Costs of Production - Production Lecture Notes - Mankiw Chapter 14

Fundamental Cost Concepts and Economic measurement

• The Origin of Costs: Costs exist fundamentally because resources are scarce and have competing uses. Choosing to produce more of one specific good inherently means forgoing the production of another good.
• Opportunity Cost: The cost of producing a good is measured by the worth of the most valuable alternative that was given up to obtain it.
  • Example: The opportunity cost of steel used for constructing office buildings is the value that same steel would have had if it were used in manufacturing automobiles.
• Diversity in Cost Perspective:
  • Economists: Always refer to opportunity costs when measuring costs. They consider how society forgoes opportunities to use resources elsewhere when committing them to a specific commodity.
  • Accountants: Generally focus on explicit, monetary movements and do not account for implicit opportunity costs.
• Economic Costs: These are the payments a firm must make to secure the resources required for production. They are categorized into two types:
  • Explicit Costs: Monetary payments made to external suppliers for resources. Examples include wages for labor, costs of raw materials from suppliers, utility costs like fuel, transportation services, and rental payments to landlords.
  • Implicit Costs: The opportunity costs of using self-owned or self-employed resources. This represents the money payment the resources could have earned in their best alternative use. Examples include wages a business owner gives up by leaving a previous job or the interest rate earned from a savings account if the capital had not been invested in the firm.
• Comparison Matrix of Explicit vs. Implicit Costs:
  • Explicit Costs: Incurred on inputs not owned by producers; involve monetary payment; considered by both accountants and economists. (Example: Renting a premise from an owner).
  • Implicit Costs: Incurred on inputs owned by the producer; do not involve monetary payment; considered by economists but ignored by accountants. (Example: Using a self-owned premise and forgoing potential rent from a tenant).

Profit Measures: Accounting vs. Economic

• Accounting (Normal) Profit: Total revenue minus accounting costs (explicit costs only).
• Economic (Abnormal) Profit: Total revenue minus economic costs (the sum of both explicit and implicit costs).
• Key Differences:
  • Economic costs are inherently larger than accounting costs because they include implicit costs.
  • Accounting profits are larger than economic profits.
  • The formula for Economic Profit is: $\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$.

Active Learning 1: Gomez's Pottery Firm Case Study

• Scenario Details:
  • Helper wages: $12,000 per year.
  • Annual rent for shop: $5,000.
  • Materials cost: $20,000 per year.
  • Personal funds invested in equipment: $40,000 (which could earn $4,000 interest elsewhere).
  • Competitor job offer (forgone salary): $15,000 per year.
  • Estimated value of entrepreneurial talent: $3,000 per year.
  • Total annual revenue: $72,000.
• Calculation of Costs:
  • Explicit Costs: $12,000 + 5,000 + 20,000 = 37,000$
  • Implicit Costs: $4,000 + 15,000 + 3,000 = 22,000$
• Calculation of Profits:
  • Accounting Profit: $72,000 - 37,000 = 35,000$
  • Economic Profit: $72,000 - 37,000 - 22,000 = 13,000$

Short-Run vs. Long-Run Production

• Short-Run: A timeframe in which at least one production factor (typically capital) is fixed. The firm can only vary output by applying different levels of variable resources like labor and materials.
  • Example: A firm with 10 machines cannot increase the number of machines in the short run but can hire more workers.
• Long-Run: A timeframe in which all production factors are variable. Firms have sufficient time to enter or leave an industry, and all inputs can be adjusted.
• Short-Run Production Function: This shows the relationship between input and output. The formula is expressed as:     $Q = F(K, L)$
  • Where $Q$ is the quantity of output.
  • $K$ is capital (constant in the short-run).
  • $L$ is labor (variable).

Concepts of Physical Product

• Total Physical Product (TPP): The total output of goods and services produced.
• Marginal Physical Product (MPP): The additional output generated by adding one more unit of variable input.     $\text{MPP} = \frac{\Delta \text{Total Output}}{\Delta \text{Labour Input}}$
• Average Physical Product (APP): The output produced per unit of variable input.     $\text{APP} = \frac{\text{Total Output}}{\text{Total Input}}$

Wheat Production Data Example (Tonnes per Year)

The Law of Diminishing Returns

• Definition: As increasing amounts of a variable factor (labor) are added to a given amount of a fixed factor (capital), there will come a point where each extra unit of the variable factor produces less extra output than the previous unit.
• Stages of Returns:
  1. Increasing Marginal Returns: TPP rises at a rising rate. MPP is positive and rising. This occurs because fixed factors (equipment, space) are initially underutilized, and the first few workers contribute significantly.
  2. Diminishing Marginal Returns: TPP continues to rise but at a slower (diminishing) rate. MPP is positive but falling. This happens because workers must share a fixed amount of capital, leading to overutilization of space and equipment, and time spent waiting to use tools.
  3. Negative Marginal Returns: TPP begins to fall. MPP becomes negative. Adding more workers becomes counterproductive and reduces total output.
• The Critical Relationship: If MPP is above APP, the APP must be rising. If MPP is below APP, the APP must be falling.
• Global Implication: Diminishing returns suggest that rapid population growth could lead to food crises as more people crowd onto a limited amount of land.

Short-Run Production Costs

• Total Fixed Costs (TFC): Costs that do not vary with the level of output. Even at zero output, TFC is incurred (e.g., rent).
• Total Variable Costs (TVC): Costs that change as the level of output changes (e.g., raw materials).
• Total Costs (TC): The sum of fixed and variable costs.     $\text{TC} = \text{TFC} + \text{TVC}$
• Measures of Average Cost:
  • Average Fixed Cost (AFC): $\text{AFC} = \frac{\text{TFC}}{Q}$. AFC always falls as output rises because the fixed cost is spread over more units.
  • Average Variable Cost (AVC): $\text{AVC} = \frac{\text{TVC}}{Q}$. AVC initially falls (due to rising MPP) and then rises (due to falling MPP).
  • Average Total Cost (ATC or AC): $\text{ATC} = \frac{\text{TC}}{Q} = \text{AFC} + \text{AVC}$. ATC typically exhibits a U-shape; it falls initially as both AFC and AVC fall, then rises as the increase in AVC outweighs the decrease in AFC.
• Marginal Cost (MC): The additional cost of producing one more unit of output.     $\text{MC} = \frac{\Delta \text{TC}}{\Delta Q}$
  • MC indicates if it is worthwhile to produce another unit or if costs could be saved by not producing the last unit.

Relationship Between MC and AC Curves

• The MC curve intersects the AC curve (both AVC and ATC) at its minimum point.
• When $MC < AC$, the average cost is falling.
• When $MC > AC$, the average cost is rising.
• The minimum point of the ATC curve is referred to as the point of productive efficiency.

Long-Run Production and Scale

• In the long run, all factors are variable. Firms can change their production scale and techniques.
• Returns to Scale:
  • Constant Returns to Scale: ATC stays the same as output increases.
  • Increasing Returns to Scale (Economies of Scale): ATC falls as output increases.
  • Decreasing Returns to Scale (Diseconomies of Scale): ATC rises as output increases.
• Causes of Economies of Scale:
  • Specialization and Division of Labor: Workers become more efficient when focusing on specific tasks.
  • Indivisibilities: Certain large-scale machines (e.g., combine harvesters) are only economical when used on a large scale.
  • Container Principle: Surface area increases slower than volume; thus, larger containers cost less per unit of transport.
  • Greater Efficiency of Large Machines: Large machines often produce more output per unit of input and may require the same amount of labor to operate as small machines.
  • By-products: Large-scale waste can be transformed into profitable by-products (e.g., sawdust from wood planks).
• Causes of Diseconomies of Scale:
  • Management problems regarding coordination as the organization grows.
  • Worker alienation and shirking due to the size of the firm.
  • Deteriorating industrial relations.
  • Complications in production-line interdependencies and processes.