Production and Cost - Lecture Notes

Acknowledgement of Traditional Owners

  • QUT acknowledges the Turrbal and Yugara people as the First Nations owners of the lands where QUT stands.
  • Respect is paid to their Elders, lores, customs, and creation spirits.
  • Recognition that these lands have always been places of teaching, research, and learning.
  • QUT acknowledges the important role Aboriginal and Torres Strait Islander people play within the QUT community.

Review of Last Week’s Lecture

  • Question 1: Consumer and producer surplus at market equilibrium.
    • Correct Answer: A; C
  • Question 2: Labour market with a minimum wage of $16.
    • Firms' surplus equals Area A.
  • Question 3: Market for DVDs with a price ceiling of $12 per DVD.
    • Consumer surplus equals $400,000.
  • Question 4: Market for textbooks with a $20 tax per textbook.
    • The price paid by buyers increases to $80 a textbook.
  • Question 5: Petrol market with no external cost.
    • Equilibrium quantity of petrol is 15 million litres.

Lecture 5: Production and Cost

  • Focus: Short run and long run production of a firm.

Outline of Lectures 2 – 12 (Microeconomics & Macroeconomics)

  • Microeconomics
    • Demand & Supply
    • Elasticities
    • Efficiency of markets and Government intervention
    • Production and Cost
    • Perfect Competition and Monopoly
    • Monopolistic Competition and Oligopoly
  • Macroeconomics
    • GDP and Economic growth
    • Unemployment and Inflation
    • AS and AD; and Aggregate Expenditure
    • Fiscal and Monetary Policy
    • International Trade Policy

Objectives

  • Explain and compare how economists and accountants measure a firm’s cost of production and profit.
  • Explain the relationship between a firm’s output and the labor it employs in the short run.
  • Explain the relationship between a firm’s output and costs in the short run.
  • Derive and explain a firm’s long-run average cost curve.

Lecture Outline

  • How profit is measured (Chapter 10, pp. 266-267).
  • Short-run production.
  • Long-run production.

Profit (Chapter 10, pp. 266-267)

The Firm’s Goal

  • The primary goal of a business is profit maximization.
  • Economists acknowledge firms may have other goals but consider profit maximization a strong explanation of business behavior.

How is Profit Measured?

  • Two views of profit:
    • Accounting profit
    • Economic profit
  • Accounting View vs. Economic View

Accounting Profit

  • Total revenue = price x quantity
  • Accounting\ profit = total\ revenue - accounting\ costs
  • Accounting cost = explicit costs + accounting depreciation

Economic Profit

  • Economists measure economic profit as total revenue minus opportunity cost.

  • Economic\ Profit = Total\ Revenue - Opportunity\ Cost

  • Includes both explicit and implicit costs.

  • Economic View Formula:

Economic\ Profit = Accounting\ Profit - Opportunity\ Cost

  • The accounting view only considers explicit costs and accounting depreciation.

Opportunity Cost

  • Opportunity cost = Explicit costs + Implicit cost (including normal profit and economic depreciation).
  • Implicit cost: opportunity cost of using a factor of production that the firm already owns and doesn't pay rent for.

Normal Profit

  • Normal profit is the cost of entrepreneurship; an opportunity cost of production.
  • Minimum level of profit needed to cover all costs (including opportunity costs) for a firm to remain in business.

Output and Costs

Short Run and Long Run

  • Short-run:
    • A time frame where there is at least one fixed input.
  • Long-run:
    • A time frame where all inputs can be varied (i.e., all inputs are variable).
  • Fixed Input:
    • An input that does not change in quantity when output changes.
  • Variable Input:
    • An input that changes in quantity when output changes.

Short-Run Production Example

  • Small coffee shop in Brisbane city.
    • Fixed inputs
    • Variable inputs

Short-Run Production

  • Relationship between output and quantity of labor is described using:
    1. Total Product (TP):
      • Total quantity of a good produced in a given period.
    2. Marginal Product (MP):
      • The change in total product resulting from a one-unit increase in the quantity of labor employed.
      • MP = \frac{\Delta Total Product}{\Delta Labour}
    3. Average Product (AP):
      • Total product per worker employed.
      • Also known as labor productivity.
      • AP = \frac{Total Product}{Labour}
      • Relationship between AP and MP:
        • When MP > AP, AP is rising.
        • When MP < AP, AP is falling.

Law of Decreasing Marginal Returns

  • Occurs when the marginal product of an additional worker is less than the marginal product of the previous worker.
    • Increasing marginal returns occur initially.
    • Decreasing marginal returns occur eventually.
    • Negative marginal returns are also possible.

Short-Run Cost

  • To increase output in the short run, a firm employs more labour, increasing costs.
  • Three cost concepts:
    • Total Cost
    • Marginal Cost
    • Average Cost

Total Cost

  • TC = TFC + TVC
    • Total Fixed Costs (TFC):
      • Do not vary as output varies and must be paid even if output is zero.
    • Total Variable Costs (TVC):
      • Are zero when output is zero and vary as output varies.
    • Total Cost (TC):
      • The sum of TFC and TVC at each level of output.

Marginal Cost (MC)

  • A firm’s marginal cost is the change in total cost resulting from a one-unit increase in total product.
  • MC = \frac{\Delta TC}{\Delta Q}

Average Cost

  • ATC = AFC + AVC
  • \frac{TC}{Q} = \frac{TFC}{Q} + \frac{TVC}{Q}
    • Average Total Cost (ATC)
    • Average Fixed Cost (AFC)
    • Average Variable Cost (AVC)

Relationship Between AFC, AVC, and ATC

  • The gap between ATC and AVC diminishes as output increases.
  • AFC = \frac{TFC}{Q}
  • As Q (output) increases, TFC stays fixed, implying that AFC is diminishing.

Marginal Cost Curve (MC)

  • The marginal cost curve (MC) is U-shaped and intersects the average variable cost curve (AVC) and the average total cost curve (ATC) at their minimum points.

Relationship Between MC and ATC

  • When MC < ATC, ATC is falling.
  • When MC > ATC, ATC is rising.

Illustration: Relationship Between MC and ATC

  • Example with a group of 5 individuals weighing 300 kg (average weight = 60 kg).
  • If an individual weighing 75 kg joins the group, the total weight becomes 375 kg (average weight = 62.5 kg).
  • When MC is greater than ATC, ATC is rising, and vice versa.

Relationship Between Product Curves and Cost Curves

  • Graphs illustrating the relationships between marginal product (MP), average product (AP), marginal cost (MC), average variable cost (AVC), and average total cost (ATC).

Long-Run Cost

  • In the long run, the quantity of ALL inputs can be adjusted.
  • The long-run allows greater planning for the expected level of production.
  • Because all inputs can vary, there are no diminishing returns.
  • Three outcomes when a firm changes the size of its plant:
    • Economies of scale
    • Constant returns to scale
    • Diseconomies of scale

Economies of Scale

  • Occur when a firm’s output increases as average total cost decreases.
  • The main source of economies of scale is greater specialization of both labor and capital.

Constant Returns to Scale

  • Exist when a firm’s output increases as average total cost remains constant.
  • Occur when a firm can replicate its existing production facility including its management system.

Diseconomies of Scale

  • Exist when a firm’s output increases as average total cost increases.
  • Arise from the difficulty of coordinating and controlling a large enterprise; and management complexity brings rising average total cost.

Review of Today's Lecture

  • How is profit measured?
  • Short-run production.
  • Long-run production.