Economics

Analysis of Costs: Chapter 7 - costs and production go hand in hand - costs affect level of production - costs enable businesses to choose between alternative production strategies - new worker/overtime; new factory/expand old; increase production w/more labor or capital - choose method that is most efficient, produces output at lowest costs. - look at full array of economic costs; then how accountants measure cost in practice, then opportunity cost - foundation will allow us to understand supply decisions of firms Cost – (in economics) what businesses have to pay for factors of production. - economists look beyond the money and ask “why aren’t resources free?” - productive resources are scarce: - they are limited and desired by firms that know that they can produce valuable products with them… - firms compete for resources and are willing to pay for them; resources go to the firm that is willing to pay the most. - to outbid competitors, a firm has to pay just a bit more that what the other firms are willing to pay; what they are willing to pay is determined by the value of the good that they could produce with that resource. - so the cost of a factor of production equals its value in its best alternative use Economic Cost - those payments a firm must make to resource suppliers to attract resources away from alternative production opportunities - is an opportunity cost: equals the value of a resource in its best, alternative use. - resources are scarce - when used for one purpose, are then unavailable for another use (eg: steel used for cars unavailable for making offices) - to win the use of a resource, must be willing to pay just a bit more than competitors. What competitors are willing to pay is determined by the value of what they will produce with the resource. So price you pay (economic cost of resource) must be just equal to the value of the resource in its best alternative use… - Explicit Cost: monetary payments the firm must make to outsiders who supply factors of production that the firm does not own. - traditional view of cost, accountant´s view of cost. - Implicit Cost: money payments self-owned, self-employed resources could have earned in best alternative use. - a cost is anything that leaves you with less money; could be money you pay (explicit) or income you forgo (implicit). - Economic Cost: explicit plus implicit costs - a measure of actual resources used in the production process, as opposed to just money spent (explicit). - Accounting Profit: Total revenue minus explicit cost. - Normal Profit: Implicit cost of entrepreneurial talent. - Economic Profit: Total revenue minus economic cost. - It is OK if economic profits are zero: economists say that all resources are receiving the payment that they need to keep them in that line of production… - Josephine example: She was a sales rep for a CD manufacturer, earning $20,000/yr. Quit her job to open her own retail store. Took $20,000 out of bank (was earning $1,000 interest) to buy cash register, sound booth, lighting, other capital. Hired a clerk for $20,000 yr. Occupied a self-owned building for use as her store that had been rented at $5,000/yr. At end of year, had $120,000 of revenue from sales, $40,000 costs for CD´s she purchased, $3,000 costs for utilities. Her annual capital depreciation rate is 10% and of she estimates that her entrepreneurial talents could have earned her $5,000 working for someone else. Year-end accounts: see graphic… - note: the initial investment of $20,000 to buy capital is not an economic cost (just changing a financial asset (money) into a tangible asset (capital). All value is still there…. But then as the capital begins to wear out over time it loses value (depreciation) and this is an explicit cost. Total, Fixed, and Variable Cost - total cost: the lowest total dollar expense needed to produce each level of output. TC rises as q rises. - firm produces q units of output, using inputs of capital, labor, land, materials bought in factor markets. Accountants calculate total dollar costs for each level of output q. - table shows that as q rises, so does TC: makes sense since more inputs are required to make more output - lots of work goes into figuring "lowest total dollar expense": best price on inputs, best engineering tech; honest laborers... - fixed cost: total dollar expense paid out even when no output is produced; not affected by q. - sometimes called "overhead"; - rent for space; interest payments on debt; installment payments on capital goods - must be paid no matter what, even if output is zero. - table shows constant dollar fixed cost of $55 - variable cost: expenses that vary with the level of output; all costs that are not fixed. - costs of variable inputs like raw materials, labor, energy... - variable costs rise as output rises since more inputs are needed to produce more. - TC = FC + VC - if q = 0, TC = FC, VC = 0. - table shows that both TC and VC increase as q increases; difference between TC and VC is constant FC. - graph shows total cost, variable cost, and fixed cost vs q (quantity of output). - time: length of time being considered affects whether a cost is fixed or variable. In short run, only variable inputs (materials, labor) can be changed; in long run all inputs can be adjusted (even land, capital, building): all costs are variable; - typically, in short run, consider capital to be a fixed cost, labor variable cost. Quantity q Fixed Cost FC ($) Variable Cost VC ($) Total Cost TC ($) Marginal Cost MC ($) Average Cost AC = TC/q Average Fixed Cost AFC = FC/q Average Variable Cost AVC = VC/q 0 55 0 55 1 55 30 85 30 85 55 30 2 55 55 110 25 55 27.5 27.5 3 55 75 130 20 43.3 18.3 25 4 55 105 160 30 40 13.8 26.3 5 55 155 210 50 42 11 31 6 55 225 280 70 46.7 9.1 37.5 7 55 370 90 52.8 7.8 45 8 55 480 60 6.8 53.1 Marginal Cost - marginal cost: the extra or additional cost of producing one more unit of output - one of most important concepts in economics - what is marginal cost of producing the second widget (from table)? 110-85=$25; 5th? $50 - can get MC from TC or VC column (fixed cost does not change, subtracts off) - total cost vs output graph: - increases with q, not at constant rate (slope); - at q = 0, TC = FC; at q = 1; MC (grey box) = VC. - MC (grey boxes) get smaller, then bigger. - marginal cost vs output graph: - U-shaped: MC decreases then increases. - empirical studies have shown that most MC curves are Ushaped. - relation of MC to TC is same as that of marginal product to total product; or marginal utility to total utility Average Costs - average cost (also average total cost): equals total cost divided by the number of units produced AC = TC/q; per-unit cost. - businesses compare AC to price (average revenue) to determine if the will make a profit. - table: average cost decreases at first, reaches a minimum, then increases - level of output for which average cost has its minimum value has important economic significance - since costs originate in the purchase of resources, saying that per unit cost is a minimum is equivalent to saying that per unit resources consumption is a minimum; in other words, each unit of output is being produced with the least possible quantity of inputs. - so the level of output for which AC is minimized is also where the firm maximizes its productive efficiency... - average fixed cost: equals FC/q. - AFC decreases as q increases (fixed FC is spread over more units). - average variable cost: equals VC/q - AVC falls, then rises (like AC) - AC = AFC + AVC - graph shows a) MC vs q as U-shaped curve; b) AC vs q as U shaped curve; c) FC vs q declining; d) AVC vs q U-shaped and below TC (since it does not include FC); e) AC and AVC converging (since difference is AFC) Marginal Cost and Average Cost, Minimum Average Cost - from graph note: - when the MC of an extra unit of output is below its AC, AC is decreasing. - when the MC of an extra unit is above its AC, AC is increasing - when the MC of an extra unit equals its AC (curves cross), AC is flat - this is where AC reaches its minimum level - the AC curve is always pierced at its minimum point by the rising MC curve - why? If the MC of the last unit is below the AC of all the units up to that point, the new AC must be lower (AC dragged down) If the MC of the last unit is above the AC of all the units up to that point, the new AC must be higher.`(AC pulled up) If the MC of the last unit equals the AC of all the units up to that point, the new AC must remain unchanged. - analogy: Average grade (AG) and Marginal Grades (MG): If your economics average is 87% and you score a 91 on an exam (the grade on the next unit of output), your average will rise...etc. The Link between Production and Costs - what determines a firm's total cost curve? - factor prices (land, labor, materials) - production function (how much output from given inputs: more output with same input means lower costs) - knowledge of both of these allows the firm to decide what is the least costly combination of inputs that will achieve the desired output. - example: use table to derive TC using production (wheat from land, labor) and factor price (rent, wages) data. Diminishing Returns and U-Shaped Cost Curves - Why is marginal cost curve U-shaped? - Marginal Product: - in short run, to increase output, increase variable inputs (eg labor) while holding fixed inputs (eg capital) constant - sooner or later, LDR sets in…capital is a fixed cost, labor is a variable cost. - Incrementing returns: when first few units of labor are added, marginal product of each added unit gets larger at first - make better use of the capital (too few laborers for too much capital equipment or land), specialization and division of labor. - Diminishing returns: later, as more and more labor is added, marginal product of each added unit stops increasing and starts decreasing; too many people using too little capital: each unit of labor has less capital to work with. - Marginal cost: equals the cost of the next unit of input divided by the marginal product of that input. - While marginal product (extra output) of added input is increasing, average extra cost of output is decreasing (more extra output for same extra cost of input); explains initial downward slope in AC curve - While marginal product of added input is constant, average cost of output is constant (flat) (same output for same cost of input); explains bottom (briefly horizontal) part of U-shape. - While marginal product of added input is decreasing, average cost of output is increasing (less output for same cost of input) Output (tons of wheat) Land Inputs (acres) Labor Inputs (workers) Land Rent ($/acre) Labor Wage ($/worker) Total Cost ($) 0 10 0 5.5 5 55 1 10 6 5.5 5 85 2 10 11 5.5 5 110 3 10 15 5.5 5 130 4 10 21 5.5 5 160 5 10 31 5.5 5 210 6 10 45 5.5 5 280 7 10 63 5.5 5 370 8 10 85 5.5 5 480 Choice of Inputs by the Firm: The Least-Cost Rule - in long run, all inputs are variable. - there are many possible combinations of inputs that could be used to produce any given level of output. - how does firm chose the optimal combination of inputs to produce a given level of output? (which inputs and how many) - firms are cost minimizers: will choose that combination of inputs that will produce a given level of output at least cost - simple example: say 9 units of output are desired; the production function gives two possible options to achieve this level of output: Option 1 - use ten units of energy and two units of labor or Option 2: use four units of energy and 5 units of labor. In both cases, energy costs $2/unit and labor costs $5/unit. - which is the preferred option? Calculate total costs. Option 1 at $30 cheaper than Option 2 at $33.... - generally, a firm faces more that 2 inputs and has more than 2 options... but it does not have to calculate the total cost of each. - when deciding which input to buy next, two things matter: - the marginal product of the next unit of that input - the price of the next unit of that input (assumed constant) - instead of calculating the total cost for each possible combination of inputs, find the marginal product of each unit of input and divide it the price of the input to get the marginal product of the last dollar spent on each input. - the cost minimizing combination of inputs comes when the marginal product of the last dollar spent is equal for all inputs. - If one input has a higher MP/$, would make sense to take money out of another input (w/less MP/$) and put it into the one with the higher MP/$: means more product for the same money: cheaper! Do this till the MP/$ of the higher one decreases to equal the rest again (which it will due to diminishing returns). - Least Cost Rule: To produce a given level of output at least cost, a firm should buy inputs until the marginal product of the last dollar spent on each input is the same - is like dividing inputs into dollar-sized chunks and finding the marginal product of each chunk. Then buying inputs one dollar at a time, always buying the input with the greatest marginal product per dollar first. By the time the firm has reached the desired level of output, will have spent the fewest possible dollars (minimized cost). And since MP falls as more units of each input are bought (LDR), the ratios of MP/$ will now be equal. - equation: (MP of Labor)/(Price of L) = (MPCapital)/(PCapital) = (MPLand/PLand = ...) - if a factor price declines, that makes its MP/$ higher, causing more of it to be bought and less of another (substitution) - Substitution Rule: If the price of one factor falls while all other factors prices remain the same, firms will profit by substituting the now-cheaper factor for the other factors until the marginal products per dollar are equal for all inputs. - ATM example Long-Run Average Cost (LRAC) - In long run, all inputs are variable, there are no fixed costs. - Law of Diminishing Returns does not apply, but returns to scale does. - Only interested in Average Cost, since Fixed costs no longer exist… - Consider a single-plant manufacturer: - Decides to expand. Moves into successively larger factories or plants… - Each plant size has own short-run cost curve - At first, short run cost curves get lower (due to economies of scale…). - Later, as larger and larger plant sizes are used, and the firm gets big, diseconomies of scale set in and the short run AC curves begin to rise… - LRAC: is bumpy, lower portion of joined short run AC’s for different plant sizes. - Vertical lines indicate level of output for which firm should switch to larger plant, shows where AC of next larger plant falls below that of previous plant… - In reality, there are many possible plant sizes, and many possible short run AC’s. Taking all of these into account, smooths out the LRAC. - U-shape: due to changes in returns to scale, not diminishing returns. - MES: Minimum Efficient Scale: the lowest level of output for a given industry for which a firm can minimize its long run average cost (and take advantage of economies of scale). Depends on industry characteristics. - MES high: steel, autos, heavy industry. MES level of output is large compared to industry supply. Type of market structure lends itself to few or one large firm dominating industry (natural monopoly). - MES low: bakeries, shoes. Many small firms exist. ECONOMIC COSTS AND BUSINESS ACCOUNTING - rudiments of business accounting - differences in how economists and accountants measure costs - the income statement measures the flows into and out of the firm, while that balance sheet measures the stocks of assets and liabilities at the end of the accounting year. The Income Statement (statement of profit and loss) - income statement: measures the flows (of money) into and out of the firm per over the course of one year - a flow variable measures the change of something over some period of time (eg water into and out of a water tank in a day) - statement reports 1) total revenue from sales (in a given year) 2) total expenses to be paid to others 3) net income or profit - Net income = total revenue - total expenses (explicit costs) Example income statement from Hot Dog Ventures, Inc. from Jan 1, 2000-Dec. 31, 2000: 100,000 loan for capital goods, incorporated. issued stock; sell hot dogs. - Line 1: revenues from sales (250,000) - minus... - Line 2-9: Operating expenses: cost of goods sold (cost of variable inputs: materials, labor, utilities), overhead costs (cost of fixed inputs: admin, rent, depreciation) (185,000) - Depreciation: measures annual cost of a capital input that a company owns. (amount of value "used up annually, lost due to age, ware and tare); different formulas for calculating but basically equals historical cost (purchasing price)/lifetime - Line 10: Net operating income - minus... - Line 11: Interest on loan (cost of borrowing, kept separate from other fixed costs) (6,000) - Line 12: State and local taxes (eg property) (4,000) - gives... - Line 13: Net income before corporate income taxes - minus - Line 14: Corporate Income Taxes to federal gov. (18,000) - gives... - Line 15: Net income (profit after taxes) (37,000) - minus - Line 16: Dividends paid to shareholders on stock (15,000) - gives... - Line 17: Retained earnings (22,000) The Balance Sheet - balance sheet: measures the stocks of things of value owned by the firm at the end of the year - a stock variable represents the level of something at some moment in time (eg: water in a lake, dollar value of a firm) - contrast with flow of income statement... - a picture of financial condition of the firm, records what it is worth - reports 1) assets: things of value the firm owns (valuable properties owned by the firm) on one side 2) liabilities: things of value the firm owes (money or obligations owed by the firm) and 3) net worth (net value, assets minus liabilities) on the other side total assets = liabilities plus net worth - example: balance sheet for Hot Dog Ventures: - on left are assets: Current Assets (convertible to cash w/in a year) of cash and inventory and Fixed Assets (capital goods, land) of equipment and buildings (350,000) - capital goods are valued at purchase price minus depreciation - accountants' measure value of items reflects the historical cost: objective and easily verified - on right are liabilities: Current liabilities of Accounts Payable (money owed to resource suppliers for inputs bought) and Notes Payable (money owed to banks for loans) and Long-Term liabilities of Bonds Payable (long term loans to bondholders) (150,000) - also on right is net worth: this is filled in last so as to balance sheet. Right and left sides must equal. (200,000). - The balance sheet must balance. Income Statement of Hot Dog Venture, Inc (1/1-12/31/2000) (1) Net Sales Less Cost of Goods Sold: $250,000 (2) Materials $50,000 (3) Labor Cost 90,000 (4) Misc. Operating Costs (utilities, etc.) 10,000 (5) Less Overhead Costs: (6) Selling and Administrative Costs 15,000 (7) Rent for Building 5,000 (8) Depreciation 15,000 (9) Operating Expenses 185,000 185,000 (10) Net Operating Income Less: $65,000 (11) Interest charges on Equipment Loan 6,000 (12) State and local taxes 4,000 (13) Net Income (profit) before income taxes $55,000 (14) Less: Corporation income taxes 18,000 (15) Net Income (profit) after taxes $37,000 (16) Less: Dividends paid on stock 15,000 (17) Addition to retained earnings $22,000 Balance Sheet of Hot Dog Ventures, Inc. 12/31/00 Assets Liabilities Current Assets: Cash $20,000 Current Liabilities: Accounts Payable $20,000 Inventory 80,000 Notes Payable 30,000 Fixed Assets: Long-term liabilities: Equipment 150,000 Bonds Payable 100,000 Buildings 100,000 Net Worth Stockholder's Equity: Common Stock 200,000 Total $350,000 Total $350,000