Production, Long-Run Costs, and Economic Profit Mastery Notes on Economic Profit

Administrative Announcements and Course Logistics

• Final Exam Conflict Form: Students with more than two exams scheduled on the same day can use this form to move the exam for the highest-numbered class. This only applies if there are more than two; if only two are scheduled, the highest-numbered one can be moved.
• Formula Provision: Formulas for the final exam will be provided by the instructor; students are not required to memorize them. These include the general application formulas and the elasticity formulas. No additional formulas will be provided after those.
• Class Materials: Students should check for ConceptTech 23 video tonight and complete MindTap and Canvas assignments for Chapter 14 by Monday.
• Guest Interaction: High school students may be visiting the class from a local independent high school; university students are encouraged to be welcoming and model positive college habits.

The Importance of Production and Cost in Business Strategy

• Business Plan Development: The core of starting a business is developing a plan to understand how a product reaches the market and how to hire necessary inputs.
• Performance Metrics: Inputs provide information on marginal productivity and average productivity, which indicate how well hired resources are performing.
• Productivity-Cost Relationship: There is a mirror-image relationship between productivity and cost.   * Higher productivity leads to declining costs.   * Lower productivity leads to increasing costs.
• Ultimate Goal: These metrics tie directly into the calculation of profits.

Case Study: "The Office" and Pricing Models

• Pricing Model Analysis: Michael Scott's pricing model is critiqued by the character Ryan (a business student) for being unsustainable.
• Fixed Cost vs. Variable Cost Pricing Models:   * Michael Scott uses a fixed cost pricing model, claiming volume will lead to profitability.   * Ryan argues for a variable cost pricing model because as the company grows, costs like delivery, health care, and business expansion increase.
• Volume Paradox: Ryan points out that at current low prices, selling more paper actually results in losing more money. The low prices intended to keep them in business are actually putting them out of business.
• "Crunching the Numbers": The manager insists on "crunching" the numbers (running the program again), though the mathematical reality does not change through repetition.

Fundamental Cost Formulas and Graphic Relationships

• True/False Review of Formulas:   * $Average Fixed Cost (AFC) + Average Variable Cost (AVC) = Average Total Cost (ATC)$: True.   * $Average Total Cost = \frac{Total Cost (TC)}{Quantity (Q)}$: True. This represents cost per unit of output.   * $Total Cost = Total Fixed Cost + Total Average Cost$: False. (The correct formula is $TC = TFC + TVC$ or $TC = ATC \times Q$).   * Marginal Cost (MC): The additional cost of producing one more unit.
• Curve Intersections:   * The Marginal Cost (MC) curve intersects exactly two curves: the Average Variable Cost (AVC) and the Average Total Cost (ATC).   * These intersections occur at the minimum points of the ATC and AVC curves.   * Relationship between MC and ATC:     * If $MC > ATC$, then ATC is rising.     * If $MC < ATC$, then ATC is declining.
• Visual Identification in Graphs:   * Curve A: Average Fixed Cost (identified by its continuous decline).   * Curve B: Average Variable Cost.   * Curve C: Average Total Cost.   * Curve D: Marginal Cost (the checkmark shape).   * Note: The vertical gap between Curve B (AVC) and Curve C (ATC) is exactly equal to Average Fixed Cost ($ATC - AVC = AFC$). This gap decreases as output increases because TFC is spread over more units.

Practical Application: Bakery Cost Calculation

• Scenario: Owning a bakery producing 100 loaves of bread.
• Fixed Costs: $25,000 + 5,000 = 30,000$ (These do not vary with output; if $Q = 0$, TFC is still $30,000$).
• Variable Cost per unit calculation:   * Labor: $6/hour for 25 loaves = $0.24 per loaf.   * Ingredients: $0.20 per loaf.   * Total Variable Cost per unit = $0.24 + 0.20 = 0.44$.
• Total Variable Cost (TVC) for 100 units: $0.44 \times 100 = 44$.
• Total Cost (TC): $30,000 + 44 = 30,044$.
• Average Total Cost (ATC): $30,044 / 100 = 300.44$.   * Conclusion: High ATC is due to fixed costs being spread over too low a production volume. Production must increase to make the unit cost profitable (under $1).
• Marginal Cost (MC): To produce the 101st loaf, the cost change is specifically the variable cost ($0.24 + 0.20 = 0.44$), as fixed costs do not change.
• Business Structure: The bakery in the example is described as a corporation because stocks are mentioned as being sold.

Long-Run Production and Firm Expansion

• Definitions of Time Horizons:   * Short Run: At least one input (usually capital/factory size) is fixed.   * Long Run: All inputs are variable. Fixed costs equal zero because everything can be adjusted.
• Decision Making in the Long Run: Includes opening new branch offices, expanding factory sizes, or hiring more equipment. Once a 12-month lease ends, a firm makes a long-run decision to stay or move.
• Case Study: Ale-8-One (L8): A local ginger ale company in Winchester, KY. It started small and expanded repeatedly. It refused buyouts from Coca-Cola and Pepsi to stay local. Its transition from a small facility to a thriving large location illustrates the long-run transition.
• The Planning Curve: The Long-Run Average Total Cost (LRATC) curve is a smooth U-shaped curve that envelopes multiple short-run ATC curves. Managers use this as a "planning curve" to choose the factory size that minimizes cost for a target output.

Economies and Diseconomies of Scale

• Economies of Scale: Average cost decreases as production/output increases ($LRATC \text{ falls as } Q \text{ rises}$).   * High startup costs: Massive companies like Boeing or Airbus spread high initial costs over many units.   * Specialization and Division of Labor: Increases productivity (modeled by Henry Ford’s mass production).   * Learning by doing: First-mover advantage through experience reduces costs compared to new entrants.   * Quantity Discounts: Bulk buying reduces input costs.   * Economies of Scope: Increasing production by using existing resources for different but related products (e.g., shampoo/conditioner or Uber/Uber Eats using same technology/drivers).
• Constant Returns to Scale: Average cost remains constant as output increases.
• Diseconomies of Scale: Average cost increases as production increases.   * Disorganization and oversight difficulty: Harder to manage a massive workforce.   * Shirking: Employees participating in bad behavior or unproductivity (e.g., an employee outsourcing his job to China to watch cat videos).   * High monitoring costs: Needing to hire many Teaching Assistants or managers to oversee workers.   * Morale: Large companies often see a decrease in individual employee motivation and value.
• Distinction: Diminishing returns is a short-run issue (fixed input, variable input crowding). Diseconomies of scale is a long-run issue regarding the scale of the entire operation.

Measuring Profitability: Accounting vs. Economic Profit

• Profit Definition: $Total Revenue - Total Cost$.
• Total Revenue (TR): $Price (P) \times Quantity (Q)$.
• Explicit Costs: Out-of-pocket expenses (wages, rent, ingredients, interest on loans, depreciation).
• Implicit Costs: Opportunity costs (forgone salary from a previous job, forgone interest on savings used for the business).
• Comparison of Profits:   * Accounting Profit: $Total Revenue - Explicit Costs$.   * Economic Profit: $Total Revenue - (Explicit Costs + Implicit Costs)$.   * Note: Accounting profit is always higher than economic profit. If economic profit is zero, the firm is earning a "normal" profit equal to its next best alternative ($\text{status quo}$).
• Examples:   * Jalal’s Gelato: TR = $15,000 \times 5 = 75,000$. Simple explicit costs = $32,000$. Accounting profit = $43,000$. Implicit costs = $25,000$. Economic profit = $18,000$. Conclusion: Making the gelato shop is a smart decision as she is $18,000 better off than her alternative.   * Fred’s Job Decision: TR = $200,000$. Explicit costs (Rent + Local) = $50,000 + 35,000 = 85,000$. Accounting Profit = $115,000$. Opportunity Cost (Salary) = $125,000$. Economic Profit = $-10,000$. Conclusion: Fred should not quit his current job.