Econ 201 Chapter 13 Notes
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Date Created: 03/31/16
ECON 201 Chapter 13 Notes: The Costs of Production The Law of Supply is all you need to know about firm behavior. Part of economics called: industrial organization- the study of how firm’s decisions about prices and quantities depend on the market conditions they face. What are Costs? Total Revenue, Total Cost, and Profit: The amount that the firm receives for the sale of its output is called its total revenue. The amount that the firm pays to buy inputs is called its total cost. Profit is a firm’s total revenue – its total cost. Measuring total revenue= Q times P. Costs as Opportunity Costs: It is important to keep in mind one of the Ten Principles of Economics- opportunity cost- refers to all those things that must be forgone to acquire that item. Explicit costs- input costs that require an outlay of money by the firm. Implicit costs- input costs that do not require an outlay of money by the firm. Total Cost= Implicit + Explicit Costs. The Cost of Capital as an Opportunity Cost: An important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. Economists and accountants treat costs differently, especially with capital. Economists take into account BOTH implicit and explicit costs, however accounting costs only include the explicit costs. Economic Profit vs. Accounting Profit: An economist measures a firm’s economic profit- as the firm’s total revenue minus total cost, including both explicit and implicit costs. An accountant measures the accounting profit- total revenue minus total explicit costs. From here you will notice that accounting profit is usually larger than economic profit. Making a positive economic profit will keep the business in the market, it is covering all its opportunity costs and has some revenue left to reward the firm owners. When a firm is making economic losses (negative), the business owners fail to earn enough revenue to cover costs of production. Production and Costs: Firms incur costs when they buy inputs to produce the goods and services they plan to sell. Production= the process of combining inputs (economic resources) to make goods and services. Firms should use technology= methods used by firms to convert inputs into outputs (same as the production function which is expressed mathematically). Q= (K-Capital, Labor, Raw Material, Energy) which also equals maximum output. The Production Function: The relationship between the quantity of inputs (workers) and quantity of output (cupcakes). Rational people think at the margin. The third column in the table gives the marginal product of a worker. The marginal product of any input in the production process is the increase in the quantity of output obtained from one additional unit of that input. When the number of workers goes from 1 to 2, the cupcake production increases from 50 to 150. It represents the change in output as the number of workers increases from one level to another. As the number of workers increases more, the marginal product begins to decline, this is known as the Law of Diminishing Marginal Product or the Law of Variable Proportions. This can be seen in the last two rows of the table. The more workers that crowd the workplace can decrease the cupcake production from 610 to 580= -30 marginal product. The marginal product of labor that first increases is called the increasing returns to labor and when it decreases due to higher workforce is known as the decreasing returns to labor. Cupcake Production Fixed Factors # of Workers Total Product Marginal Average (L) of Labor (TPL) Product of Product of Labor (MPL) Labor (APL) 15 0 0 - - 15 1 50 50 50 15 2 150 100 75 15 3 300 150 100 15 4 400 100 100 15 5 480 80 96 15 6 540 60 90 15 7 580 40 83 15 8 610 30 76 15 9 610 - 68 15 10 580 -30 58 From the Production function to the Total-Cost Curve: The last 3 columns express the cost of producing the cupcake. It shows how the number of workers is related to the quantity of the good produced and to her total cost of production. The MOST important relationship in the table is between quantity produced and total cost- with QP on the horizontal axis and the TC on the vertical axis= total cost curve. When comparing the total cost curve and the production function a) these two curves are opposite sides of the same coin. The TC curve gets steeper as the amount produced rises, whereas the production function gets flatter as production rises. These changes occur for the same reason=high production means the workplace is crowded. The more crowded, the less efficient in production of that good. Therefore, when it is crowded, producing an additional product requires a lot of additional labor and is VERY COSTLY. When the quantity produced is large, the total cost curve is relatively steep. Marginal Product of Labor and Total Product of Labor RelationshipMPL and APL Relationship With these TPL curve on the left, when MPL > 0, TPL Increases. When MPL = 0, TRL reaches maximum output. When MPL < 0, TPL Decreases. With APL curve on the right when MPL > APL, APL Increases. When MPL = APL, it is constant. When MPL < APL, APL Decreases. Unit Costs: Q= f(K, L) K are the fixed costs (don’t change with units produced) and L are the variable (change) costs. Average Fixed Costs (AFC) = TFC/Q. Average Variable Costs (AVC) = TVC/ Q or VC* Wage/Q. AVC is a U-Shaped curve. APL AND APC. As APL increases, APC decreases. As APL decreases, APL increases. Average Total Cost (ATC) = TC/Q or AFC + AVC. Marginal Cost (MC) = Change in Total Cost/Change in Quantity or Wage/MPL. The graph starts out decreasing then it increases (supply curve). Fixed and Variable Costs: Fixed costs- costs that do not vary with the quantity of output produced. They are incurred even if the firm produces nothing at all. Variable costs- change as the firm alters the quantity of output produced. Total Cost is the sum of fixed and variable costs. Average and Marginal Cost: When deciding how much to produce, consider how the level of production affects his firm’s cost. To find the cost of the unit produced, we divide the firm’s costs by the quantity of output it produces (ATC= TC/Q) = average total cost. It is also the sum of the average fixed cost- fixed cost divided by the quantity of output, and the average variable cost- variable cost divided by the quantity of output. Average total cost tells us the cost of a unit, but not how much total cost will change as the firm alters its level of production. The amount that total cost rises when the firm increases production (MC=Change in TC/Change in Quantity produced) is called marginal cost. Cost Curves and Their Shapes: We will find graphs of average and marginal cost useful when analyzing the behavior of firms. Horizontal axis= quantity, vertical axis= marginal and average costs. The graph includes ATC- Average Total Cost, AFC- Average Fixed Costs, AVC- Average Variable Costs, and MC- Marginal Costs. Rising Marginal Cost: Marginal cost rises as the quantity of output produced increases. This reflects the diminishing marginal product. The more workers, more equipment is being used. Therefore when the quantity of a product produced is already high, the MP of an extra worker is low, and the MC of an extra product is large. U-Shaped Average Total Cost: ATC is the sum of average fixed and variable costs. Average fixed cost always declines as output rises because fixed cost is spread over a larger number of units. ATC typically rises as output increases because of diminishing marginal product. The bottom of the U-Shape occurs at the quantity that minimizes ATC, which is usually called the efficient scale. The two forces are balanced to yield the lowest average total cost. The Relationship between MC and ATC: Whenever MC is less than ATC, ATC is falling. Whenever MC is greater than ATC, ATC is rising. Example: your grade. When taking a test it can increase or decrease your average grade. Here, the MC curve crosses the ATC at its minimum. Typical Cost Curves: Marginal Cost eventually rises with the quantity of output, the ATC curve is U shaped, and the MC curve crosses the ATC curve at the minimum of ATC. Costs in the Short Run and the Long Run The Relationship between Short Run and Long Run ATC: The division of total costs between fixed and variable costs depends on the time horizon. In the short run- at least 1 economic resource is fixed while the others are variable. (BSU assets) Long run- all economic resources will be variable, NO fixed items. The curves definitely differ. The long run ATC curve is much flatter U shape than the short run ATC. Short run lies on or is above the long run. There is more flexibility in the long run. In essence, in the long run, the firm gets to choose which short run curve it wants to use. But in the short run, it has to use whatever short run curve it has, based on past decisions. Economies and Diseconomies of Scale: The ATC curves tell us how costs vary with the scale-the size- of a firm’s operations. When long run ATC declines as output increases, there are said to be economies of scale. When ATC rises as output increases, there are diseconomies of scale. When long run ATC does not vary with the level of output (stays the same) there are constant returns of scale. There is an economies of scale when higher production levels allow specialization. Diseconomies of scale occurs because of coordination problems (can’t keep costs down), that are inherent in any large organization.