CHAPTER 1 - THE ART AND SCIENCE OF ECONOMIC …



CHAPTER 7 – PRODUCTION AND COST IN THE FIRM (6e)

We have been focusing on the behavior of consumers (i.e., on the demand side of the market). We will now look at the behavior of producers (i.e., at the supply side of the market and at production and cost issues).

I. Cost and Profit

Producer’s objective: to maximize profit!

Profit = total revenue minus total cost

There are different ways of looking at total cost and at profit:

A. Explicit and Implicit Costs

1) Definition of explicit cost:

Examples:

2) Definition of implicit cost:

Examples:

Three Ways of Measuring Profit

Ex. 1

3) Accounting profit =

4) Economic profit =

OR

Economic profit =

5) Normal profit: =

II. Production in the Short Run

How can a firm adjust its level of output in order to maximize profit? The answer depends on the time frame involved.

1 Short Run vs. Long Run

1) The short run (SR):

2) The long run (LR):

3 Variable and Fixed Resources

3) Variable resources:

Examples:

4) Fixed resources:

Examples:

4 Total Product and Marginal Product

5) Total Product (TP):

2) Production function:

3) Marginal product (MP):

MP = ∆TP ÷ ∆Q of variable resource

5 The Law of Diminishing Marginal Returns

For now we will focus on the short run. (The long run is discussed in section IV below.)

Ex. 2

Assume the firm’s fixed resources are in place, and the only variable resource is labor (# of workers).

The firm can add labor to increase its output, or TP. At first, as labor is added (through the 3rd worker), the TP rises at an increasing rate, due to the increased specialization and efficiency made possible by the added labor. Thus, at first, MP rises; this is called increasing marginal returns.

As more labor is added (beyond the 3rd worker), the TP continues rising but at a decreasing rate (and TP eventually falls), due to the overuse and resulting decline in efficiency of the variable resource within the limiting framework provided by the fixed resources. So now MP is falling (and eventually becomes negative); this is called diminishing marginal returns (or just diminishing returns). In this example, diminishing marginal returns set in beginning with the 4th worker.

Law of diminishing marginal returns: As more units of a variable resource are added to a set of fixed resources, at some point the added output produced by each added unit of the variable resource will begin to decline (i.e., beyond some point, MP falls).

Examples:

A. Graphing Total Product and Marginal Product

Ex. 3

When increasing marginal returns are occurring, the TP curve is rising at an increasing rate, and the MP curve is sloping up.

When diminishing marginal returns set in, there is a point of inflection on the TP curve after which the curve rises at a decreasing rate; the MP curve begins to decline.

When the TP curve peaks and levels out, MP is zero. When the TP curve begins to fall, MP becomes negative.

III. Costs in the Short Run

A. Categories of Short-Run Costs: Total and Marginal Costs

1) Fixed cost (FC) = the payment for the use of fixed resources; cost that does not vary in the SR even if output varies; cost incurred even when no output is produced.

Examples:

Ex. 4, column 2 shows FC

2) Variable cost (VC) = the payment for the use of variable resources; cost that varies directly with the level of output.

Examples:

Ex. 4, column 3 shows the variable resource (labor)

Ex. 4, column 4 shows the VC

3) Total cost (TC) = the sum of fixed cost and variable cost

TC = FC + VC

Ex. 4, column 5 shows TC

4) Marginal cost (MC) = the change in total cost resulting from a one-unit change in output; the additional cost of producing one more unit.

MC = ΔTC ÷ ΔQ of output

Ex. 4, column 6

Relationship between MP and MC: changes in MC reflect changes in the MP of the variable resource.

When MP is rising, MC is falling. (Workers 1 through 3)

When MP is at its peak, MC is at its minimum. (At worker #3)

When MP is falling, MC is rising. (After worker #3)

Compare Ex. 2, column 3 and Ex. 4, column 6.

B. Graphing the Total and Marginal Cost Curves

Ex. 5 (based on data in Ex. 4)

FC is a horizontal line. (FC is also the vertical distance between VC and TC)

VC begins at the origin, rising slowly at first relative to output while increasing marginal returns are occurring, then rising more rapidly relative to output after diminishing returns set in.

TC is the vertical sum of FC and VC, and follows the same pattern as VC for the same reasons.

MC slopes down as long as increasing marginal returns are occurring.

MC slopes up when diminishing marginal returns begin to occur.

C. Categories of Short-Run Costs: Average Costs

Exhibit 6 (In your textbook, fixed cost and average fixed cost figures are not given, but I have included them in the table below):

|Tons Moved per Day |Fixed Cost |Variable Cost |Total Cost |Marginal Cost |Average Fixed |Average Variable Cost |Average Total Cost|

|(Q) | |(2) |(3) |(4) |Cost |(5) |(6) |

|(1) | | | | | | | |

|0 |$200 |$0 |$200 |--- |--- |--- |--- |

|2 |200 |100 |300 |50.00 |$100.00 |$50.00 |$150.00 |

|5 |200 |200 |400 |33.33 |40.00 |40.00 |80.00 |

|9 |200 |300 |500 |25.00 |22.22 |33.33 |55.55 |

|12 |200 |400 |600 |33.33 |16.67 |33.33 |50.00 |

|14 |200 |500 |700 |50.00 |14.29 |35.71 |50.00 |

|15 |200 |600 |800 |100.00 |13.33 |40.00 |53.33 |

1) Average fixed cost (AFC) = fixed cost per unit of output

AFC = FC ÷ Q of output

Therefore AFC x Q = FC

Since FC is constant, as Q increases the AFC will decline continuously.

2) Average variable cost (AVC) = variable cost per unit of output

AVC = VC ÷ Q of output

Therefore AVC x Q = VC

Ex. 6, column 5

3) Average total cost (ATC) = total cost per unit of output

ATC = TC ÷ Q of output

Therefore ATC x Q = TC

Also ATC = AFC + AVC

Ex. 6, column 6

D. Relationship Between Average and Marginal Cost

Ex. 6 and Ex. 7

The relationship between AVC and MC is as follows:

When MCAVC, it causes AVC to rise.

The same basic relationship holds true for ATC and MC:

When MCATC, it causes ATC to rise.

6 Graphing the Average and Marginal Cost Curves

Ex. 7

AFC declines continually (not shown in your book).

AVC first declines and then rises as output increases.

ATC first declines and then rises as output increases.

The vertical distance between AVC and ATC is the value of AFC.

MC first declines and then rises as output increases. As long as MC is below AVC, AVC will slope down. When MC rises above AVC, AVC will slope up. Note that when MC intersects AVC, AVC is at its lowest point.

The same relationships hold true for MC and ATC. Just re-read the previous paragraph, substituting “ATC” in place of “AVC.”

Costs in the Long Run

Remember that the LR is a period during which all resources under the firm’s control can be varied; i.e., nothing is fixed. The LR represents the firm’s “planning horizon”. A critical LR decision that the firm must make is to choose its plant size.

7 The Long-Run Average Cost (LRAC) Curve

Ex. 8

Suppose a firm can choose a small, medium or large plant size. Which plant size is best? The one that minimizes the average cost of production for the output level the firm wants to produce.

Ex. 9

The long-run average cost (LRAC) curve:

8 Shape of the LRAC Curve

Why does the LRAC curve have a “U-shape”?

Ex. 10

1) Economies of scale: forces that cause LRAC to fall as the scale of operation increases in the long run. As a firm expands its plant size, it often enjoys greater specialization and efficiency, which lowers average production costs.

2) Constant long-run average cost: it is possible that over a certain range of output, LRAC neither falls nor rises, but remains constant.

3) Diseconomies of scale: forces that cause LRAC to rise as the scale of operation increases in the long run. As a firm continues to expand its plant size, it often begins to suffer from inefficiencies, miscommunication, and lack of coordination, which raise average production costs.

Omit the appendix to Chapter 7.

END

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