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Chapter 7: Production and Cost in the Firm

by: David Falcone

Chapter 7: Production and Cost in the Firm ECON 2005

Marketplace > Virginia Polytechnic Institute and State University > ECON 2005 > Chapter 7 Production and Cost in the Firm
David Falcone
Virginia Tech

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About this Document

These notes cover Chapter 7: Production and Cost in the Firm and will be tested on Exam 2. All information comes from Aplia/ Principles of Microeconomics by William A. Mceachern.
Principles of Economics
Steve Trost
Class Notes
Explicit Cost, Implicit Costs, Accountingprofit, economic, profit, Variableresource, Fixedresource, Shortrun, Longrun, Totalproduct, Productionfunction, Marginalproduct, Increasingmarginalreturns, LDMU, Totalcost, fixedcost, variablecost, averagevariablecost, averagefixedcost
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This 9 page Class Notes was uploaded by David Falcone on Thursday September 8, 2016. The Class Notes belongs to ECON 2005 at Virginia Polytechnic Institute and State University taught by Steve Trost in Fall 2015. Since its upload, it has received 3 views.


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Date Created: 09/08/16
Chapter 7: Production and Cost in the Firm  Cost and profit o Producers try to maximize their profit  Firms try to earn a profit by transforming resources into salable products  Explicit and Implicit Costs o To hire a resource, a firm must pay at least the resource’s opportunity cost—that is, at least what the resource could earn in its best alternative use  For most resources, a cash payment approximates the opportunity cost o Firms do not make direct cash payments for resources they own  Yet these resources are not free  Whether hired in resource markets or owned by the firm, all resources have an opportunity cost o Company-owned buildings can be rented or sold; small-business owners can find other work o Explicit costs- Opportunity cost of resources employed by a firm that takes the form of cash payments  Wages, rent, interest, insurance, taxes, etc. o Implicit costs- A firm’s opportunity cost of using its own resources or those provided by its owners without a corresponding cash payment  Examples include the use of a company-owned building, use of company funds, and the time of the firm’s owners  Like explicit costs, implicit costs are opportunity costs  Unlike explicit costs, implicit costs require no cash payment and no entry in the firm’s accounting statement, which records its revenues, explicit costs, and accounting profit.  Alternative Measures of Profit o An example may help clarify the distinction between explicit and implicit costs. Wanda Wheeler earns $50,000 a year as an aeronautical engineer with the Skyhigh Aircraft Corporation. On her way home from work one day, she gets an idea for a rounder, more friction-resistant airplane wheel. She decides to quit her job and start a business, which she calls Wheeler Dealer. To buy the necessary machines and equipment, she withdraws $20,000 from a savings account earning interest of $1,000 a year. She hires an assistant and starts producing the wheel using the spare bay in her condominium’s parking garage, which she had been renting to a neighbor for $100 a month.  Company revenue in 2012 totaled $105,000. After paying her assistant and for materials and equipment, the firm shows an accounting profit of $64,000.  Accounting profit- A firm’s total revenue minus its explicit costs (AP=(R-EC))   Accounting profit IGNORES the opportunity cost o First is the opportunity cost of her time. Remember, she quit a $50,000-a-year job to work full time on her business, thereby forgoing that salary. Second is the $1,000 in annual interest she passes up by funding the operation with her own savings. And third, by using the spare bay in the garage for the business, she forgoes $1,200 per year in rental income. The forgone salary, interest, and rental income are implicit costs because she no longer earns income from the best alternative uses of these resources.  Economic profit- A firm’s total revenue minus its explicit and implicit costs (EP=R-(EC+IC))  Economic profit takes into account the opportunity cost of all resources used in production.  Normal profit- The accounting profit earned when all resources earn their opportunity cost; equal to implicit cost  Zero economic profit  Any accounting profit in excess of a normal profit is economic profit. If accounting profit is large enough, it can be divided into normal profit and economic profit. The $64,000 in accounting profit earned by Wanda’s firm consists of:  a normal profit of $52,200, which covers her implicit costs —the opportunity cost of resources she supplies the firm, and  an economic profit of $11,800, which is over and above what these resources, including Wanda’s time, could earn in their best alternative use.  Fixed and Variable Resources o Variable resources- Any resource that can be varied in the short run to increase or decrease production o Fixed resources- Any resource that cannot be varied in the short run o Short run- A period during which at least one of a firm’s resources is fixed  Output can be changed in the short run by adjusting variable resources, but the size, or scale, of the firm is fixed in the short run o Long run- A period during which all resources under the firm’s control are variable (aka none are fixed)  In the long run, all resources can be varied. The length of the long run differs from industry to industry because the nature of production differs.  For example, the size of a McDonald’s outlet can be increased more quickly than can the size of an auto plant. Thus, the long run for that McDonald’s is shorter than the long run for an automaker.  The Law of Diminishing Marginal Returns o Total product- A firm’s total output o Production function- The relationship between the amount of resources employed and a firm’s total product o Marginal product- The change in total product that occurs when the use of a particular resource increases by one unit, all other resources constant o o Increasing Marginal Returns  Increasing marginal returns- The marginal product of a variable resource increases as each additional unit of that resource is employed  In the example more workers are hired, which increases marginal return; at least, until the 4 worker is hired o Diminishing Marginal Returns th  The marginal return decreases after the 4 worker is hired, however the total product still increases  Law of diminishing marginal returns- As more of a variable resource is added to a given amount of other resources, marginal product eventually declines and could become negative  The law of diminishing marginal returns is the most important feature of production in the short run.  When Smoother Mover hires an eighth worker, workers start getting in each other’s way, and they take up valuable space in the moving van.  The Total and Marginal Product Curves o  Costs in the Short Run o Fixed cost- Any production cost that is independent of the firm’s rate of output  For example, in the steel industry, giant ovens must remain hot even when the plant isn’t making steel. Otherwise, bricks inside would disintegrate. o Variable cost- Any production cost that changes as the rate of output changes  Labor  When no labor is employed, output is zero, as is variable cost. As workers are hired, output increases, as does variable cost.  Total Cost and Marginal Cost in the Short Run o o Total cost= fixed cost + variable cost o Marginal cost- The change in total cost resulting from a one-unit change in output; the change in total cost divided by the change in output delta TC/ delta q.  When the firm experiences increasing marginal returns, the marginal cost of output falls; when the firm experiences diminishing marginal returns, the marginal cost of output increases. o Total and Marginal Cost Curves   Marginal cost indicates how much total cost increases if one more unit is produced or how much total cost drops if production declines by one unit.  Average Cost in the Short Run o Average variable cost= VC/q o Average total cost= TC/ q   The Relationship between Marginal Cost and Average Cost o Once marginal cost exceeds average cost, marginal cost pulls up average cost. The fact that marginal cost first pulls average cost down and then pulls it up explains why the average cost curves have U shapes. The shapes of the average variable cost curve and the average total cost curve are determined by the shape of the marginal cost curve, so each is shaped by increasing, then diminishing, marginal returns. o o Notice also that the rising marginal cost curve intersects both the average variable cost curve and the average total cost curve where these average curves reach their minimum. This occurs because the marginal pulls down the average where the marginal is below the average and pulls up the average where the marginal is above the average. One more thing: The distance between the average variable cost curve and the average total cost curve is average fixed cost, or AFC, which gets smaller as the rate of output increases. (Why does average fixed cost get smaller?) o The law of diminishing marginal returns determines the shapes of short-run cost curves. When the marginal product of labor increases, the marginal cost of output falls. Once diminishing marginal returns take hold, the marginal cost of output rises. Thus, marginal cost first falls and then rises. And the marginal cost curve dictates the shapes of the average cost curves. When marginal cost is less than average cost, average cost declines. When marginal cost is above average cost, average cost increases.  Economies of Scale o Economies of scale- Forces that reduce a firm’s average cost as the scale of operation increases in the long run  A larger size often allows for larger, more specialized machines and greater specialization of labor  A larger scale of operation allows a firm to use larger, more efficient machines and to assign workers to more specialized tasks. Production techniques such as the assembly line can be introduced only if the rate of output is sufficiently large. Typically, as the scale of a firm increases, capital substitutes for labor and complex machines substitute for simpler machines.  Diseconomies of Scale o Diseconomies of scale- Forces that may eventually increase a firm’s average cost as the scale of operation increases in the long run  As the amount and variety of resources employed increase, so does the task of coordinating all these inputs.  As the workforce grows, additional layers of management are needed to monitor production. In the thicket of bureaucracy that develops, communications may get mangled. Top executives have more difficulty keeping in touch with the factory floor because information is distorted as it moves up and down the chain of command. Indeed, in large organizations, rumors may become a primary source of information, reducing efficiency and increasing average cost.  Diseconomies of scale result from a larger firm size, whereas diminishing marginal returns result from using more variable resources in a firm of a given size.  The Long-Run Average Cost Curve o o The long-run average cost curve- A curve that indicates the lowest average cost of production at each rate of output when the size, or scale, of the firm varies; also called the planning curve  These points of tangency represent the least-cost way of producing each particular rate of output, given resource prices and the technology. o o Each point of tangency between a short-run average cost curve and the long-run average cost curve represents the least-cost way of producing that particular rate of output. o It is possible for average cost to neither increase nor decrease with changes in firm size. o Constant long-run average cost- A condition that occurs if, over some range of output, long-run average cost neither increases nor decreases with changes in firm size o The output rate must reach quantity A for the firm to achieve the minimum efficient scale, which is the lowest rate of output at which long-run average cost is at a minimum. o  Only two relationships between resources and output underlie all the curves. In the short run, it’s increasing and diminishing returns from the variable resource. In the long run, it’s economies and diseconomies of scale.


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