Chapter 12: The Costs of Production

1© 2014 by McGraw-Hill Education 1 Chapter 12 The Costs of Production © 2014 by McGraw-Hill Education 2 What will you learn in this chapter? • How to define total revenue, total cost, and profit. • How to differentiate between: – Fixed and variable costs. – Explicit and implicit costs. • How to calculate economic and accounting profit. • How to define marginal product and show diminishing marginal product. • How to define average and marginal cost. • How to think about long-run and short-run costs. • How to define returns to scale and its implications. © 2014 by McGraw-Hill Education 3 Revenues, costs, and profits • A firm’s goal is to maximize profits: Profit = Total revenue – Total cost • Total revenue is the amount that a firm receives from the sale of goods and services and is calculated as the quantity sold multiplied by the price paid for each unit: Total revenue = Quantity x Price = (Q1xP1) + (Q2xP2) + + (QnxPn) • Total cost is the amount that a firm pays for inputs used to produce goods or services. • While total revenue is simple to calculate, costs are more complex and harder to calculate. 2© 2014 by McGraw-Hill Education 4 Active Learning: Calculating total revenue • Suppose a firm produces two goods: – Bouncy balls that sell for $1. – Gumball machines that sell for $25. • Last year the firm sold 100,000 balls and 10,000 gumball machines. Calculate total revenue. © 2014 by McGraw-Hill Education 5 Fixed and variable costs • A firm’s total cost is defined as: Total costs = Fixed costs + Variable costs • Fixed costs are costs that do not depend on the quantity of output produced. – One-time, upfront payments before production begins, like buying equipment. – Ongoing payments, like monthly rents. • Fixed costs are constant as quantity increases. • Even if a firm produces nothing, it still incurs a fixed cost. © 2014 by McGraw-Hill Education 6 Fixed and variable costs • Variable costs are those that depend on the quantity of output produced. – Includes raw materials as well as labor costs. • Total variable costs increase with each additional unit produced. • If a firm produces nothing, variable costs are zero. 3© 2014 by McGraw-Hill Education 7 Fixed and variable costs This table provides the fixed and variable costs for a firm. Quantity of pills (millions) 100,000 00 200,000 300,000 400,000 500,000 600,000 700,000 800,000 30 40 50 60 70 80 10 20 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,300,000 1,400,000 1,500,000 1,600,000 1,700,000 1,800,000 1,100,000 1,200,000 Total costs ($) Variable costs ($) Fixed costs ($) • As the quantity produced increases, the fixed costs remain constant and the variable costs increase. © 2014 by McGraw-Hill Education 8 Active Learning: Calculating costs Fill in the table assuming fixed costs are $1,000 and variable costs are $20 per unit. Quantity 0 30 40 50 60 70 80 10 20 Total costs ($) Variable costs ($) Fixed costs ($) © 2014 by McGraw-Hill Education 9 Explicit and implicit costs • A firm’s opportunity cost of operation has two components. • The first is composed of the fixed and variable costs. – These are explicit costs that require a firm to spend money. • The second is composed of forgone opportunities. – These are implicit costs that represent opportunities that could have generated revenue if the firm had invested its resources in another way. • To properly account for the total costs incurred by a firm, total cost includes both types of costs. 4© 2014 by McGraw-Hill Education 10 Economic and accounting profit • When companies report their profits, they provide accounting profits: Accounting profit = Total revenue – Explicit costs • Accounting profits may be a misleading indicator of how well a business is really doing. • To account for implicit costs, economic profit further subtracts implicit costs: Economic profit = Accounting profit – Implicit costs © 2014 by McGraw-Hill Education 11 Economic and accounting profit The following dialog illustrates why economic profits matter. Executive B: But you’re forgetting about all of the other things we could do with $10 million. By my calculations, we could earn $6 million in interest over the next 10 years of we invested the money. That means that the true cost of buying the facility is $16 million, and the revenue would be only $13 million. If we bought the factory, we could lose $3 million! Executive A: The new facility would cost $6 million to buy and $4 million to operate over the next decade, for a total cost of $10 million. The medicines we could produce there would bring in revenue of $13 million. We could make $3 million in profits. Buy the factory! CEO: We have the opportunity to buy a new manufacturing facility. Is this a smart move for you company? © 2014 by McGraw-Hill Education 12 Total production, marginal product, and average product • Firms create value by bringing together different ingredients to create a good or service that consumers want. • A production function is the relationship between the quantity of inputs and the resulting quantity of outputs. • The increase in output that is generated by an additional unit of input is the marginal product. – The principle of diminishing marginal product states that the marginal product of an input decreases as the quantity of the input increases. • The average product is total production divided by the number of workers. 5© 2014 by McGraw-Hill Education 13 Total production and marginal product This table provides the total production and marginal product from each additional unit of labor. Labor (# employees) Total production (# pizzas) Marginal product of labor (# pizzas) 0 1 2 8 7 6 5 3 4 50 180 360 800 735 660 480 575 0 50 130 65 75 85 95 180 120 0 • The first three workers have an increasing marginal product. After three workers, each additional worker contributes less to total production, reflected by decreasing marginal product. • Note that even though marginal product of labor is decreasing, total production is still rising. © 2014 by McGraw-Hill Education 14 Active Learning: Total production, marginal product, and average product Fill in the table. At what point does marginal product start to diminish? Average productLabor (# employees) Total production 0 1 2 8 7 6 5 3 4 20 45 75 150 145 135 100 120 0 Marginal product © 2014 by McGraw-Hill Education 15 Production function • The production function can be represented visually. • The marginal product is the slope of the total production curve. 0 100 200 300 400 500 600 700 800 900 1,000 2 4 6 8 10 Quantity of pizzas Quantity of workers Curve gets steeper as marginal product increases. Curve flattens as diminishing marginal product kicks in. Total production • When output is very low, each additional worker has a higher marginal product than the previous one. • As more workers are added, marginal product starts to diminish. 6© 2014 by McGraw-Hill Education 16 Average and marginal product • The principle of diminishing marginal product and average product can be represented visually. • This establishes the relationship between marginal and average product. Quantity of pizzas Quantity of workers Marginal product 2. Eventually, marginal product starts to decrease. 1. Initially, adding more workers increases marginal product. 0 25 50 75 100 125 150 175 200 2 4 6 8 10 Average product • When an additional worker’s marginal product is greater than the existing average product, the average product increases. • When the marginal product curve crosses the average product curve, the average product also starts to decrease. • When an additional worker’s marginal product is less than the existing average product, the average product decreases. © 2014 by McGraw-Hill Education 17 Costs of production • When a firm increases its output by adjusting its use of inputs, it incurs the costs associated with that decision. • The relationships between output and costs are: Average fixed cost (AFC) = ி௜௫௘ௗ ௖௢௦௧ொ௨௔௡௧௜௧௬ Average variable cost (AVC) = ௏௔௥௜௔௕௟௘ ௖௢௦௧ொ௨௔௡௧௜௧௬ Average total cost (ATC) = ்௢௧௔௟ ௖௢௦௧௦ொ௨௔௡௧௜௧௬ = AFC + AVC Marginal cost (MC) = ୼ ௧௢௧௔௟ ௖௢௦௧୼ ௤௨௔௡௧௜௧௬ © 2014 by McGraw-Hill Education 18 Costs of production The table below provides the production and costs of a pizza joint that requires a lease for $300 and wages for workers at $200 each. 0 0 300 0 300 – – – 6 660 300 0.45 1,200 1.82 1,500 2.27 85 2.35 9 855 300 0.35 1,800 2.11 2,100 2.46 55 3.67 10 900 300 0.33 2,000 2.22 2,300 2.55 45 4.44 8 800 300 0.38 1,600 2.00 1,900 2.38 65 3.08 7 735 300 0.41 1,400 1.90 1,700 2.31 75 2.67 5 575 300 0.52 1,100 1.74 1,300 2.26 95 2.11 4 480 300 0.63 800 1.67 1,100 2.30 120 1.61 3 360 300 0.83 600 1.67 900 2.50 180 1.11 2 180 300 1.67 400 2.22 700 3.89 130 1.54 1 50 300 6.00 200 4.00 500 10.00 50 4.00 –– Labor (# workers) Total production (# pizzas) Fixed costs ($) Average fixed costs ($/pizza) Variable costs ($) Average variable costs ($/pizza) Total costs ($) Average total costs ($/pizza) Marginal product (# pizzas) Marginal cost ($/pizza) 7© 2014 by McGraw-Hill Education 19 Cost curves Cost functions can be represented visually. 0 500 1,000 1,500 2,000 2,500 200 400 600 800 1,000 Quantity of pizzas TC Cost ($) FC VC Because of diminishing marginal product, variable costs increase more as each additional pizza is added. Fixed costs, on the other hand, stay the same regardless of how many pizzas are produced. The total cost curve is the sum of variable and fixed costs. • The VC curve initially becomes less steep, reflecting the increasing marginal product of the first few employees. • As the principle of diminishing marginal product kicks in, the variable cost curve gets gradually steeper. • Adding FC and VC yields TC. © 2014 by McGraw-Hill Education 20 Cost curves Average costs can be represented visually. • AFC trends downward. – Same cost spread out over more units of output. • AVC is U-shaped. – First decreases and then increases, reflecting the marginal product of inputs. • ATC curve is U-shaped. – Decreases in AFC and increases with AVC.0 1 2 3 4 5 6 7 8 9 10 200 400 600 800 1,000 Quantity of pizzas ATC AFC AVC Cost/pizza ($) © 2014 by McGraw-Hill Education 21 Cost curves Marginal cost can be represented visually. • The MC curve is U-shaped and is the inverse shape of the marginal product curve. – Every additional unit of input costs the same, regardless of its contribution to production. – As marginal product of labor initially increases, MC decreases. – As marginal product diminishes, the MC increases. 0.50 0 1.00 1.50 2.00 2.50 3.00 3.50 4.00 4.50 5.00 200 400 600 800 1,000 Quantity of pizzas MC Cost / pizza ($) 8© 2014 by McGraw-Hill Education 22 • When the MC of producing another unit is less than the ATC, producing an extra unit decreases the ATC. • When the marginal cost of producing another unit is more than the average total cost, producing an extra unit will increase the ATC. • The MC curve intersects the ATC curve at its lowest point. Marginal and average cost curves 0 1 2 3 4 5 6 7 8 9 10 500 1,000 Quantity of pizzas MC ATC Cost/pizza ($) The relationship between marginal and average total cost can be established visually. © 2014 by McGraw-Hill Education 23 Summarizing costs The following summarizes various costs. Cost Total cost (TC) The amount that a firm pays for all of the inputs (fixed and variable) that go into producing goods and services Fixed cost (FC) Costs that don’t depend on the quantity of output produced — Variable cost (VC) Costs that depend on the quantity of output produced — Explicit cost Costs that require a firm to spend money — Implicit cost Costs that represent forgone opportunities — MC = DTC / DQ ATC = TC / Q AVC = VC / Q AFC = FC / Q TC = FC + VC Total costs divided by the quantity of output Variable costs divided by the quantity of output Fixed costs divided by the quantity of output Average fixed costs (AFC) Average variable costs (AVC) Average total costs (ATC) Marginal cost (MC) The additional cost incurred by a firm when it produces one additional unit of output Description Calculation © 2014 by McGraw-Hill Education 24 Active Learning: Costs Fill in the table, assuming that a lease for a building is $300 and workers’ wages are $100 each. 0 0 – – 10 165 8 150 6 135 4 100 2 45 –– Labor (# workers) Total production (# pizzas) Fixed costs ($) Average fixed costs ($/pizza) Variable costs ($) Average variable costs ($/pizza) Total costs ($) Average total costs ($/pizza) Marginal cost ($/pizza) 9© 2014 by McGraw-Hill Education 25 Costs in the long run • Costs that are fixed may be adjusted in the long-run. – For example, factory sizes can be adjusted to increase or decrease capacity. • In the short-run, fixed inputs can not be adjusted. • The long-run is the time required for a firm to vary all of its costs, if so desired. – The long-run depends on firm and production types. • The cost curves considered so far are short-run cost curves. • When a firm adjusts one of its long-run costs, the entire fixed cost curve shifts, as it is more efficient and can produce higher output. © 2014 by McGraw-Hill Education 26 Returns to scale • The relationship between costs and output is based on the scale of production. – The planet size or scale of production to produce a certain amount of output. • If increasing the scale of production to obtain higher output lowers the minimum of the average total cost, then economies of scale occur. • If increasing the scale of production to obtain higher output raises the minimum of the average total cost, then diseconomies of scale occur. • Constant returns to scale occur when the minimum of the average total cost does not depend on the quantity of output. – When the average total cost is at its minimum, an efficient scale is achieved. © 2014 by McGraw-Hill Education 27 Active Learning: Economies and diseconomies of scale Match each segment of the long-run ATC with its respective scale or production (economies, constant, and diseconomies). Output Average total cost Long-runATC 9/25/2014 1 © 2014 by McGraw‐Hill Education 28 Long‐run ATC • Short‐run ATC curves  cover a smaller range of  output. • By increasing or  decreasing scale of  production, firms can  move along the long‐run  ATC curve from one short‐ run ATC curve to another. The long‐run ATC curve is constructed by combining all possible short‐ run ATC curves. Short‐run ATC curves are identified by changing the scale of production. Output Long-run ATC Smaller firms Larger firms Average total cost Short-run ATCs faced by firmsof varying sizes © 2014 by McGraw‐Hill Education 29 Summary • The pursuit of profits drives every firm’s  decision‐making process, including how much  to produce and whether to stay in business. • Profit is the difference between cost and  revenues. • This chapter investigates the relationships  between inputs, outputs, and costs by studying  a firm’s profitability. © 2014 by McGraw‐Hill Education 30 Summary • Fixed costs are those that don’t depend on the  quantity of output produced. • Variable costs are those that do depend on the  quantity of output produced. • Costs include both implicit and explicit costs. • Firms are able to adjust scale of production over  time. – Thus, some costs are fixed in the short run, but  become variable in the long run. • A firm’s long‐run cost curve reflects the increased  flexibility of fixed costs.