YR1SM1 Microeconomics Chapter 14 - Costs of production

Assumed objective of firms

to max profit

Total revenue (TR) =

P x Q

Total cost (TC) definition

the market value of the inputs needed for production

Profit =

TR - TC

Explicit vs implicit costs; examples of both?

Explicit costs are input costs that require an outlay of money by the firm to some other entity (wages to workers, money for physical capital), while implicit costs are opportunity costs, or what could have been earned by doing an alternate action (how much one could have earned working another job; how much interest someone could’ve earned by keeping money in savings)

Pulling from a savings account: explicit and implicit costs?

Pulling from one’s own savings is not an outlay of money to another person, so this is not an explicit cost. If someone kept the money in their savings, they could have earned interest, so this interest amount counts as an implicit cost

Borrowing at an interest rate: implicit and explicit costs?

No implicit cost, but an explicit cost in the form of the interest one must pay back over time

Total cost =

Explicit cost + implicit cost

Accounting profit vs economic profit

Accounting profit = TR - explicit costs, whereas economic profit = TR - total costs

2 assumptions about production in the short run

factory size and other physical capital are fixed

must hire more workers to increase production

Why is physical capital, such as machinery purchases and factory expansion, considered fixed in the short run but unskilled labor is not?

Short run provides inadequate time for adjustments to physical production means to be made; however, unskilled labor is variable due to the (presumably) ready population of unskilled workers looking for a job

The production function relates which two variables?

the quantity of inputs used to make a good and the quantity of outputs made of that good

As production rises, the production function becomes ___, meaning what between the quantity of inputs and the quantity of outputs

flatter; as quantity of inputs rise, quantity of outputs made do rise but not as fast

What is always the starting point on a number of workers vs quantity of outputs (production function) graph?

(0, 0), because with no workers, no production can even occur

Which concept explains the flattening of the production curve?

Law of diminishing marginal returns

What is marginal product?

all other inputs ceteris paribus, marginal product is the increase in output that arises from an additional unit of one input

How is marginal product represented on the production function graph?

as the derivative/slope of every point on the curve

Marginal Product of Labor (MP_L) =

∆Q / ∆L

change in output quantity / change in laborers

(NO PERCENT CHANGE HERE!!)

Why does the law of diminishing marginal returns/product occur?

In the short run, the input that is increased is unskilled labor. Since resources together synthesize the good, over time, the stagnant amount of fixed inputs will hinder more production

BOH Restaurant example of the law of diminishing marginal return/product?

increasing number of workers but keeping the amount of physical capital (such as ovens and stoves) the same → less and less capital per worker → overcrowding and inefficiency

Rational people think at the margin meaning

At some point, the cost of increasing an input equals the added revenue that this increase brings in; so while no financial benefit is gained, increasing this input will still improve efficiency (EX: hiring one more clerk to reach the margin does not bring financial gain, but lines will be shorter)

As quantity of output increases, total cost …

increases at an increasing rate

Total cost (TC) = what two variables?

fixed cost + variable costs

In the short run, fixed costs do…

How are fixed costs represented on a quantity of output vs total cost graph?

do not vary with the quantity of output produced, even if production is zero

as the y-intercept

Fixed cost is what type of resource? Variable cost is what type of resource?

Capital goods that process intermediate goods

Labor + intermediate goods

Bakery business: identify examples of fixed costs and variable costs

Fixed: physical location, kitchen equipment

Variable: # of laborers, ingredients

Variable costs do vary with ..

with the quantity of output produced

Average fixed cost (AFC) =

Average variable cost (AVC) =

Average total cost (ATC) =

Fixed cost / quantity

variable cost / quantity

total cost / quantity OR AFC + AVC

Marginal cost =

∆ total cost / ∆ quantity

AFC, AVC, and ATC are always equal to what when the quantity is 0?

undefined

As quantity produced increases, what happens to the size of AFC?

AFC decreases because as output made rises, fixed costs stay the same

What can marginal cost also equal and why?

∆ VC / ∆ Q

since VC and FC comprises TC, with FC always staying the same, changes in VC is the only factor to change TC

Efficiency Scale

the quantity that minimizes average total cost

What are the usual shapes (2) of a marginal cost line on a quantity of output vs costs graph?

Like a curved checkmark: decreases throughout smaller quantities of output before reaching a minimum and later increasing

Sometimes it is shown as just increasing

What is the usual shape of a AFC line on a quantity of output vs cost graph?

a curved line that approaches the x axis, because as quantity increases, fixed costs stay the same, so they make up a smaller portion of the total cost

At low enough quantities, as the cost to produce an additional unit decreases, what happens to the ATC?

Marginal cost decreases then increases but is still ~low because the output made is substantial in comparison to the production costs, a relationship which causes a downward trend in ATC (magnitude of trend isn’t as severe)

At high enough quantities (past the efficiency scale), as the cost to produce an additional unit increases, what happens to the ATC?

Marginal costs increase because the production cost rises at a faster rate than output made, causing the ATC line to exhibit a positive, increasing trend (though the magnitude of this increase is not as severe as the increase in marginal cost)

Describe how the MC and ATC lines are connected with one another at low quantities, at the point of minimized total cost, and at high quantities?

Low quantities: MC is below the ATC and continues to decrease until the minimum marginal cost, thus causing a negative trend in the ATC curve

Point at the minimum of total cost, also known as the efficiency scale point: the MC curve crosses the ATC curve

High quantities: the MC is now above the ATC curve and continues to increase, thus causing a positive trend in the ATC curve

Short run in relation to inputs and costs

In the short run, some inputs are fixed, thus the costs of these inputs are considered fixed costs (FC)

Why are all inputs considered variable in the long run? EX?

Fixed inputs require adequate time to be adjusted, and the long run offers the time needed

EX: expanding factories vs selling factories in response to price changes

In the long run, the ATC at any Q is…

the lowest cost of production per unit that results from using the most favorable, efficient mix of inputs

How does the curvature of marginal cost relate to the law of diminishing marginal returns/product?

Initially, adding more units of an input does allow a substantial increase in quantity and thus a decrease in marginal cost and ATC (because quantity increase outweighs the additional production costs), though later, the disproportionate lack of fixed inputs will prevent the full potential of these added inputs and cause a lower return on investment, resulting in a growing marginal cost and ATC

How does the variability of inputs in the long run alleviate the issue of diminishing marginal returns/product and growing marginal costs?

At higher quantities, firms can expand their availability of previously fixed inputs, allowing for greater utilization of the other added inputs which will incur a lower ATC

What is the typical relationship between quantity of output and ATC in the long run?

At lower quantities, ATC slopes downward and becomes relatively flat for medium quantities, but at higher quantities, ATC slopes upward

When are economies of scales most common, and what is the relationship between quantity of output and LR ATC?

when quantity is low

LR ATC falls as the quantity of output rises

When are constant returns to scale most common, and what is the relationship between quantity of output and the LR ATC?

medium level of output quantity

LR ATC stays ~same as the quantity of output increases

When are diseconomies of scale most common, and what is the relationship between quantity of output and LR ATC?

when quantity of output is high

As quantity rises, LR ATC rises