Published on October 4, 2007
Slide1: 7 Production and Cost in the Firm How do economists calculate profit? What is a production function? What is marginal product? How are they related? What are the various costs, and how are they related to each other and to output? How are costs different in the short run vs. the long run? What are “economies of scale”? Total Revenue, Total Cost, Profit: Total Revenue, Total Cost, Profit We assume that the firm’s goal is to maximize profit. Profit = Total revenue – Total cost 0 Costs: Explicit vs. Implicit: Costs: Explicit vs. Implicit Explicit costs – actual cash payments for resources, such as paying wages to workers Implicit costs – opportunity cost of using owner-supplied resources, such as the opportunity cost of the owner’s time Remember: The cost of something is the value of the next best alternative. This is true whether the costs are implicit or explicit. Both matter for a firm’s decisions. 0 Explicit vs. Implicit Costs: An Example: Explicit vs. Implicit Costs: An Example Suppose you need $100,000 to start your business. The interest rate is 5%. Case 1: borrow $100,000 explicit cost = Case 2: use $40,000 of your savings, borrow the other $60,000 explicit cost = implicit cost = 0 Economic Profit vs. Accounting Profit: Economic Profit vs. Accounting Profit Accounting profit = total revenue minus total explicit costs Economic profit = total revenue minus total costs (including BOTH explicit and implicit costs) Accounting profit ignores implicit costs, so it will be greater than economic profit. 0 A C T I V E L E A R N I N G 2: Economic profit vs. accounting profit: A C T I V E L E A R N I N G 2: Economic profit vs. accounting profit The equilibrium rent on office space has just increased by $500 per month. Compare the effects on your firm’s accounting profit and economic profit if a. you rent your office space b. you own your office space 5 Production in the Short Run: Production in the Short Run Some resources are considered to be variable and some are considered to be fixed. It depends on how quickly the level can be altered to change the rate of output. In the short run, at least one resource is fixed. In the long run, all resources are variable. 0 The Production Function: The Production Function A production function shows the relationship between the quantity of inputs used to produce a good, and the quantity of output of that good. It can be represented by a table, equation, or graph. Example 1: Farmer Jack grows wheat. He has 5 acres of land. He can hire as many workers as he wants. 0 EXAMPLE 1: Farmer Jack’s Production Function: EXAMPLE 1: Farmer Jack’s Production Function 0 Marginal Product: Marginal Product The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. If Farmer Jack hires one more worker, his output rises by the marginal product of labor. Marginal product of labor (MPL) = 0 EXAMPLE 1: Total & Marginal Product: EXAMPLE 1: Total & Marginal Product MPL 0 EXAMPLE 1: MPL = Slope of Prod. Function: MPL equals the slope of the production function. Notice that MPL diminishes as L increases. This explains why the production function gets flatter as L increases. EXAMPLE 1: MPL = Slope of Prod. Function 3,000 5 200 2,800 4 400 2,400 3 600 1,800 2 800 1,000 1 1,000 0 0 MPL Q (bushels of wheat) L (# of workers) 0 Why MPL Is Important: Why MPL Is Important Recall from Chapter 1: Rational people choose actions for which the expected marginal benefit exceeds the expected marginal cost. When Farmer Jack hires an extra worker, his costs rise by the wage he pays the worker his output rises by MPL Comparing the wage and the change in his output helps Jack decide whether he would benefit from hiring the worker. EXAMPLE 2: A “Fold-It” Factory: EXAMPLE 2: A “Fold-It” Factory We are going to create a factory that produces a product known as a “fold-it” Resources: factory paper stapler staples labor Why MPL Diminishes: Why MPL Diminishes The Law of Diminishing Marginal Returns: the marginal product of a variable resource eventually falls as the quantity of the resource used increases (other things equal) If we increases the # of workers but not the # of staplers or the desk area, each add’l worker has less to work with and will be less productive. In general, MPL diminishes as L rises whether the fixed resource is land (as would be the case with Jack the wheat farmer) or capital (our desk and stapler). EXAMPLE 1: Farmer Jack’s Costs: EXAMPLE 1: Farmer Jack’s Costs Farmer Jack must pay $1,000 per month for the land, regardless of how much wheat he grows. The market wage for a farm worker is $2,000 per month. So Farmer Jack’s costs are related to how much wheat he produces…. EXAMPLE 1: Farmer Jack’s Costs: EXAMPLE 1: Farmer Jack’s Costs Total Cost 3,000 5 2,800 4 2,400 3 1,800 2 1,000 1 0 0 Cost of labor Cost of land Q (bushels of wheat) L (# of workers) 0 EXAMPLE 1: Farmer Jack’s Total Cost Curve: EXAMPLE 1: Farmer Jack’s Total Cost Curve Marginal Cost: Marginal Cost Marginal Cost (MC) is the increase in Total Cost from producing one more unit: EXAMPLE 1: Total and Marginal Cost: EXAMPLE 1: Total and Marginal Cost $10.00 $5.00 $3.33 $2.50 $2.00 Marginal Cost (MC) EXAMPLE 1: The Marginal Cost Curve: MC usually rises as Q rises, as in this example. EXAMPLE 1: The Marginal Cost Curve $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 TC MC 3,000 2,800 2,400 1,800 1,000 0 Q (bushels of wheat) Why MC Is Important: Why MC Is Important Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce more wheat or less? To find the answer, Farmer Jack needs to “think at the margin.” If the cost of an additional bushel of wheat (MC) is less than the revenue he would get from selling it, Jack’s profits rise if he produces more. (In the next chapter, we will learn more about how firms choose Q to maximize their profits.) EXAMPLE 3: EXAMPLE 3 Our third example is more general, and applies to any type of firm producing any good with any types of resources. EXAMPLE 3: Costs: EXAMPLE 3: Costs 7 6 5 4 3 2 1 0 TC VC FC Q $0 $100 $200 $300 $400 $500 $600 $700 $800 0 1 2 3 4 5 6 7 Q Costs FC VC TC 0 EXAMPLE 3: Marginal Cost: Recall, Marginal Cost (MC) is the change in total cost from producing one more unit: Usually, MC rises as Q rises, due to diminishing marginal product. Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.) EXAMPLE 3: Marginal Cost 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 MC TC Q 140 100 70 50 40 50 $70 EXAMPLE 3: Average Fixed Cost: EXAMPLE 3: Average Fixed Cost 100 7 100 6 100 5 100 4 100 3 100 2 100 1 $100 0 AFC FC Q Average fixed cost (AFC) is fixed cost divided by the quantity of output: AFC = FC/Q Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 0 ---- EXAMPLE 3: Average Variable Cost: EXAMPLE 3: Average Variable Cost 520 7 380 6 280 5 210 4 160 3 120 2 70 1 $0 0 AVC VC Q Average variable cost (AVC) is variable cost divided by the quantity of output: AVC = VC/Q As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 0 ---- EXAMPLE 3: Average Total Cost: EXAMPLE 3: Average Total Cost ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 TC Q 0 Average total cost (ATC) equals total cost divided by the quantity of output: ATC = TC/Q Also, ATC = AFC + AVC EXAMPLE 3: Average Total Cost: Usually, as in this example, the ATC curve is U-shaped. EXAMPLE 3: Average Total Cost 88.57 80 76 77.50 86.67 110 $170 ---- ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 TC Q 0 EXAMPLE 3: The Cost Curves Together: EXAMPLE 3: The Cost Curves Together 0 A C T I V E L E A R N I N G 3: Costs: A C T I V E L E A R N I N G 3: Costs Fill in the blank spaces of this table. 30 210 150 100 30 10 VC 43.33 35 8.33 260 6 30 5 37.50 12.50 150 4 36.67 20 16.67 3 80 2 $60.00 $10 1 ---- ---- ---- $50 0 MC ATC AVC AFC TC Q 60 30 $10 EXAMPLE 3: Why ATC Is Usually U-shaped: EXAMPLE 3: Why ATC Is Usually U-shaped 0 As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up. EXAMPLE 3: ATC and MC: EXAMPLE 3: ATC and MC 0 When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. The MC curve crosses the ATC curve at the ATC curve’s minimum. Costs in the Long Run: Costs in the Long Run Short run: Some inputs are fixed Long run: All inputs are variable (firms can build new factories, or remodel or sell existing ones) In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (the factory size with the lowest ATC). EXAMPLE 4: LRAC with 3 Factory Sizes: EXAMPLE 4: LRAC with 3 Factory Sizes Firm can choose from 3 factory sizes: S, M, L. Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run. EXAMPLE 4: LRAC with 3 Factory Sizes: EXAMPLE 4: LRAC with 3 Factory Sizes LRATC A Typical LRAC Curve: A Typical LRAC Curve In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRAC curve looks like this: How LRAC Changes as the Scale of Production Changes: How LRAC Changes as the Scale of Production Changes Economies of scale: LRAC falls as Q increases. Constant returns to scale: LRAC stays the same as Q increases. Diseconomies of scale: LRAC rises as Q increases.