of a good produced at each quantity of a resource employed (usually labor)

Index Card #2 Marginal Product (MP) The change in total product resulting from a change in the input (addition of a worker) MP = (Change in TP) / (Change in # of Inputs) If labor is changing one unit at a time, then: MP = Change in TP Index Card #3 Average Product (AP)

Total product divided by the number of inputs employed (# of workers) AP = TP / # of inputs Example: Short-Run Production Measures for the Lemonade Stand over One Month Units of Labor Total Product (TP) Marginal Product

(MP) Average Product (AP) 0 1 2 3 4 5 6 7 8 0 Units 10 25 45

60 70 75 75 70 --- --- Graph the TP, MP, and AP data from the previous slide. (This is the last slide of day 1.) Locate the point where the MP & AP curves intersect. What do you notice about this point of intersection? Look

at the marginal product curve as the quantity of inputs increases. What can be said about the change in MP as outputs increase? Why do you think MP changes the way you observed in the previous question? Law of Diminishing Marginal Returns (1st slide of day 2) As successive units of a variable resource are added to a fixed resource, the additional output will eventually decrease. It

is not always more efficient to add more inputs, as we learned in the tennis ball game! Short-Run Costs Index Card #4 - Total Cost: Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC) Example: Total Costs for our Lemonade Stand

(add 4 additional columns to the right for later) Total Total Fixed Product (Q) Cost (TFC) 0 1 2 3 4 5 6 7 $6 Total Variable Cost (TVC) $0

5 8 13 19 26 34 43 Total Cost (TC = TFC + TVC) Index Card #5 - Marginal Cost (MC) Marginal Cost (MC) = Change in TC

Change in Q of Output (Change in output may often be equal to one) 3 Types of Short-run Average Costs Index Card #6 Average Fixed Cost (AFC) = TFC / (Q of Output) or AFC = ATC - AVC Index Card #7 Average Output)

Variable Cost (AVC) = TVC / (Q of or AVC = ATC - AFC Index Card #8 Average Total Cost (ATC)= TC / (Q of Output) Example: Marginal & Average Costs for our Lemonade Stand Total Product (Q) TFC

TVC TC MC AFC AVC ATC 0 $6 $0 $6

-- -- -- -- 1 6 5 11 2 6

8 14 3 6 13 19 4 6 19 25

5 6 26 32 6 6 34 40 7 6

43 49 MC Familiarize yourself with these short run cost curves. This is typically how they will look. Short-run & Longrun Decisions Short run: a time period when at least one

production input (plant size) is fixed and cannot be changed to respond to a change in product demand Long run: a time period that is the amount of time required to change the plant size . Short Run Long Run Plant Size (Capital) Fixed Costs

Variabl Entry/Exit e Costs of Firms Fixed Some Some No Variable None All Yes

Long-run costs In the long run, the firm has enough time to adjust plant capacity. The firm must ask itself: At what scale do we want to operate? Short-run average cost curves are snapshots of the firms ability to produce efficiently at the fixed plant size. If

we put these SRAC curves together, we can see a more continuous picture of the firms average costs. (You dont need to draw this the graph on the next slide is the one you need to know. This just shows where it comes from.) Economies

of scale: downward part of the LRAC curve LRAC falls as plant size increases (costs go down, output goes up) Result of specialization and ability to purchase more efficient capital goods Plant size doubles & total output of the firm more than doubles. Constant returns to scale: occurs when LRAC is constant over a variety of plant sizes (flattest part) Plant size doubles, and so does the total

output. Diseconomies of scale: upward part of the LRAC curve LRAC rises as plant size increases. Result of difficulty of managing larger firms (distant management, worker alienation, problems with communication & coordination) Plant size doubles, and total output less than doubles.

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