Microeconomics Chapter 14
Chapter 14: The Costs of Production
Introduction
Focus of Chapter: Understanding production costs in economic theory.
Key Definitions:
Production Function: Describes the relationship between inputs and the quantity of output produced.
Marginal Product: Increase in output attributed to an additional unit of input.
Main Concepts in Production Costs
Importance of understanding various types of costs and their relationships to output.
Differences between short-run and long-run costs.
Overview of:
Economies of scale
Diseconomies of scale
Constant returns to scale
Total Revenue, Total Cost, and Profit
Firm's Goal: Maximize profit.
Key Formulas:
Total Revenue (TR): TR = P imes Q (Price multiplied by Quantity sold)
Total Cost (TC): Market value of inputs used in production.
Profit: Profit = TR - TC
Example 1A: Jelani’s Gelato Shop
Produces: 15,000 pints at $5 each.
Total Costs: $65,000.
Calculations:
Total Revenue: TR = 5 imes 15,000 = 75,000
Profit: Profit = 75,000 - 65,000 = 10,000
Opportunity Costs
Definition: The cost of something is what you give up to obtain it.
Explicit Costs: Out-of-pocket expenses, e.g., wages to workers.
Implicit Costs: Non-monetary opportunity costs, e.g., time spent working instead of pursuing another job.
Total Costs: Sum of explicit and implicit costs.
Example 1B: Costs for Jelani’s Gelato Shop
Explicit Costs: Raw materials ($20,000) + Rent ($12,000) = $32,000.
Implicit Cost: Opportunity cost of owner's time ($25,000).
Total Costs: 32,000 + 25,000 = 57,000
Example 1C: The Cost of Capital for Jelani
Investment: $80,000 for factory/equipment (withdrawn $30,000 from savings, borrowed $50,000 at 10% interest).
Explicit Cost: Interest on borrowed money = 0.10 imes 50,000 = 5,000 .
Implicit Cost: Interest lost on savings = 0.10 imes 30,000 = 3,000 .
Total Capital Cost: $8,000.
Economic vs. Accounting Profit
Accounting Profit: Total Revenue - Total Explicit Costs
Economic Profit: Total Revenue - Total Costs (Explicit + Implicit)
Important Note: Accounting profit will always be greater than economic profit due to the exclusion of implicit costs in the accounting profit.
Economists vs. Accountants Diagram
Economists consider both implicit and explicit costs. Accountants consider only explicit costs. This results in economic profit being less than accounting profit.
Active Learning 2: Impact of Increased Rent
Scenario: Rent increases by $500/month.
Accounting Profit Impact: No change (explicit costs unchanged).
Economic Profit Impact: Falls by $500/month (implicit costs increase).
Production and Costs Concepts
Production in the Short Run:
Fixed factory size; increasing output requires hiring more workers.
Production Function: Relationship between quantity of inputs and output.
Gets flatter as input increases.
Example 2A: Xavier’s Popcorn Truck
Truck as fixed resource.
Production Variance with Workers:
1 worker produces 30 buckets.
2 to 5 workers yield 55, 75, 90, and 100 buckets respectively.
Marginal Product of Labor (MPL)
Definition: Increase in output from an additional unit of input while keeping other inputs constant.
MPL Formula: MPL = rac{ riangle Q}{ riangle L}
Example Calculation: If 1 more worker is hired, output rises by the MPL.
Diminishing Marginal Product
Concept: Marginal product declines as more units of input are added.
Production function flattens (slope diminishes) as more inputs are used.
Rational decision-making involves thinking at the margin; hiring one extra worker increases costs by the wage paid.
Active Learning 2: Diminishing MPL Questions
Q1: What is MPL of the second worker? Answer: 40.
Q2: MPL of the fourth worker? Answer: 20.
Does the production function exhibit diminishing returns? Answer: Yes.
Example 2C: Costs for Xavier’s Truck
Daily fixed cost of the truck: $200.
Market wage per worker: $50/day.
Example 2D: Xavier’s Total Cost Curve
Total cost calculated at varying levels of output.
Total Cost Measures
Total Cost (TC): TC = FC + VC
Fixed Costs (FC): Do not vary with quantity produced.
Variable Costs (VC): Vary with quantity produced.
Example 3: Angel’s Knitted Scarves Business
Producing scarves, different costs associated with output values.
Average and Marginal Cost Formulas
Average Fixed Cost (AFC): AFC = rac{FC}{Q}
Average Variable Cost (AVC): AVC = rac{VC}{Q}
Average Total Cost (ATC): ATC = rac{TC}{Q} = AFC + AVC
Marginal Cost (MC): MC = rac{ riangle TC}{ riangle Q}
Example 3B: Angel’s Average and Marginal Cost Outcomes
Different cost calculations for each quantity of output produced.
Long-Run vs Short-Run Costs
Short Run (SR): Fixed inputs, costs include fixed costs.
Long Run (LR): All inputs variable, costs change based on production levels.
Long-Run Average Total Cost (LRAC) Curve
Reflects firm’s ability to change factory size in long-run versus fixed costs in short-run.
Economies and Diseconomies of Scale
Economies of Scale: Average total cost decreases as quantity increases.
Constant Returns to Scale: Average total cost remains constant as quantity increases.
Diseconomies of Scale: Average total cost increases as quantity increases, often due to coordination problems as firms grow larger.
Conclusion
The chapter emphasizes the significance of costs in firm operation, production efficiency, and profit maximization.
Understanding marginal costs, average costs, and the effects of scale is critical for effective decision-making in economics.