Costs of Production (CH 8)

Cost of Production Short and Long Run
Chapter 8 and Week 7
Costs
Why do we care about them so much? Costs determine:

Firm supply function Structure of industry (competitive, monopoly,) Profits
Costs are determined by:

Production technology Price of inputs
Learning Objectives
Delineate the nature of a firms cost explicit as well as implicit Opportunity Cost. Outline how cost is likely to vary with output in the short run and various measures of short-run cost. Detail the typical shapes of a firms short-run cost curves. See how a firm will choose to combine inputs in its production process in the long run when all inputs are variable. Show how input price changes affect a firms cost curves.
(continued)
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John Wiley & Sons, Inc.
Learning Objectives

(continued)
Differentiate between a firms long-run and shortrun cost curves. Understand how the minimum efficient scale of production is related to market structure. Quick note on how cost functions can be empirically estimated through surveys and regression analysis.
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Opportunity Cost
Opportunity cost: the cost of something is what you have to give up to get it.
Value of the highest forsaken alternative
What is the opportunity cost of

Coming to class? Going to university? Male vs. Female ? (Groups)
Question
Connor is sitting at home studying microeconomics on Friday night. He says: - If Id worked tonight, Id have made $100 - If Id stayed at home and played on-line poker, Id have made $150. - He concludes the opportunity cost of sitting at home studying is $100+$150 or $250.
Has he studied enough, or should he study some more?

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Official Slogan for O.C.
There is no such thing as a free lunch!
Copyright 2012
The Profits of a Firm

Accounting Profits Total Revenues Total Costs*
* Explicit costs
Costs & the Profits of a Firm

Explicit Costs
Expenses that business managers must take account of because they must actually be paid out by the firm, e.g. purchase inputs from other parties, wages paid to employees, Expenses that business managers do not have to pay out of pocket, e.g., cost of using own resources vs could have been used elsewhere. Reflects both explicit and implicit costs
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Implicit Costs
Opportunity Cost
Economic Profit and Optimal Decision Making

Economic Profit
The difference between total revenues and the opportunity cost of all factors of production.

Accounting Profits Versus Economic Profits
Economic profits = total revenues total opportunity cost of all inputs used
or
Economic profits = total revenues (explicit+implicit costs)
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Total revenues (gross sales)
Economic profit Normal rate of return on investment = opportunity cost of capital + any other implicit costs Accounting profit
Total revenues (gross sales)
Economic costs = accounting costs + normal rate of return on investment (opportunity cost of capital) + all other implicit costs
Accounting costs
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Some Terminology
Sunk costs*: Once incurred, cannot be recovered. Avoidable costs: Need not be incurred Example: After getting 25% on your first test, you decide to drop ECON 2001. Which costs are sunk? Partially avoidable?
* unavoidable
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Economic Decision Making
Ignore sunk costs.
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More terminology
Fixed costs. Unavoidable. Have to be incurred regardless of level of output produced, e.g. safety testing for new pharmaceuticals, rent paid per month Variable costs. Avoidable. Only have to incur if you actually produce output, e.g., labour, raw materials
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Short-Run Cost
To produce more output in the short run, the firm must employ more labour, which means that it must increase its costs. We describe the way a firms costs change as total product changes by using three cost concepts and three types of cost curve: Total cost Marginal cost Average cost
Short-Run Cost
Total Cost A firms total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firms fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firms variable inputs. Variable costs do change with output.
TC = TFC + TVC
Short-Run Cost
Total fixed cost is the same at each output level.
Total variable cost increases as output increases. Total cost, which is the sum of TFC and TVC also increases as output increases.
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Behind Cost Relationships
A firms costs are determined by its production function:

Input combinations (quantities) Input prices
The shape of the TVC curve is determined by the shape of the TP curve, which in turn reflects diminishing marginal returns.
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Short-Run Cost
The TVC curve gets its shape from the TP curve.
Notice that the TP curve becomes steeper at low output levels and then less steep at high output levels. In contrast, the TVC curve becomes less steep at low output levels and steeper at high output levels.
Short-Run Cost
To see the relationship between the TVC curve and the TP curve, lets look again at the TP curve.
But let us add a second x-axis to measure total variable cost. 1 worker costs $25; 2 workers cost $50: and so on, so the two x-axes line up.
Short-Run Cost
We can replace the quantity of labour on the x-axis with total variable cost.
When we do that, we must change the name of the curve. It is now the TVC curve. But it is graphed with cost on the x-axis and output on the yaxis.
Short-Run Cost
Marginal Cost Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product.
Over the output range with increasing marginal returns, marginal cost falls as output increases. Over the output range with diminishing marginal returns, marginal cost rises as output increases.
Short-Run Cost
Average Cost Average cost measures can be derived from each of the total cost measures: Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output.
ATC = AFC + AVC
Short-Run Cost
The AFC curve shows that average fixed cost falls as output increases. The AVC curve is U-shaped. As output increases, average variable cost falls to a minimum and then increases.
Short-Run Cost
The ATC curve is also U-shaped.
The MC curve is very special. The outputs over which AVC is falling, MC is below AVC. The outputs over which AVC is rising, MC is above AVC. The output at which AVC is at the minimum, MC equals AVC.
Short-Run Cost
Similarly, the outputs over which ATC is falling, MC is below ATC. The outputs over which ATC is rising, MC is above ATC. At the minimum ATC, MC equals ATC.
Product & Cost Relationship
Table 8.1
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Figure 8.2 - Short-Run Total and Per-Unit Cost Curves
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Short-Run Cost
Shifts in Cost Curves
The position of a firms cost curves depend on two factors: - Technology - Prices of factors of production
Short-Run Cost
Technology
Technological change influences both the productivity curves and the cost curves. An increase in productivity shifts the AP and MP curves upward and the ATC and MC curves downward. If a technological advance brings more capital and less labour into use, fixed costs increase and variable costs decrease. In this case, ATC increases at low output levels and decreases at high output levels.
Short-Run Cost
Prices of Factors of Production

An increase in the price of a factor of production increases costs and shifts the cost curves. An increase in a fixed cost shifts the total cost (TC ) and average total cost (ATC ) curves upward but does not shift the marginal cost (MC ) curve. An increase in a variable cost shifts the total cost (TC ), average total cost (ATC ), and marginal cost (MC ) curves upward.
Group Problem
No Pain No Gain Inc is a dental practice advocating a natural approach to dentistryspecializing in root canal operations no Novocain! If output is measured as # of root canals performed on a daily basis, define the following measures of their SR cost: TFC, TVC, TC, MC, AFC, AVC & ATC., then fill in the spaces in the table below: Output TFC TVC 1 $100 $50 2 3 4 5
Copyright 2012 John Wiley & Sons, Inc.
TC
MC $30
AFC
AVC ATC
$40 $270 $70

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Answer
TFC is total fixed cost which consists of the costs incurred by the firm that do not depend on how much output it produces. TVC is total variable cost and consists of the costs incurred by the firm that depend on how much output it produces. TC (Total Cost) = TFC + TVC MC (Marginal Cost) = the change in total cost that results from a one-unit change in output AFC (Average Fixed Cost) = TFC/output.; AVC (Average Variable Cost) = TVC/output; ATC (Average Total Cost) = TC/output. ATC= AFC + AFC
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Answer Contd
Output TFC TVC TC MC AFC AVC ATC
1 $100
$50
$150
$50
$100
$50
$150
2 $100
$80
$180
$30
$50
$40
$90
3 $100
4 $100
$120
$170
$220
$270
$40
$50
$33.3
$25
$40 $73.3
$67.5
$42.5 $50
5 $100
$250
$350
$80
$20
$70
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Cost Curves in 60 seconds!
http://www.youtube.com/watch?v=S3iLMfm6CGY&feature=related
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Isocost LineLong Run
An isocost line is a line that identifies all the combinations of capital and labor, two factor inputs, that can be purchased at a given total cost. The line intersects each axis at the quantity of that input that the firm could purchase if only that input were purchased. Slope = - w (w = wage; r = rent) r
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Figure 8.4 - Isocost Lines and the Long-Run Expansion Path
-w r
MRTS = - w r
The expansion path is a curve formed by connecting the points of tangency between isocost lines and the highest respective attainable isoquants.
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Least Costly Input Combination

A point of tangency between an isocost line and an isoquant show the least costly way of producing a given output level. Alternatively, a point of tangency shows the maximum output attainable at a given cost as well as the minimum cost necessary to produce that output.
Copyright 2012 John Wiley & Sons, Inc. 47
Interpreting the Tangency Points
Golden rule of cost minimization: To minimize cost, the firm should employ inputs in such a way that the MP per dollar spent is equal across all inputs.
Pts A, B, C all symbolized by (5), (6), and (7).
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If the firm is not producing at a tangency point

Whenever MPL/w > MPK/r, a firm can increase output without increasing production cost by shifting outlays from capital to labor. Whenever MPL/w < MPK/r, a firm can increase output without increasing production cost by shifting outlays from labor to capital.
Copyright 2012 John Wiley & Sons, Inc. 49
Moneyball
http://www.youtube.com/watch?v=AiAHlZVgXjk
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Is Production Cost Minimized?
Cost minimization is a necessary condition for but not the same as profit maximization Cost minimization occurs at all points on the expansion path, but profit maximization involves selecting the most profitable output from among those on the expansion path.
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Table 8.2 The Productivity Gains from Privatization
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Long-Run Cost Curves
LTC shows the minimum cost at which each rate of output may be produced, just as the expansion path does. LMC and LAC are derived from the LTC in the same way that the short-run marginal and average curves are derived from the short-run total cost curve. LAC is U-shapedwhy?

Economies of scale Diseconomies of scale
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Figure 8.6 - Long-Run Cost Curves
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Economies of Scale and Diseconomies of Scale
Economies of scale a situation in which a firm can increase its output more than proportionally to its total input cost
Reflects increasing returns to scale
Diseconomies of scale a situation in which a firms output increases less than proportionally to its total input cost
Reflects decreasing returns to scale
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The Long Run and Short Run Revisited
Long-run average cost curve (LAC): the lowest average cost attainable when all inputs are variable.
Each point on the LAC is associated with a different short-run scale of operation that the firm could choose.
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Long Run Cost Curves

Average Cost (dollars per unit of output)
Build plant 1 if expected output at Q1.
Average Cost (dollars per unit of output)
SAC1 SAC2 SAC3
SAC8 SAC7 SAC4
SAC6 SAC5
SAC1
C2 C4 C1 C3
SAC2
LAC
SAC3
Q1 Q2
Build plant 2 if expected output at Q2.
Output per Time Period


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Long-Run Average Cost Curve
Differ among firms and industries. The locus of points representing the minimum unit cost of producing any given rate of output, given current technology and resource prices.
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Long-Run Average Costs (dollars per unit)
Economies of scale are features of a firms technology that lead to falling long-run average cost as output increasese.g. specialization, innovation,
LAC
Output per Year

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Constant returns to scale are features of a firms technology that lead to constant long-run average cost as output increases.
LAC
Output per Year

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Diseconomies of scale are features of a firms technology that lead to rising long-run
average cost as output increases
LAC
Output per
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Reasons for Diseconomies of Scale
Limits to the efficient functioning of management. A more than proportionate increase in managers and staff people may be needed as plant size grows, because of increasing costs of information and communication.
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Long-Run Average Costs (dollars per year)
Point A is the minimum efficient scale because it is the point at which the output reaches minimum costs.
10
1,000
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Importance of Cost Curves to Market Structure
Minimum efficient scale the scale of operations at which average cost per unit reaches a minimum Impact on industry structure

Number of firms Proportion of industry output by each firm Degree of competition
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Figure 8.3 Minimum Efficient Plant Scales
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Group Problem
In the U.S., more than 50 firms produce textiles, but only 3 produce automobiles. This statistic shows that the Government anti-monopoly policy has been applied more harshly to the textile industry than to the automobile industry.
Can you give an alternative explanation for the difference in the number of firms in the 2 industries?
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Answer
The minimum efficient scale is much larger for the
automobile industry than it is for textiles, so there is not
room for many car companies while a larger number of

textile companies can exist in the same market.
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Learning by Doing
Learning by doing is associated with improvements in productivity resulting from a firms cumulative output experience Advantages of Learning by Doing to Pioneering Firms

Attainment of lower production costs Incentive to produce more in any given period
Limits to Advantages:

Benefits spill over to other firms New products can give newer firms a competitive advantage
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Figure 8.8 - Learning by Doing Versus Economies of Scale
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Estimating Cost Functions

Techniques:
Surveys New entrant/survivor technique method for determining the minimum efficient scale of production in an industry based on investigating the plant sizes either being built or used by firms in the industry Econometric specification
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Appendix
Additional Info for you!
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Opportunity Cost of Capital
The normal rate of return*, or the available return on the next-best alternative investment.
*Normal Rate of Return: The amount that must be paid to an investor to induce investment in a business.
Econ vs. Acctg Profit Example

Here is an example of how economic profits and accounting profits differ. Imagine that two years after receiving your college degree your annual salary as an assistant store manager is $28,000, you own a building that rents for $10,000 yearly, and your financial assets generate $3,000 per year in interest. On New Years Day, after deciding to be your own boss, you quit your job, evict your tenants, and use your financial assets to establish a pogo-stick shop. At the end of the year, your books tell the following story: Salary $28,000 Rent $10,000 Interest $3,000 Total Implicit Costs$41,000; Congratulations, your bookkeeper pipes up, you made a Hold it just a moment, you say, I have studied economics. You forgot to subtract my implicit costs. Being in this business caused me to lose as income: Salary $28,000 Therefore, Ive had an economic profit thats negative, a loss of $36,000 This business is a loser!
Ralph Burns

Costs of Production (CH 8)

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Cost of Production Short and Long Run

Chapter 8 and Week 7

Why do we care about them so much? Costs determine:

Costs are determined by:

John Wiley & Sons, Inc.

John Wiley & Sons, Inc.

Value of the highest forsaken alternative

What is the opportunity cost of

Coming to class? Going to university? Male vs. Female ? (Groups)

Has he studied enough, or should he study some more?

Official Slogan for O.C.

There is no such thing as a free lunch!

John Wiley & Sons, Inc.

The Profits of a Firm

Costs & the Profits of a Firm

Economic Profit and Optimal Decision Making

The Profits of a Firm

Copyright 2012 Pearson Canada Inc., Toronto, Ontario

The Profits of a Firm

Total revenues (gross sales)

Copyright 2012 Pearson Canada Inc., Toronto, Ontario

Economic Decision Making

Ignore sunk costs.

Behind Cost Relationships

A firms costs are determined by its production function:

Input combinations (quantities) Input prices

John Wiley & Sons, Inc.

The TVC curve gets its shape from the TP curve.

ATC = AFC + AVC

The ATC curve is also U-shaped.

Product & Cost Relationship

John Wiley & Sons, Inc.

Figure 8.2 - Short-Run Total and Per-Unit Cost Curves

John Wiley & Sons, Inc.

Shifts in Cost Curves

Prices of Factors of Production

$40 $270 $70

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John Wiley & Sons, Inc.

Cost Curves in 60 seconds!

Isocost LineLong Run

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Figure 8.4 - Isocost Lines and the Long-Run Expansion Path

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Least Costly Input Combination

Copyright 2012 John Wiley & Sons, Inc. 47

Interpreting the Tangency Points

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If the firm is not producing at a tangency point

Copyright 2012 John Wiley & Sons, Inc. 49

Is Production Cost Minimized?

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Table 8.2 The Productivity Gains from Privatization

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Long-Run Cost Curves

Economies of scale Diseconomies of scale

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Figure 8.6 - Long-Run Cost Curves

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Economies of Scale and Diseconomies of Scale

Reflects increasing returns to scale

Reflects decreasing returns to scale