Production and Cost Flashcards

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.

Outline of Lecture

• How is profit measured (Chapter 10, pp. 266-267)

• Short-run production.

• Long-run production.

Profit

• Chapter 10, pp. 266-267

The Firm’s Goal

• The main goal of business is profit maximization.

• Economists recognize that firms sometimes pursue other goals, but profit maximization is a powerful way of explaining business behavior.

How is Profit Measured?

• Two views of profit:

  • Accounting profit

  • Economic profit

How is Profit Measured? - Accounting Profit

• Total revenue = price x quantity

• Accounting profit = total revenue - accounting costs.

• Accounting cost = explicit costs + accounting depreciation.

How is Profit Measured? - Economic Profit

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

• Economic Profit = Total Revenue - Opportunity Cost

• Accounting Profit = Total Revenue - Accounting Costs

How is Profit Measured? - Opportunity Cost

• Opportunity cost = Explicit costs + Implicit cost (including normal profit and economic depreciation).

• Implicit cost is the opportunity cost equal to what a firm must give up to use a factor of production for which it already owns and thus does not pay rent.

Normal Profit

• Normal profit is the cost of entrepreneurship and is an opportunity cost of production.

• It is the minimum level of profit a firm needs to cover all its costs, including the opportunity cost of resources, 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., variable inputs).

• 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: A small coffee shop in Brisbane city.

  • Fixed inputs and variable inputs.

Short-Run Production - Concepts

• Three related concepts to describe the relationship between output and the quantity of labor:

  • Total product (TP): the total quantity of a good produced in a given period.

  • Marginal product (MP): the change in total product that results from a one-unit increase in the quantity of labor employed. MP = \frac{\Delta TP}{\Delta L}

  • Average product (AP): the total product per worker employed (also known as labor productivity). AP = \frac{TP}{L}

Short-Run Production - Marginal Product

• Marginal product can be illustrated as the orange bars that form steps along the total product curve.

• The height of each step represents marginal product.

• "Too many cooks spoil the broth."

Short-Run Production - Law of Decreasing Marginal Returns

• 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.

Short-Run Production - Average Product

• Relationship between AP and MP:

  • When MP > AP, AP is rising.

  • When MP < AP, AP is falling.

Short-Run Cost

• To produce more output in the short run, a firm employs more labor, which means the firm must increase its costs.

• Three cost concepts:

  • Total cost

  • Marginal cost

  • Average cost

Short-Run Cost - Total Cost

• TFC (Total Fixed Costs): Do not vary as output varies and must be paid even if output is zero.

• TVC (Total Variable Costs): Are zero when output is zero and vary as output varies.

• TC (Total Cost): Is the sum of TFC and TVC at each level of output. TC = TFC + TVC

Short-Run Cost - Marginal Cost

• Marginal Cost (MC): A firm’s marginal cost is the change in total cost that results from a one-unit increase in total product. MC = \frac{\Delta TC}{\Delta Q}

Short-Run Cost - Average Cost

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

Short-Run Cost - Relationship between AFC, AVC, and ATC

• The gap between ATC and AVC diminishes.

• AFC = TFC/Q

• As Q increases, TFC stays fixed, so TFC/Q is diminishing.

• AFC decreases as output increases.

Short-Run Cost - Marginal Cost Curve

• 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.

Short-Run Cost - Relationship between MC and ATC

• When MC < ATC, ATC is falling.

• When MC > ATC, ATC is rising.

Short-Run Cost - Simple Illustration of MC and ATC

• Analogy using weights of individuals in a group to illustrate the relationship.

• If a group of 5 individuals has a total weight of 300 kg, the average weight is 300/5 = 60 kg.

• If an individual weighing 75 kg joins the group, the total weight becomes 375 kg, and the average weight becomes 375/6 = 62.5 kg (an increase!).

Short-Run Cost - Relationship between Product Curves and Cost Curves

• Relationship between Marginal Product (MP), Average Product (AP), Marginal Cost (MC), and Average Variable Cost (AVC).

• Rising MP corresponds to falling MC and rising AP corresponds to falling AVC.

• Falling MP corresponds to rising MC and falling AP corresponds to rising AVC.

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 arise when a firm changes the size of its plant:

  • Economies of scale

  • Constant returns to scale

  • Diseconomies of scale

Long-Run Cost - Economies 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.

• Graph illustrating economies of scale with SRAC curves.

Long-Run Cost - Economies of Scale - Ford Assembly Line

• Assembly lines enable economies of scale from the increased specialization of the workforce.

• Workers do a specific job, needing less training to perform a specific task.

Long-Run Cost - Constant Returns to Scale

• 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.

• Graph illustrating constant returns to scale with SRAC curves.

Long-Run Cost - Diseconomies of Scale

• 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.

• Graph illustrating diseconomies of scale with SRAC curves.

Long-Run Cost - Diseconomies of Scale - Ford Assembly Line

• Problems with assembly lines:

  • A bottleneck in one place could cause the whole process to come to a complete stop.

  • Work becomes highly repetitive and boring.

  • Hard to identify sources of error and maintain quality control.

Review Of Today's Lecture

• How is profit measured.

• Short-run production.

• Long-run production.