Transcript Chapter 13 - Powerpoint

THEORY OF PRODUCTION AND COST
Production is the use of factors of production to
produce and market goods and services.
Inputs include the broad categories of land, labor,
capital, other intermediate inputs and
entrepreneurship.
In a mixed economy, both firms and governments
organize the production of various goods and
services.
Production in the Short-run
An input that cannot vary in quantity during the relevant
time period is called a fixed input or fixed factor.
An input having a quantity that can change during the
relevant time period is called a variable input or
variable factor.
The short-run is a period of time such that there is at least
one fixed factor.
The long-run is a period of time such that all inputs are
variable in quantity.
A production function summarizes the relationship
between all combinations of inputs and the corresponding
maximum attainable levels of output, for a given
technology.
The total product, TP, of a variable input is the amount
of output produced over the period when that input is used
with fixed quantities of all other inputs.
The marginal product of an input F, MPF, is the
additional output per unit increase in the input, holding all
other inputs (and technology) constant;
 TP
MPF 
F
Total Product
TP
250
bushels of potatoes
fertilizer
TP,
Output
MP,
Marginal
output
per unit
of input
200
150
100
0
0
---
1
15
15
2
38
23
3
68
30
pounds of fertilizer
4
103
35
Marginal Product
5
137
34
6
168
31
7
192
24
8
211
19
9
226
15
10
235
9
50
0
bushels of potatoes
per unit of fertilizer
0
2
4
6
8
10
30
20
MP
.
10
0
0
2
4
6
pounds of fertilizer
8
10
Diminishing marginal product: As more of
a variable input is employed, with the
quantities of all other inputs held constant,
the marginal product of the variable input
will decline after some point.
Diminishing marginal product results from the
process of adding additional units of a variable
input to given quantities of other inputs.
Measuring costs and profits
Total (Economic) Cost is the monetary value of all
inputs used in a particular activity over a given period.
Explicit Costs correspond to the monetary payments for
inputs.
Implicit Costs are the opportunity costs of inputs that
have no explicit monetary payments as a result of the
inputs not being purchased in markets.
All opportunity costs, both explicit and implicit, are
part of economic costs.
Measuring costs
Economic depreciation is the reduction in the value of
a capital good over the relevant period that results from
wear and tear as well as obsolescence.
Accounting depreciation measures the annual
accounting cost of capital, expressed as some portion of
the capital’s monetary cost.
Accounting costs measure the explicit costs of
production during a given period plus accounting
depreciation.
Measuring costs and profits
Total revenue is the explicit monetary return
associated with an economic activity over a given
period.
Economic activities can also yield implicit
returns.
The total return includes both total revenues and
implicit returns.
Economic and accounting profits are defined below:
Total return
less:
explicit costs
economic depreciation
other implicit costs
Total revenue
less:
explicit costs
accounting depreciation
Economic Profits
Accounting Profits
Economic profits measure the net (private) economic
gain resulting from an economic activity.
When economic profits are zero the returns to owner
supplied inputs exactly equal the opportunity costs of
those inputs. These returns are called normal profits.
Related Cost Measures
Variable cost, VC, is the cost of the variable input(s)
used to produce any given level of output.
Fixed costs, FC, is the cost of all fixed inputs.
Total cost, TC, is the sum of the costs of all inputs used
to produce output during the period;
TC = VC + FC.
Example of Potato Production
(The price of fertilizer is $50 per unit and the costs associated with fixed input $40.)
F
Q
FC
VC
TC
fert.
bushels of
potatoes
$
$
$
0
0
40
0
40
1
15
40
50
90
2
38
40
100 140
3
68
40
150 190
4
103
40
200 240
5
137
40
250 290
6
168
40
300 340
7
192
40
350 390
8
211
40
400 440
9
226
40
450 490
10
235
40
500 540
Related Cost Measures
Marginal cost, MC, is the increase in total or
variable cost per unit increase in output, Q;
VC TC
MC 

Q
Q
Average variable cost, AVC, is the variable cost
VC
of production per unit of output; AVC 
.
Q
Average fixed cost, AFC, is the fixed cost per
FC
unit of output; AFC 
.
Q
Average cost, AC, is the total cost of all inputs
TC
per unit of output; AC 
.
Q
TC VC  FC VC FC
AC 



Q
Q
Q
Q
AC  AVC  AFC
Various Costs for Potatoes Example
Q
MC AVC AFC
AC
0
--------15
3.33 3.33 2.67
6.00
38
2.17 2.63 1.05
3.68
68
1.67 2.21 0.59
2.79
103 1.43 1.94 0.39
2.33
137 1.47 1.82 0.29
2.12
168 1.61 1.79 0.24
2.02
192 2.08 1.82 0.21
2.03
211 2.63 1.90 0.19
2.09
226 3.33 1.99 0.18
2.17
235 5.56 2.13 0.17
2.30
dollars per unit of Q
Marginal, Average, Average Variable and
Average Fixed Costs
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
AC
MC
AVC
1.43
AFC
0
50
103
100
150
Q, quantity of output
200
250
Various Costs for Potatoes Example
Q
MC AVC AFC
AC
0
--------15
3.33 3.33 2.67
6.00
38
2.17 2.63 1.05
3.68
68
1.67 2.21 0.59
2.79
103 1.43 1.94 0.39
2.33
137 1.47 1.82 0.29
2.12
168 1.61 1.79 0.24
2.02
192 2.08 1.82 0.21
2.03
211 2.63 1.90 0.19
2.09
226 3.33 1.99 0.18
2.17
235 5.56 2.13 0.17
2.30
dollars per unit of Q
Marginal, Average, Average Variable and
Average Fixed Costs
6.0
5.5
5.0
4.5
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
AC
MC
2.33
0.39
0
50
103
AVC
1.94
AFC
100
150
Q, quantity of output
200
250
Family of Average Costs
Fixed cost FC
AFC =
=
Quantity
Q
Variable cost VC
AVC =
=
Quantity
Q
Total cost TC
ATC =
=
Quantity
Q
Marginal Cost
(Change in total cost)
MC =
(Change in quantity)
= TC
Q
Note the relationship between MP and MC.
fertilizer
0
1
2
3
4
5
6
7
8
9
10
TP
0
15
38
68
103
137
168
192
211
226
235
MP
--15
23
30
35
34
31
24
19
15
9
Q
0
15
38
68
103
137
168
192
211
226
235
TC
40
90
140
190
240
290
340
390
440
490
540
MC
--3.33
2.17
1.67
1.43
1.47
1.61
2.08
2.63
3.33
5.56
The marginal cost of output directly depends upon
the marginal product and price of each variable
input;
input price
MC 
MPL
.
For example, if MPL= 0.5 widgets per hour and the wage
rate is a constant $10.00 per hour,
MC = ($10 per hour) / (0.5 widgets per hour)
= $20 per widget .
Intuition: If MPL= 0.5, it takes two hours of work to
create one widget. With a wage of $10 per hour, this
translates into a marginal cost of $20.00 for an additional
widget.
input price
MC 
.
MPL
Implications:
• An increase in the price of a variable input, ceteris paribus,
will result in an increase in the marginal cost of output.
• Holding the input price constant, an increase in the marginal
product of a variable input will cause MC to decrease.
• Often we talk about MC increasing as output increases (after
some point). The underlying reason is diminishing marginal
product of the variable input(s).
Total-Cost Curve...(Another Example)
$16.00
Total-cost
curve
$14.00
MC = 1.90
Total Cost
$12.00
$10.00
MC = 1.30
$8.00
$6.00
MC = 0.70
$4.00
ΔTC = 0.70
$2.00
ΔQ = 1
$0.00
0
2
4
6
8
Quantity of Output
10
12
Average-Cost and Marginal-Cost
Curves...
$3.50
$3.00
Costs
$2.50
MC
$2.00
$1.50
AVC
$1.00
$0.50
$0.00
0
2
4
6
8
Quantity of Output
10
12
Relationship Between Marginal Cost and
Average Variable Cost
Whenever MC is greater than AVC,
AVC will be rising.
Whenever MC is less than AVC, AVC
will be falling.
Relationship Between Marginal Cost and
Average Total Cost
$3.50
$3.00
Costs
$2.50
MC
$2.00
ATC
$1.50
$1.00
$0.50
$0.00
0
2
4
6
8
Quantity of Output
10
12
Relationship Between Marginal Cost and
Average Total Cost
Whenever MC is less than ATC, ATC
will be falling.
Whenever MC is greater than ATC,
ATC will be rising.
Average-Cost and Marginal-Cost
Curves...
$3.50
$3.00
Costs
$2.50
MC
$2.00
ATC
AVC
$1.50
$1.00
$0.50
$0.00
AFC
0
2
4
6
8
Quantity of Output
10
12
Cost Curves and Their Shapes
The average total-cost curve is U-shaped.
At very low levels of output ATC is high because
fixed cost is spread over only a few units.
ATC initially declines as output increases because of
the decline in AFC.
ATC eventually starts to rise because AVC rises
substantially.
Total-Cost Curve...
$16.00
Total-cost
curve
$14.00
Total Cost
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
0
2
4
6
8
Quantity of Output
10
12
Big Bob’s Cost Curves...
$20.00
$18.00
Total Cost Curve
$16.00
Total Cost
$14.00
$12.00
$10.00
$8.00
$6.00
$4.00
$2.00
$0.00
0
2
4
6
8
10
Quantity of Output
(bagels per hour)
12
14
16
Big Bob’s Cost Curves...
3.5
3
2.5
MC
Costs
2
1.5
AVC
1
0.5
0
0
2
4
6
8
Quantity of Output
10
12
14
16
Big Bob’s Cost Curves...
3.5
3
2.5
MC
Costs
2
1.5
AVC
1
0.5
AFC
0
0
2
4
6
8
Quantity of Output
10
12
14
16
Big Bob’s Cost Curves...
3.5
3
2.5
MC
Costs
2
1.5
ATC
AVC
1
0.5
AFC
0
0
2
4
6
8
Quantity of Output
10
12
14
16
Three Important Properties of Cost Curves:
Marginal cost eventually rises with the
quantity of output.
The average-total-cost curve is Ushaped.
The marginal-cost curve crosses the
average-total-cost and averagevariable-cost curves at their minimums.
Cost Curves and Their Shapes
•The bottom of the U-shape AC curve
corresponds to the quantity that minimizes
the average cost of production.
•This quantity is sometimes called the
efficient scale of the firm.
•The marginal-cost curve crosses the
average-total-cost curve at the efficient
scale.
Costs in the Long Run
For many firms, the division of total costs
between fixed and variable costs depends
on the time horizon being considered.
 In the short run some costs are fixed.
 In the long run fixed costs become
variable costs.
Average Total Cost in the Short and
Long Runs...
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory
ATC in long run
0
Quantity of
Cars per Day
Economies and Diseconomies of
Scale
Economies of scale occur when long-run
average total cost declines as output
increases.
Diseconomies of scale occur when longrun average total cost rises as output
increases.
Constant returns to scale occur when longrun average total cost does not vary as
output increases.
Average
Total
Cost
Economies and Diseconomies of
Scale
ATC in long run
Economies
of scale
0
Constant Returns
to scale
Diseconomies
of scale
Quantity of
Cars per Day