chapter 20 the costs of production. the firm in the circular flow model businesses / firms...

Chapter 20 Chapter 20

The Costs of ProductionThe Costs of Production

THE FIRM IN THE CIRCULAR FLOW MODEL

BUSINESSES/ FIRMS

HOUSEHOLDS

RESOURCEMARKET

RESOURCES INPUTS

$ COSTS $ INCOMES

PRODUCTMARKET

GOODS &SERVICES

GOODS &SERVICES

$ CONSUMPTION$ REVENUE

WHAT ARE COSTS? WHAT ARE COSTS? The Law of Supply states firms are willing to The Law of Supply states firms are willing to produce and sell a greater quantity of a good produce and sell a greater quantity of a good when the price of the good is high, resulting in an when the price of the good is high, resulting in an upward sloping curve.upward sloping curve.

The economic goal of a firm is to maximize profitsThe economic goal of a firm is to maximize profits

The firm must assess costs before it can assess The firm must assess costs before it can assess profitprofit

ECONOMIC COSTSEconomic Costs are AKA

the Opportunity Costs

Definition: The value or worth the resource would have in its best alternative use.

TOTAL REVENUE, TOTAL TOTAL REVENUE, TOTAL COST, and PROFITCOST, and PROFIT

TOTAL REVENUETOTAL REVENUEThe amount a firm receives for the sale of itsThe amount a firm receives for the sale of its

output.output.

TOTAL COSTTOTAL COST

The market value of the inputs a firm uses inThe market value of the inputs a firm uses in

productionproduction

PROFITPROFIT

The firm’s total revenue minus its total costThe firm’s total revenue minus its total cost

Profit = Total Revenue – Total CostProfit = Total Revenue – Total Cost

COSTS AS OPPORTUNITY COSTS AS OPPORTUNITY COSTSCOSTS

A firm’s cost of production includes all the opportunity A firm’s cost of production includes all the opportunity costs of making its output of goods and services. costs of making its output of goods and services. They are known as They are known as ExplicitExplicit and and ImplicitImplicit Costs Costs

Explicit costs Explicit costs are input costs that require a are input costs that require a direct outlay of money by the firmdirect outlay of money by the firm

Implicit costs Implicit costs are input costs that do not are input costs that do not require an outlay of money by the firmrequire an outlay of money by the firm

ARE THEY EXPLICIT OR ARE THEY EXPLICIT OR IMPLICIT COSTS?IMPLICIT COSTS?

Hiring a new workerHiring a new worker Spending time with your significant other Spending time with your significant other

instead of workinginstead of working Taking a client to lunchTaking a client to lunch Going to college instead of getting a jobGoing to college instead of getting a job Studying for a test instead of plowing snow Studying for a test instead of plowing snow

for moneyfor money Buying new work clothesBuying new work clothes

E

I

E

I

I

E

ECONOMIC PROFIT VERSUS ECONOMIC PROFIT VERSUS ACCOUNTING PROFITACCOUNTING PROFIT

Economists measure a firm’s economic profit Economists measure a firm’s economic profit as as Total Revenue – Total CostTotal Revenue – Total Cost, including , including both explicit and implicit costs.both explicit and implicit costs.

Accountants measure the accounting profit as Accountants measure the accounting profit as the firm’s Total Revenue – only the firm’s the firm’s Total Revenue – only the firm’s Explicit Costs.Explicit Costs.

When Total Revenue exceeds both When Total Revenue exceeds both explicit and implicit costs, the firm earns explicit and implicit costs, the firm earns economic profit.economic profit.

Economic profit is smaller than Economic profit is smaller than accounting profit. accounting profit.

ECONOMIC PROFIT VERSUS ECONOMIC PROFIT VERSUS ACCOUNTING PROFITACCOUNTING PROFIT

EconomicProfit

Implicit costs(including a

normal profit)

ExplicitCosts

Accountingcosts (explicit

costs only)

AccountingProfit

Ec

on

om

ic (

op

po

rtu

nit

y) C

os

ts

TOTAL

REVENUE

How anEconomist

Views a Firm

How anAccountant

Views a Firm

ECONOMIC COSTS

TRY THIS PROBLEMTRY THIS PROBLEMGomez runs a small pottery firm. His costs are:

One helper at $12,000 per yearAnnual Rent = $5000Expenditures on materials = $20,000His personal investment in the company = $40,000(he could earn $4000 per year if his money is alternatively invested)

He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3000 per year.Total Revenue from pottery sales is $72,000

Calculate the accounting profit and the economic profit for Gomez’s pottery firm.

ANSWER to the PROBLEMANSWER to the PROBLEMEXPLICIT COSTS EXPLICIT COSTS = $37,000 = $37,000

$12,000 for the helper$12,000 for the helper

$5,000 for rent$5,000 for rent

$20,000 for materials$20,000 for materials

IMPLICIT COSTS IMPLICIT COSTS = $22,000= $22,000

$4000 of forgone interest$4000 of forgone interest

$15,000 of forgone salary$15,000 of forgone salary

$3,000 of entrepreneurship$3,000 of entrepreneurship

ACCOUNTING PROFIT ACCOUNTING PROFIT = = $35,000 $35,000 ($72,000 of revenue - $37,000 of explicit ($72,000 of revenue - $37,000 of explicit costs)costs)

ECONOMIC PROFIT ECONOMIC PROFIT = = $13,000 $13,000 ($72,000 - $37,000 of explicit costs - $22,000 of ($72,000 - $37,000 of explicit costs - $22,000 of implicit costs)implicit costs)

Short-Run versus Long-Short-Run versus Long-Run CostsRun Costs

The Economic Short Run vs the Long RunThe Economic Short Run vs the Long Run The Short Run is:The Short Run is:

A period too brief for a firm to alter its plant capacity, A period too brief for a firm to alter its plant capacity, yet long enough to permit a change in the degree to yet long enough to permit a change in the degree to which the fixed plant is used.which the fixed plant is used.

The firm can alter the intensity with which it uses its The firm can alter the intensity with which it uses its resources.resources.

In the short run, output can change but production In the short run, output can change but production processes are fixed.processes are fixed.


The Economic Short Run vs the Long RunThe Economic Short Run vs the Long Run The Long Run is:The Long Run is:

a period of time long enough for the firm to adjust the a period of time long enough for the firm to adjust the quantities of all the resources that it employs quantities of all the resources that it employs including plant capacity.including plant capacity.

In the long run, all inputs can be varied and In the long run, all inputs can be varied and production processes can be changed.production processes can be changed.


Fixed Costs and Variable CostsFixed Costs and Variable Costs Fixed costs = costs that cannot be changedFixed costs = costs that cannot be changed Variable costs = costs that can be changedVariable costs = costs that can be changed

In the In the Short RunShort Run, some costs are fixed. , some costs are fixed.

In the In the Long RunLong Run, all costs are variable., all costs are variable.

WHICH ARE SHORT-RUN AND WHICH ARE SHORT-RUN AND WHICH ARE LONG-RUN?WHICH ARE LONG-RUN?

*Wendy’s builds a new restaurant *Wendy’s builds a new restaurant

*Harley-Davidson hires 200 more production *Harley-Davidson hires 200 more production workersworkers

*A farmer increases the amount of fertilizer *A farmer increases the amount of fertilizer used on his corn crop used on his corn crop

*An Alcoa aluminum plant adds a third shift of *An Alcoa aluminum plant adds a third shift of workersworkers

*A farmer switched from growing corn to *A farmer switched from growing corn to growing asparagusgrowing asparagus

LR

SR

SR

SR

LR

A firm’s costs of production depend on A firm’s costs of production depend on the prices of the resources needed and the prices of the resources needed and the quantities of resources needed to the quantities of resources needed to produce their outputproduce their output

Firm’s will analyze the cost relationships Firm’s will analyze the cost relationships between their inputs and outputbetween their inputs and output

Section 2 - SHORT-RUN PRODUCTION Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS RELATIONSHIPS

Total Product (TP) – AKA Total Physical Product (TPP) - The total quantity, or total output, of a particular good or service produced.

Marginal Product (MP) – the extra output or added product associated with adding a unit of a variable resource, usually labor, to the production process.

Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS

Marginal Product =Change in Total Product

Change in Labor Input

Average Product =Total Product

Units of Labor

Average Product (AP) Average Product (AP) is output per unit of is output per unit of labor inputlabor input

Section 2 - SHORT-RUN PRODUCTION Section 2 - SHORT-RUN PRODUCTION RELATIONSHIPS RELATIONSHIPS

TPP for TPP for Al’s Al’s

Building Building CompanyCompany

How many employeesis too many?

TPP with Different TPP with Different Quantities of CarpentersQuantities of Carpenters

TPP

G

F E

D

C

B

A

5

Quantity of Carpenters per Year

7 6 4 3 2 1

40

32 35

30

25

20

15

10

5

0

Gar

ages

per

Yea

rT

ota

l Ou

tpu

t in

Al’s Al’s Product Product SchedulSchedulee

Al’s Marginal Physical Al’s Marginal Physical Product (MPP) Curve Product (MPP) Curve

6

MPP

Negative marginal returns

Diminishing marginal returns

Increasing marginal returns

Number of Carpenters

7 5 4 3 2 1

14

12

10

8

6

4

2

0

–2

–4

–6

MP

P i

n

Gar

ages

pe

r Y

ear

0

How many carpenters should Al hire?

Inputs of Labor

Total Product Marginal Product

Average Product

0 0

1 15

2 34

3 51

4 65

5 74

6 80

7 83

8 82

Complete the table by calculating marginal product and average product from the data given


Complete the table by calculating Complete the table by calculating marginal product and average product marginal product and average product from the data givenfrom the data given

Inputs of Labor

Total Product Marginal Product

Average Product

0 0 x x1 15 15 152 34 19 173 51 17 174 65 14 16.255 74 9 14.86 80 6 13.337 83 3 11.868 82 -1 10.25


Graph TP, MPand AP

The “Law” of Diminishing The “Law” of Diminishing Marginal ReturnsMarginal Returns

Diminishing Marginal Returns – definition: Is the Diminishing Marginal Returns – definition: Is the property whereby the marginal product of an input property whereby the marginal product of an input declines as a quantity of input increases.declines as a quantity of input increases.

Example: As more workers are hired at a firm, each Example: As more workers are hired at a firm, each additional worker contributes less and less to the additional worker contributes less and less to the production because the firm has a limited amount production because the firm has a limited amount of equipment.of equipment.It explains the shape of the marginal physical It explains the shape of the marginal physical product curveproduct curve

The Flower Pot ExampleThe Flower Pot Example

A farmer plants 80 acres of corn but does A farmer plants 80 acres of corn but does not weed his fields. His yield is 40 bushels not weed his fields. His yield is 40 bushels per acre. If he weeds once his yield rises to per acre. If he weeds once his yield rises to 50 bushels per acre. Two weedings yield 50 bushels per acre. Two weedings yield 57 bushels per acre. Three weedings yield 57 bushels per acre. Three weedings yield 61 bushels per acre. Each weeding adds 61 bushels per acre. Each weeding adds less and less yield per acre – less and less yield per acre – Diminishing Diminishing Marginal ReturnsMarginal Returns

If diminishing marginal If diminishing marginal returns didn’t occur more returns didn’t occur more weedings, seeds, and weedings, seeds, and fertilizer would continue to fertilizer would continue to yield more and more corn yield more and more corn per acre. The world could per acre. The world could be fed out of a flowerpot.be fed out of a flowerpot.

The Flower Pot ExampleThe Flower Pot Example

Law of Diminishing Returns

SHORT-RUN PRODUCTIONRELATIONSHIPS

To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

IncreasingMarginalReturns



To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

DiminishingMarginalReturns



To

tal P

rod

uct

, TP

Quantity of Labor

Ave

rag

e P

rod

uct

, AP

, an

dM

arg

inal

Pro

du

ct, M

P

Quantity of Labor

Total Product

MarginalProduct

AverageProduct

NegativeMarginalReturns

Short-Run Production Short-Run Production CostsCosts

Production information must be coupled Production information must be coupled with resource prices to determine the total with resource prices to determine the total and per-unit costs of producing various and per-unit costs of producing various levels of output.levels of output.

In the short-run some resources, those In the short-run some resources, those associated with the firm’s plant, are fixed. associated with the firm’s plant, are fixed. Other resources are variable. Therefore, Other resources are variable. Therefore, short-run costs are either fixed or variable.short-run costs are either fixed or variable.

Fixed Costs – Examples: rent, interest on Debts, insurance premiums

Total Fixed CostsAverage Fixed Costs =

Total Fixed CostsQuantity of output

Variable Costs – Examples: materials, fuels,Utilities, transportation, and labor

Total Variable Costs

Average Variable Costs =Total Variable Costs

Quantity of output

SHORT-RUN PRODUCTION COSTS

Total CostTC = Total Fixed + Variable Costs

Average Total Cost =Total Costs

Quantity of output

Marginal Cost – the extra, or additional, costof producing one more unit of output

Total Variable Costs

Marginal Cost =Change in Total Costs

Change in Quantity of output

SHORT-RUN PRODUCTION COSTS

Marginal Cost = MC

Total Fixed Costs = TFCTotal Variable Costs = TVC

Average Variable Costs = AVC

Total Costs = TC

Average Total Costs = ATC

Average Fixed Costs = AFC

Summary of DefinitionsSHORT-RUN PRODUCTION COSTS

Marginal Cost Curve rises with the amount of output produced reflecting the property of diminishing marginal product.

COST CURVES AND THEIR SHAPES


The Average Total Cost Curve is U-shaped. At low levels of output ATC is high because fixed cost is spread over only a few units. ATC declines as output increases. ATC starts rising because AVC rises substantially.


The Relationship between MC and ATCWhen MC is less than ATC, ATC is falling.When MC is greater than ATC, ATC is rising.The MC curve crosses the ATC curve at the efficient scale (the quantity that minimizes ATC

SHORT-RUN COSTS GRAPHICALLY-AVERAGE AND MARGINAL

COSTS

Co

sts

(do

llar

s)

Quantity

AFC

AVC

ATC

MC

SHORT-RUN COSTS GRAPHICALLY

Quantity

Co

sts

(do

llar

s)

TC

TotalCost

Fixed CostTVC

Variable Cost

TFC

Combining TVCWith TFC to get

Total Cost

PRODUCTIVITY AND COST CURVES

Co

sts

(d

olla

rs)

Ave

rag

e P

rod

uct

an

dM

arg

inal

Pro

du

ctQuantity of labor

Quantity of output

MPAP

MCAVC

Al’s (Variable) Cost Al’s (Variable) Cost SchedulesSchedules

Al’s Total Variable Cost Al’s Total Variable Cost CurveCurve

TC

(a)

To

tal V

aria

ble

Co

st

pe

r Y

ear

(t

ho

usa

nd

s $

)

Quantity of Garages

10 8 6 4 2

200 180 160 140 120 100 80 60 40 20

0

Al’s Average Variable Cost Al’s Average Variable Cost CurveCurve

C

D

AVC

(b)

Av

era

ge

Var

iab

le C

os

t p

er

Gar

age

(th

ou

san

ds

$)

Quantity of Garages

10 8 6 4 2

30

25

20

15

10

5

0

Al’s Marginal Variable Al’s Marginal Variable Cost CurveCost Curve

(c)

Mar

gin

al V

aria

ble

Co

st p

er A

dd

edG

arag

e (t

ho

usa

nd

s $)

Quantity of Garages

10 8 6 4 2

50 45 40 35 30 25 20 15 10 5

0

MVC

Fixed Costs: TotalFixed Costs: Total

TFC

(a)

To

tal F

ixed

Co

st

per

Yea

r (t

ho

usa

nd

s o

f $

)

Output 10 8 6 4 9 7 5 3 1 2

14

12

10

8

6

4

2

0

Al’s Fixed CostsAl’s Fixed Costs

Fixed Costs: AverageFixed Costs: Average

AFC

(b)

Ave

rag

e F

ixed

Co

st p

er G

arag

e (t

ho

usa

nd

s $)

Output 10 8 6 4 9 7 5 3 1 2

14

12

10

8

6

4

2

0

Section 3 – Long-Run Section 3 – Long-Run Production CostsProduction Costs

A typical average cost curve declines at A typical average cost curve declines at first because average fixed costs decline.first because average fixed costs decline.

It then reaches a minimum and begins to It then reaches a minimum and begins to rise because of decreasing marginal rise because of decreasing marginal returns.returns.


• Costs differ in the short and long runs, Costs differ in the short and long runs, because in the long run, more adjustments because in the long run, more adjustments can be made. For example: A firm increases can be made. For example: A firm increases the size of its plantthe size of its plant

* Because many costs are fixed in the short-* Because many costs are fixed in the short-run but variable in the long run, a firm’s long-run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost run cost curves differ from its short-run cost curves.curves.


The long-run The long-run average total cost curve average total cost curve (ATC) (ATC) shows the lowest possible short-shows the lowest possible short-run average cost corresponding to each run average cost corresponding to each output level.output level.

ATC makes no distinction between fixed ATC makes no distinction between fixed and variable costs (all resource costs are and variable costs (all resource costs are variable in the long run)variable in the long run)

LONG-RUN PRODUCTION COSTS

All such plant capacities can be plotted on the same graph.

For every plant capacity size...there is a short-run ATC curve.


Un

it C

ost

s

Output


The long-run ATC just “envelopes”all of the short-run ATC curves.

Un

it C

ost

s

Output


Un

it C

ost

s

Output

long-run ATC

Short-Run and Long-Run Short-Run and Long-Run Average Cost CurvesAverage Cost Curves

V B

S

Ave

rag

e C

ost

per

Po

un

d o

f C

hic

ken

$0.40 0.35

Output in Pounds of Chicken

100 40 0

U L

W

G T

ECONOMIES OF SCALE

Economies of Scale refers to the property whereby long-run average total cost falls as the quantity of output increases.

It explains the downsloping part of the long-run ATC curve.

ECONOMIES OF SCALE

As plant size increases, a number of factors will for a time lead to lower average costs of production.

1. Labor Specialization – hiring more workers means jobs can be divided and subdivided.Workers can work full-time on the tasks for which they have special skills.

ECONOMIES OF SCALE

2. Managerial Specialization – means the better and more efficient use of management. Instead of an executive performing many functions he/she can focus on his area of expertise.

3. Efficient Capital – As a firm grows it can afford more efficient andModern equipment.

4. Other Factors – start-up costs, advertising costs, depreciation costs, and many others

Economies of Scale Economies of Scale becomes becomes Constant Constant Returns to ScaleReturns to Scale

In some industries a wide range of output In some industries a wide range of output may exist between the output at which may exist between the output at which economies of scale end and the output at economies of scale end and the output at which Diseconomies of Scale begin. which Diseconomies of Scale begin.

That range, where long-run average That range, where long-run average costs remains stable is called costs remains stable is called Constant Returns to Scale.Constant Returns to Scale.

Diseconomies of ScaleDiseconomies of Scale

In time the expansion of a firm may lead In time the expansion of a firm may lead to higher average total costs, causing to higher average total costs, causing Diseconomies of ScaleDiseconomies of Scale.. When a firm becomes bigger it is more When a firm becomes bigger it is more

difficult to be efficient with managerial difficult to be efficient with managerial practices as bureaucratic interference practices as bureaucratic interference evolves. evolves.

Employees might feel alienated and more Employees might feel alienated and more likely to be less attentive to their worklikely to be less attentive to their work

Possible Shapes for the Possible Shapes for the Long-Run AC CurveLong-Run AC Curve

Lo

ng

-Ru

n A

ve

rag

e C

os

t

(c) Quantity of Output

Decreasing returns to scale

Lo

ng

-Ru

n A

ve

rag

e C

os

t

(b) Quantity of Output

Constant returns to scale

Lo

ng

-Ru

n A

ve

rag

e C

os

t

(a) Quantity of Output

Increasing returns to scale

AC

AC

AC

ECONOMIES ANDDISECONOMIES OF SCALE

Un

it C

ost

s

Output

long-run ATC

Economiesof scale


Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Constant returnsto scale


Un

it C

ost

s

Output

long-run ATC

Economiesof scale

Diseconomiesof scale

Constant returnsto scale


Un

it C

ost

s

Output

long-run ATC

Where extensiveeconomies of

scale exist


Un

it C

ost

s

Output

long-run ATC

Where economiesof scale are

quickly exhausted

CHAPTER SUMMARYCHAPTER SUMMARY

The goal of firms is to maximize profit, The goal of firms is to maximize profit, which equals total revenue minus total which equals total revenue minus total cost.cost.

When analyzing a firm’s behavior, it is When analyzing a firm’s behavior, it is important to include all the opportunity costs important to include all the opportunity costs of productionof production

Some opportunity costs are explicit while Some opportunity costs are explicit while other opportunity costs are implicit.other opportunity costs are implicit.

CHAPTER SUMMARYCHAPTER SUMMARY A firm’s costs reflect its production process.A firm’s costs reflect its production process.

* A typical firm’s production function gets flatter as * A typical firm’s production function gets flatter as the quantity of input increases, displaying the the quantity of input increases, displaying the property of diminishing marginal productproperty of diminishing marginal product

*A firms total costs are divided between fixed and *A firms total costs are divided between fixed and variable costs. Fixed costs do not change when variable costs. Fixed costs do not change when the firm alters the quantity of output. Variable the firm alters the quantity of output. Variable costs do change with outputcosts do change with output

Average total cost is total cost divided by the Average total cost is total cost divided by the quantity of output.quantity of output.

Marginal cost is the amount by which total Marginal cost is the amount by which total cost would rise if output were increased cost would rise if output were increased by one unit.by one unit.

The marginal cost always rises with the The marginal cost always rises with the quantity of output.quantity of output.

Average cost first falls as output increases Average cost first falls as output increases and then rises.and then rises.


The average-total-cost curve is U-shapedThe average-total-cost curve is U-shaped The marginal-cost curve always The marginal-cost curve always

crosses the average-total-cost curve at crosses the average-total-cost curve at the minimum of ATCthe minimum of ATC

A firm’s costs often depend on the time A firm’s costs often depend on the time horizon being consideredhorizon being considered

In particular, many costs are fixed in the In particular, many costs are fixed in the short-run but variable in the long-run.short-run but variable in the long-run.


Historical Costs versus Historical Costs versus Analytical Costs CurvesAnalytical Costs Curves

All points on the analytical cost curve All points on the analytical cost curve (used in economic analysis) refer to the (used in economic analysis) refer to the same period of time. same period of time.

An historical cost curve, showing the An historical cost curve, showing the actual relationship between cost and actual relationship between cost and output at different periods of time, is output at different periods of time, is probably not a good indicator of the probably not a good indicator of the analytical cost curve.analytical cost curve.

Declining HCC Declining HCC w/declining Analytical ACCw/declining Analytical ACC

B

A

2005 analytical cost curve


Historical cost curve

$100

75

50

25

0

Co

st p

er U

nit

Quantity of Output

Declining HCC with U-Declining HCC with U-shaped Analytical ACCshaped Analytical ACC

A B



Historical cost curve

$100

75

50

25

0

Co

st

pe

r U

nit

Quantity of Output

Cost Minimization in Cost Minimization in Theory and PracticeTheory and Practice

Real business situations are more Real business situations are more complex than those outlined in this complex than those outlined in this chapter, and the quality of the available chapter, and the quality of the available information is less precise.information is less precise.

Yet when managers are doing their jobs Yet when managers are doing their jobs well and the market is functioning well and the market is functioning smoothly, these models are a good smoothly, these models are a good approximation to the real world.approximation to the real world.

Character of the Character of the Production Indifference Production Indifference CurvesCurves

Each production indifference curve Each production indifference curve shows all combinations of input quantities shows all combinations of input quantities capable of producing a given quantity of capable of producing a given quantity of output.output.

Higher curves correspond to higher Higher curves correspond to higher outputs on a production indifference map.outputs on a production indifference map.

A Production Indifference A Production Indifference MapMap

C

B

Qu

anti

ty o

f L

and

in A

cres

Quantity of Labor in Years

10 7 5 3 0

200

400

600

220,000 bushels

240,000 bushels

260,000 bushels D

E

A

Character of the Character of the Production Indifference Production Indifference CurvesCurves

Budget line: a curve that shows all the Budget line: a curve that shows all the combinations of inputs that keep total combinations of inputs that keep total costs constant.costs constant.

Slope of the budget line: the trade-off Slope of the budget line: the trade-off between one input and another, which between one input and another, which keeps total costs constant.keeps total costs constant.

Constant input prices Constant input prices constant slope constant slope of a budget lineof a budget line

Cost Minim., Expansion Cost Minim., Expansion Path, and Cost CurvesPath, and Cost Curves

The least costly way to produce any The least costly way to produce any given level of output is shown by the given level of output is shown by the point of tangency between a budget line point of tangency between a budget line and the production indifference curve and the production indifference curve corresponding to that level of output.corresponding to that level of output.

The combination of these points shows The combination of these points shows the firm’s expansion path.the firm’s expansion path.

A Budget LineA Budget Line

K

J

Qu

anti

ty o

f L

and

in A

cres

360

40

Number of Workers

Cost MinimizationCost Minimization

240,000 bushels $270,000

$450,000

450

360

270

15 50 30 K

J

Qu

anti

ty o

f L

and

in A

cres

225

40

Number of Workers

A

B

T

$360,000

Effects of Changes in Effects of Changes in Input PricesInput Prices

input prices input prices slope of the budget slope of the budget lineline

Optimal input proportions then change.Optimal input proportions then change. Point at which the budget line is tangent Point at which the budget line is tangent

to an indifference curve also changes.to an indifference curve also changes.

The Firm’s Expansion The Firm’s Expansion PathPath

$270,000

240,000 bushels

300,000 bushels

B

B 0 10

200,000 bushels

15

B'

B' K

J

Qu

an

tity

of

La

nd

in

Ac

res

Number of Workers

E

E

S

S'

T

Optimal Input at a Optimal Input at a Different Set of Input Different Set of Input PricesPrices

V

W

300

240

180

75 60 45

Qu

anti

ty o

f L

and

in A

cres

Quantity of Labor in Years

240,000 bushels E

Chapter 8Chapter 8

Output, Price, and ProfitOutput, Price, and Profit

EconomicProfit

Implicit costs(including a

normal profit)

ExplicitCosts

Accountingcosts (explicit

costs only)

AccountingProfit

Ec

on

om

ic (

op

po

rtu

nit

y) C

os

ts

TOTAL

REVENUE

Profits to anEconomist

Profits to anAccountant

ECONOMIC COSTS

Price and Quantity: One Price and Quantity: One Decision, Not TwoDecision, Not Two

Firms face a demand curve on which Firms face a demand curve on which price and quantity are related.price and quantity are related.

They can choose either price or quantity, They can choose either price or quantity, but not both.but not both.

Demand Curve for Al’s Demand Curve for Al’s GaragesGarages

15

25

16

D

D

Profit maximum

5

5

Output, Garages Marketed per Year

Pri

ce p

er G

arag

e (t

ho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

10

20 19

22

26

30

35

i h

g

e f

d c

b a

j

Total Profit: Keep Your Total Profit: Keep Your Eye on the GoalEye on the Goal

Simplifying assumption: maximum total Simplifying assumption: maximum total profit is the firm’s goal.profit is the firm’s goal.

Total profit = total revenue - total costsTotal profit = total revenue - total costs Economic profit Economic profit accounting profit accounting profit


Total, Average, and Marginal RevenueTotal, Average, and Marginal Revenue Total Revenue = P Total Revenue = P Q Q Average Revenue = TR/Q = (P Average Revenue = TR/Q = (P Q)/Q = Q)/Q =

PP Marginal Revenue = Marginal Revenue = total revenue from total revenue from

one more unit of output.one more unit of output.

Demand for Al’s GaragesDemand for Al’s Garages

Total Revenue Curve for Total Revenue Curve for Al’s GaragesAl’s Garages

TR

A

B

C

D E

F G H I

J

5

To

tal R

even

ue

per

Yea

r (t

ho

usa

nd

s $)

Output, Garages Sold per Year

10 9 8 7 6 4 3 2 1 0

20

40

60

80

100

120

140


Total, Average, and Marginal CostTotal, Average, and Marginal Cost The shapes of the cost curves mean that The shapes of the cost curves mean that

there is some size for the firm that is most there is some size for the firm that is most efficient.efficient.

Firms that are smaller or larger than this Firms that are smaller or larger than this optimal size will have higher average costs.optimal size will have higher average costs.

Al’s Total, Average, and Al’s Total, Average, and Marginal CostsMarginal Costs

Cost Curves for Al’s Cost Curves for Al’s GaragesGarages

TC

(a) Total Cost Output, Garages per Year

5

To

tal

Co

st p

er Y

ear

(th

ou

san

ds

$)

10 9 8 7 6 4 3 2 1 0

20

40

60

200

180

160

140

120

100

80


(b) Average Cost Output, Garages per Year

5

Ave

rag

e C

os

t p

er G

arag

e (

tho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

5

10

15

45

40

35

30

25

20 AC


MC

(c) Marginal Cost Output, Garages per Year

5

Mar

gin

al

Co

st p

er A

dd

ed G

arag

e (t

ho

usa

nd

s $

)

10 9 8 7 6 4 3 2 1 0

5

10

15

45

50

40

35

30

25

20

Marginal Analysis and Marginal Analysis and ProfitProfit

Marginal cost = Marginal cost = in TC / in TC / in Q in Q

Marginal Revenue = Marginal Revenue = total revenue (TRa – total revenue (TRa – TRb) from one more unit of output.TRb) from one more unit of output.

Marginals Analysis For The Marginals Analysis For The Producer FirmProducer Firm

Inputs Inputs Costs Costs How much does one more unit of input change output?How much does one more unit of input change output?

Input Costs Input Costs Output Output Will one more unit of output increase MR?Will one more unit of output increase MR?

Output Output Profit Profit Will one more unit of output increase or decrease profit?Will one more unit of output increase or decrease profit? If MR > MC, If MR > MC, production production profits profits If MR < MC, If MR < MC, production production profits profits

Profit maximizing level output: MR = MCProfit maximizing level output: MR = MCTR – TC = Total ProfitTR – TC = Total Profit


Maximization of Total ProfitsMaximization of Total Profits Profits typically increase with output, then Profits typically increase with output, then

fall.fall. Some intermediate level of output, therefore, Some intermediate level of output, therefore,

generates the maximum profit.generates the maximum profit.

TR, Costs, and Profit for TR, Costs, and Profit for Al’s GaragesAl’s Garages

Marginal Analysis and Marginal Analysis and Maximization of Total Maximization of Total ProfitProfit

Marginal profit is the slope of the total Marginal profit is the slope of the total profit curve.profit curve.

Profit is at a maximum when the marginal Profit is at a maximum when the marginal profit is zero.profit is zero.

Profit MaximizationProfit Maximization

TC

TR

22,000

Profit

(a) Total Revenue. Total Cost Output, Garages per Year

5 To

tal R

even

ue,

To

tal C

ost

per

Yea

r (t

ho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

200

180

160

140

120

100

80

60

40

20

74 B

96 A

Profit MaximizationProfit Maximization

5

(b) Total Profit Output, Garages per Year

Total profit

F

D

E C

10 9 8 7 6 4 3 2 1

–80

–60

–40

–20

0

20

40

To

tal

Pro

fit

pe

r Y

ea

r (t

ho

us

an

ds

$)

M 34


Optimum Marginal Revenue and Optimum Marginal Revenue and Marginal CostMarginal Cost If MR > MC, If MR > MC, production production profits profits If MR < MC, If MR < MC, production production profits profits

Profit maximizing level output: MR = MCProfit maximizing level output: MR = MC

Al’s Marginal Revenue Al’s Marginal Revenue and Marginal Costand Marginal Cost

Profit Maxim: Another Profit Maxim: Another Graphical InterpretationGraphical Interpretation

Output, Garages per Year (a) Marginal Revenue and Marginal Cost

5

MR

an

d M

C p

er

Gar

age

pe

r Y

ear

(th

ou

san

ds

$)

10 9 8 7 6 4 3 2 1

–10

0

10

20

30

40

50

MR

MC

E


TC

TR

22,000

Profit

(a) Total Revenue. Total Cost Output, Garages per Year

5 To

tal R

even

ue,

To

tal C

ost

per

Yea

r (t

ho

usa

nd

s $)

10 9 8 7 6 4 3 2 1 0

200

180

160

140

120

100

80

60

40

20

74 B

96 A


5

(b) Total Profit Output, Garages per Year

Total profit

F

D

E C

10 9 8 7 6 4 3 2 1

–80

–60

–40

–20

0

20

40

To

tal

Pro

fit

pe

r Y

ea

r (t

ho

us

an

ds

$)

M 34


Finding the Optimal Price from Optimal Finding the Optimal Price from Optimal OutputOutput MR = MC: rule for determining the level MR = MC: rule for determining the level

of outputof output Demand curve Demand curve price buyers will pay to price buyers will pay to

purchase that level of outputpurchase that level of output Both output and price are now determined Both output and price are now determined

for the profit maximizing firm.for the profit maximizing firm.

Logic of Marginal Logic of Marginal Analysis & MaximizationAnalysis & Maximization

If a decision is to be made about the If a decision is to be made about the quantity of some variable, then maximize quantity of some variable, then maximize net benefit.net benefit.

Net benefit = total benefit - total costNet benefit = total benefit - total cost To maximize net benefit, select a value of To maximize net benefit, select a value of

the variable at which marginal benefit = the variable at which marginal benefit = marginal cost.marginal cost.

Logic of Marginal Logic of Marginal Analysis & MaximizationAnalysis & Maximization

Application: Fixed Cost and Profit Application: Fixed Cost and Profit MaximizationMaximization An increase in fixed costs does not change An increase in fixed costs does not change

optimal output or price because it does not optimal output or price because it does not affect marginal costs.affect marginal costs.

Rise in Fixed Cost: Total Rise in Fixed Cost: Total Profits Before and AfterProfits Before and After

Fixed Cost Does Not Affect Fixed Cost Does Not Affect Profit-Maximizing OutputProfit-Maximizing Output

5 10 9 8 7 6 4 3 2 1

Profit with a fixed cost

Profit with zero fixed cost

N

To

tal

Pro

fit

per

Yea

r

(th

ou

san

ds

$)

Output in Garages per Year

M

0

40

20

The Role of Marginal The Role of Marginal AnalysisAnalysis

Marginal analysis can be used to Marginal analysis can be used to illuminate many everyday problems, in illuminate many everyday problems, in business and elsewhere, sometimes with business and elsewhere, sometimes with surprising results.surprising results.

For example, a new activity will add to For example, a new activity will add to profits if it more than covers its marginal profits if it more than covers its marginal cost, not the fully allocated average cost.cost, not the fully allocated average cost.

The Role of Marginal The Role of Marginal AnalysisAnalysis

Any problem involving optimization can Any problem involving optimization can be illuminated with marginal analysis.be illuminated with marginal analysis.

The logic of marginal analysis can be The logic of marginal analysis can be applied to government, universities, applied to government, universities, hospitals and other organizations as well hospitals and other organizations as well as businesses.as businesses.

Theory and RealityTheory and Reality

Business people seldom use marginal Business people seldom use marginal analysis in a literal sense.analysis in a literal sense.

They often rely on intuition and hunches.They often rely on intuition and hunches. But these theories can be used to But these theories can be used to

understand and predict behavior.understand and predict behavior.

Average = total Average = total the number of units the number of units Total = average Total = average the number of units the number of units

Relationships Among Relationships Among Total, Average, and Total, Average, and Marginal DataMarginal Data

Relationships Among Relationships Among Total, Average, and Total, Average, and Marginal DataMarginal Data

Marginal value of the xth unit = total Marginal value of the xth unit = total value of x units - total value of (x - 1) value of x units - total value of (x - 1) units.units.

Total value of x units = Total value of x units = marginal marginal values of the first x units.values of the first x units.

The marginal, average and total values The marginal, average and total values for the first unit are usually equal.for the first unit are usually equal. If marginal < average, the average is If marginal < average, the average is

falling.falling. If marginal > average, the average is rising.If marginal > average, the average is rising. If marginal = average, the average is If marginal = average, the average is

constant; that is, the average is at a constant; that is, the average is at a maximum or minimum.maximum or minimum.

Relationships Among Relationships Among Total, Average and Total, Average and Marginal DataMarginal Data

Relationship Between Relationship Between Marginal and Average CurvesMarginal and Average Curves

F

E

A D

B

C

Average weight

Marginal weight

Mar

gin

al a

nd

Ave

rag

e W

eig

ht

(po

un

ds)

Number of Persons

6 5 4 3 2 1 0

50

100

150

chapter 20 the costs of production. the firm in the circular flow model businesses / firms...

Documents

firms explicit costs

input costs

costs of productionthe

firmimplicit costs

materialsimplicit costs

problemexplicit costs

total revenue total

profit total revenuethe