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Topic 5

Topic 5. Business and Costs of Production. Definition: Cost and Profit. As consumers maximize utility, Producers maximize profit Profit is the reward for the entrepreneur for organizing the production process by pooling land, labor and capital and taking risk

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Topic 5

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  1. Topic 5 Business and Costs of Production

  2. Definition: Cost and Profit • As consumers maximize utility, Producers maximize profit • Profit is the reward for the entrepreneur for organizing the production process by pooling land, labor and capital and taking risk • Profit is the residual that is left after all resource providers are paid for and goes to the entrepreneur • Profit = Total Revenue – Total Cost

  3. Types of Cost Three types of cost: • Explicit costs • Payments for resources • Shows up in the accounting book • Implicit costs • cost of the resources owned by the firm owners • No cash payment is transferred • Opportunity cost Opportunity cost = Explicit cost + Implicit cost

  4. Alternative Measures of Profit Since Profit = Total Revenue – Total Cost and there are three types of cost, we have three alternative measures of profit. Accounting profit =Total revenue - Explicit costs Economic Profit = Total Revenue – O.C. Economic Profit = Total Revenue – (Explicit Costs + Implicit Costs)

  5. Normal Profit • When total revenue is just equal to explicit and implicit cost, the economic profit is zero • In this case, all resource owners are just paid for and no excess profit left. • Including entrepreneur who receives his opportunity cost (highest value forgone) • In this case (economic profit = 0), we say firm is earning a normal profit • When economic profit > 0, firm is earning above normal or excess profit

  6. Wheeler Dealer Accounts, 2007

  7. Types of Resources • Variable Resources: Resources that must vary with output produced • Raw materials • Labors • Electricity or Energy • Fixed Resources: Resources that remain unchanged regardless of output • Rent • Interest payment for fixed resources

  8. Short Run and Long Run • Short Run or Long Run has nothing to do with time. • They are based on how quickly resources can be varied. • Short run: At least one of the resources is fixed or cannot be varied • Long run: None of the resource is fixed or all resources can be varied

  9. Production Function • Production function • Describes the relationship between amount of resources employed and total output • Y= f(L,K) Here, Y = total output or total product L = Amount of labor used K = Amount of Capital used • For example, Y=2.L + 5K • Calculate the total product or Y when • L=100 and K=50

  10. Total and Marginal Product • Total Product: Cumulative amount of output produced at different levels of inputs (resources) • Marginal product: Additional amount of output produced from an additional unit of input (resource) • Marginal product of labor: • MPL = ∆TP / ∆L • Marginal product of capital: • MPK = ∆TP / ∆K

  11. In Class Practice 1 • Compute the MPL

  12. In Class Practice 2 • Compute the MPL

  13. Law of Diminishing Marginal Returns • When one of the resources is fixed, marginal product of the variables resource fall • When more and more labor (variable resource) is employed to a same grill (fixed resource) to produce hamburger MPL or productivity of each additional worker will rise first (synthesis effect)

  14. Law of Diminishing Marginal Returns • However, after a while, the MPL or the labor productivity will fall • This happens due to fixed resource and known as the Law of Diminishing Marginal Returns • Therefore, this is essentially a short run phenomenon

  15. Marginal Returns

  16. Marginal Returns • Diminishing Marginal Return kicks in at 4th unit labor • But total product keeps rising until 7th unit labor • Total product is rising at a “decreasing rate” from 4th to 7th unit • Total product falls at the 8th unit of labor when MPL is negative

  17. TP and MPL TP 15 Total product 10 5 Labor 0 5 7 10 MPL Diminishing but positive marginal returns Increasing marginal returns 5 4 3 Negative marginal returns 2 1 0 Labor 7 Marginal product 5 10

  18. Total Product (TP) • 5 labors produce 500 unit does not mean that each worker produce 100 unit • Although this can a possible way, but this is very improbable, why? • Law of diminishing return may be at work, especially when we are in the short run (at least one of the inputs is fixed) • To know the contribution of individual labors into the production process, we need to look at the Marginal Product (MP) information

  19. Total Product (TP) • For example, consider the following table: • In all four TP series, TP=500 when L=5 • But, this table says nothing about 3rd worker’s contribution to the production process • Actually, 3rd worker’s contribution is different for different series. We can see it in the associated MP table

  20. Marginal Product (MP) • Looking at the associated MP series, we can tell: • TP1 exhibits constant marginal return for labor • TP2 exhibits increasing marginal return for labor • TP3 exhibits both increasing and decreasing marginal return for labor • TP4 exhibits decreasing marginal return for labor • Which TP series you think represents a typical short run production function?

  21. Marginal Product (MP) • Looking at the associated MP series, we can tell: • TP1 exhibits constant marginal return for labor • TP2 exhibits increasing marginal return for labor • TP3 exhibits both increasing and decreasing marginal return for labor • TP4 exhibits decreasing marginal return for labor • Which TP series you think represents a typical short run production function?

  22. Production Costs • Costs are simply the payments to resource providers • There are three types in short run: • Fixed cost (FC): Payment for the fixed resources. • No fixed cost in the long run (why?) • Variable cost (VC): Payment for variable resources • Total costTC = FC + VC

  23. In Class Practice 3 • Marginal Cost: Change in Total Cost to produce one more unit of output. Formula: MC = ∆TC/∆Q • Compute the Marginal Cost

  24. MC and MPL • MC and MPL are related • Increasing marginal product (MPL) • Implies that MC must be falling • Diminishing marginal product (MPL) • Implies MC must be rising

  25. In Class Practice 4 • Short-run TC and MC data for Smoother Mover For first 3 labors, Increasing marginal returns (MPLrises): MC falls With the 4th labor, Diminishing marginal returns hits (MPLrises): MC rises

  26. In Class Practice 4 For first 3 labors, Increasing marginal returns (MPL rises): Therefore, MC is falling Starting with the 4th labor, Diminishing marginal returns kicks in (MPL rises): Therefore, MC is rising

  27. Total Cost (TC) • Total Cost (TC) simply means total expenditure on inputs used • Total cost is a function of number of output produced (not inputs used, a common mistake) • We may find that total cost is $500 when 5 units of output is produced • This is an information about total cost • But, this information says nothing about the cost of producing the 3rd unit of output

  28. Shapes of TC and MC Curves Total cost FC = $200 at all levels of output Total dollars Variable cost VC starts from origin; increases slowly at first; with diminishing returns, VC increases rapidly Fixed cost $500 TC is the vertical sum of FC and VC 200 Fixed cost Tons per day 0 3 6 9 15 12 MC first declines: TC increasing at decreasing rate [From 0-9] Then after 9, MC increases: • TC increases at an increasing rate • Diminishing marginal returns Cost per ton Marginal cost $50 25 Tons per day 3 6 9 12 15 0

  29. Average Cost (AC) • Although MC for each unit varies, sometime it is important to know the per unit cost • Average Cost is calculates this per unit cost • Consider a part of the preceding table

  30. Average Cost (AC) • Although MC for each unit varies, sometime it is important to know the per unit cost • Average Cost is calculates this per unit cost • Consider a part of the preceding table

  31. Average Cost (AC) • Although MC for each unit varies, sometime it is important to know the per unit cost • Average Cost is calculates this per unit cost • Consider a part of the preceding table

  32. Average Cost (AC) • Important question is what do MC and ATC really mean? • MC=$33.33 simply means that the 5th unit costs $50 • ATC=$80 means: • when 5 units are produced, on an average each unit costs $80 • In other words, when Q=5, per unit cost is $80

  33. Average Cost (AC) We know, AC= Cost/Quantity There are three types of costs: • Fixed cost (FC) • Variable cost (VC) • Total cost (TC) Consequently, there are three types of Average Costs • Average Fixed Cost (AFC=FC/Q) • Average Variable Cost (AVC=VC/Q) • Average Total Cost (ATC=TC/Q)

  34. ATC = AFC +AVC • Total Cost = Fixed Cost + Variable Cost • TC = FC +VC • Show that ATC = AFC +AVC • ATC = TC/Q ………………………….[Definition of ATC] = (FC + VC)/Q = FC/Q +VC/Q = AFC + AVC ………………..[Definition of AFC and AVC] Therefore, ATC = AFC + AVC

  35. FC, VC, TC, AFC, AVC and ATC • Short run TC, MC, and AC data for Smoother Mover • Note, ATC = AFC + AVC

  36. FC, VC, TC, AFC, AVC and ATC • Short run TC, MC, and AC data for Smoother Mover • Note, ATC = AFC + AVC

  37. Relationship Between MC and AC Consider a NBA player with a career average score of 30. • In his next game, if he scores 40. What will happen to his career average? • When MC > AC The marginal pulls his average UP

  38. Relationship Between MC and AC Consider a NBA player with a career average score of 30. • Conversely, if he scores 20. What will happen to his career average? • When MC < AC The marginal pulls the average DOWN

  39. MC and ATC • Short run TC, MC, and AC data for Smoother Mover • When MC < ATC, the ATC Falls • When MC > ATC, the ATC Rises • This means, when MC=ATC, the ATC does not change • Graphically, this means MC must go through the lowest point of ATC

  40. Shape of ATC=TC/Q As Q goes up, ATC falls initially • Because we are dividing by a larger number • Note, Fixed Cost is being distributed across many units However, as Q goes further up ATC rises • Because the Law of diminishing marginal returns reduces labor productivity (MPL) and increases the Total Cost • Therefore, ATC is of U-shape

  41. Shape of ATC and AVC Cost ($) $150 125 100 ATC 75 AVC 50 25 0 5 10 15 Q

  42. ATC, AVC and MC • When MC is above AVC and ATC, AVC and ATC is increasing • When MC is below AVC (ATC), the AVC and ATC is falling • When MC = AVC (ATC), AVC (ATC) is at its minimum. Cost ($) MC $150 125 100 ATC 75 AVC 50 25 Q 0 5 10 15

  43. Costs in the Long Run Definition: It is a time period in which all resources or inputs can be varied • Long is often considered as a Planning Horizon Because, • Firms plan in the long run • But, produce in the short run • Long run is generated by aggregating many possible short run cost curves

  44. LRATC curve from SRATC Cost per unit Consider three short run ATC curve: SS’, MM’ and LL’ Long run ATC curve: SabL’ L’ S M’ M L S’ a b Q per period 0 qa q’ qb

  45. LRAC is an Envelop of SRAC Long-run average cost ATC10 ATC1 • curve ATC9 ATC2 $11 b ATC8 a 10 ATC3 ATC7 9 • 10 possible plant sizes are shown • Each point of tangency represents the least cost way of producing that level of output in the short run ATC4 ATC6 Cost per unit c ATC5 0 q q’ Output per period • The long run average cost curve is drawn by connecting the lowest point of SRATC. • Therefore, LRATC is an envelop of SRATC

  46. Costs in the Long Run U-shaped long-run average cost curve has three components that represent: • Economies of scale (Increasing Returns to Scale) • LRAC falls as output expands • Diseconomies of scale (Increasing Returns to Scale) • LRAC increases as output expands • Constant Returns to Scale • LRAC is constant or horizintal

  47. Economies of Scale in Long Run Long-run average cost Cost per unit 0 A B Output per period Economies of scale Constant average cost Diseconomies of scale

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