Production and Cost: Short Run and Long Run

Acknowledgement of Traditional Owners

QUT acknowledges the Turrbal and Yugara as the First Nations owners of the lands where QUT now stands, paying respect to their Elders, lores, customs, and creation spirits. The university recognizes these lands have always been places of teaching, research, and learning, and 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 equilibrium.
    • Correct Answer: A; C
  • Question 2: Labour market with minimum wage.
    • Correct Answer: Area E
  • Question 3: Market for DVDs with a price ceiling.
    • Correct Answer: $100,000
  • Question 4: Market for textbooks with a tax.
    • Correct Answer: Increases to $80 a textbook.
  • Question 5: Petrol market without external costs.
    • Correct Answer: 15 million litres.

Lecture 5: Production and Cost

  • Focus: short-run and long-run production of a firm.

Outline of Lectures 2-12 (Microeconomics and 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

  • Reference: Chapter 10, pp. 266-267

The Firm’s Goal

  • The main motivation or goal of business is profit maximization.
  • Economists recognize firms may pursue other goals but profit maximization is a powerful explanation of business behavior.

How is Profit Measured?

  • Two views of profit:
    • Accounting profit
    • Economic profit

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.
  • EconomicProfit=TotalRevenue−OpportunityCostEconomic Profit = Total Revenue - Opportunity Cost
  • The relationship between economic profit, accounting profit, and opportunity cost is illustrated.

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 is an input that does not change in quantity when output changes.
  • Variable input is an input that changes in quantity when output changes.

Short-Run Production Example

  • A small coffee shop in Brisbane city illustrates fixed and variable inputs.

Short-Run Production Concepts

  • Three concepts describe the relationship between output and labor:
    1. Total Product (TP): the total quantity of a good produced in a given period.
    2. Marginal Product (MP): the change in total product that results from a one-unit increase in the quantity of labor employed.
    • MP=""ΔTPΔLabourMP = " "\frac{\Delta TP}{\Delta Labour}
    1. Average Product (AP): the total product per worker employed.
    • Also known as labor productivity.
    • AP="TPLabourAP = "\frac{TP}{Labour}
    • 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 can also occur.

Short-Run Cost

  • To produce more output in the short run, a firm employs more labor, which increases costs.
  • Three cost concepts:
    • Total cost
    • Marginal cost
    • Average cost

Short-Run Cost Components

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

Marginal Cost

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

Average Cost

  • Average cost (or ATC) = Average fixed cost (AFC) + Average variable cost (AVC)
  • TCQ=TFCQ+TVCQ\frac{TC}{Q} = \frac{TFC}{Q} + \frac{TVC}{Q}

Relationship between AFC, AVC, and ATC

  • The gap between ATC and AVC diminishes because AFC decreases as output increases.
  • As QQ increases, TFCQ\frac{TFC}{Q} diminishes.

Marginal Cost Curve

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

Relationship between MC and ATC

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

Illustration of MC and ATC Relationship

  • If a group of 5 individuals has a total weight of 300 kg, the average weight is 3005=60\frac{300}{5} = 60 kg.
  • If an individual weighing 75 kg joins the group, the total weight becomes 375 kg, and the average weight becomes 3756=62.5\frac{375}{6} = 62.5 kg (an increase).
  • This illustrates that when MC (the weight of the new individual) is greater than ATC, ATC is rising, and vice versa.

Relationship between Product Curves and Cost Curves

  • Maximum MP corresponds to the minimum MC.
  • Maximum AP corresponds to the minimum AVC.
  • Rising MP and falling MC.
  • Rising AP and falling 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

Economies of Scale

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

Constant Returns to Scale

  • Exists 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.