Chapter 4 Production, Costs, and Profit.notebook. February 03, Chapter 4: Production, Costs, and Profits Pages

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1 Chapter 4: Production, Costs, and Profits Pages business an enterprise that brings individual, financial resources, and economic resources together to produce a good or service for economic gain (profit). Production is the process of transforming a set of resources (inputs) into a good or service (outputs) that has economic value. inputs resources used in production. outputs the good or service that is a result of production. Three main sectors into which businesses and industries fall: 1) primary industries which extract natural resources. 2) secondary industries which process goods. 3) service industry that does work for a customer. Productive Efficiency: Two main processes from which businesses can choose: 1) labour intensive a process that employs more labour and less capital than other processes in order to produce a certain quantity of output. 2) capital intensive a process that employs more capital and less labour than other processes to produce a certain quantity of output. productive efficiency making a quantity of output at the lowest cost. This will determine the production process that a business will use. Example Page 92: Daily cost of worker = $100 Daily cost of sewing machine = $25 Process Cost A Economic Costs: Two types of costs: 1) explicit costs payments made by a business to people or businesses outside of it. salaries, electric bill 2) implicit costs estimates of what owners give up (opportunity costs) by being involved with a business. normal profit minimum return an owner must receive to keep their funds and entrepreneurial skills tied up in the business. Calculated by estimating the highest possible return they could have received by using funds and entrepreneurial skills in another way. ** Note example bottom of page 92 and top of page 93. economic costs a business' total implicit and explicit costs. B 1

2 Economic Profit: accounting profit profit calculated by subtracting explicit costs from total revenue. economic profit profit calculated by subtracting economic costs from total revenue. explicit costs = $1050 implicit costs = $200 economic costs = $ $200 = $1250 revenue = $1500 Production in the Short Run: ** NOTE: Production depends upon labour!! Two types of inputs in the short run: 1) fixed inputs inputs that cannot be adjusted. 2) variable inputs inputs that can be adjusted. accounting profit = $1500 $1050 = $450 economic profit = $1500 $1250 = $250 **NOTE As long as a business' economic profit is positive, it should continue to operate. However, if economic profit is negative, the business should consider shutting down since it can't cover all of its costs. total product (TP) the overall quantity of output (q) associated with a certain workforce. average product (AP) the quantity of output produced per worker. found by dividing the total product (q) by the quantity of labour (L). L q MP AP marginal product (MP) the extra output produced when an additional worker is hired. found by dividing the change in total product (Δq) by the change in the amount of labour employed (ΔL)

3 Page 95 Law of Diminishing Marginal Returns as more units of a variable input are added to a fixed input, at some point, the MP will start to decrease. Sets in when MP reaches a maximum. **Note example in the latter part of first paragraph on page 96 using reductio ad absurdum. Page 97 Three Stages of Production: 1) If MP rises, TP rises at a faster rate. 2) If MP falls, but is still positive, TP rises but at a slower rate. (Businesses operate somewhere within this range) 3) If MP is negative, TP falls. 3

4 Relationship between AP and MP: 1) If MP > AP, then AP is rising. 2) If MP = AP, then AP is at a maximum. 3) If MP < AP, then AP is falling. Costs in the Short Run: NOTE: Costs depend upon output!! Fixed Costs (FC) costs which do not change when a business changes its quantity of output. Variable Costs (VC) costs which do change when a business changes its quantity of output. Total Cost (TC) sum of all fixed and variable costs at each quantity of output. TC = FC + VC Marginal Cost (MC) the extra cost which results when an additional uni of output is produced. found by dividing the change in TC or the change in VC by the change in output (q). Average Fixed Cost (AFC) is the fixed cost per unit of output. Found by dividing FC by the total product (q). TP (q) FC VC TC AFC AVC AC MC 0 $825 $ Average Variable Cost (AVC) is the variable cost per unit of output. Found by dividing VC cost by the total output (q) Average Cost (AC) the business' total cost per unit of output. found by dividing TC by total output or adding AFC and AVC

5 Page 100 Page 102 ** NOTES: AFC curve declines continuously. If MC lies below AC or AVC, AC and AVC fall. If MC lies above AC or AVC, AC and AVC rise. If MC intersects the AC or the AVC curve, AC and AVC are at a minimum. **Notes: MC decreases as long as MP increases. MC is at a minimum when MP is at a maximum. MC increases when MP decreases. Production and Costs in the Long Run: Recall Long run consists of all variable factors. As a result, the law of diminishing marginal returns does not apply. When a business is in a position to vary all inputs, there are three situations that may result with regards to output: #1 increasing returns to scale (economies of scale) a situation which occurs in the long run in which a business expands all inputs by a certain percentage and the output increases by a greater percentage. This occurs for three main reasons: (1) division of labour every person has a special task, becoming more efficient at their job. (2) specialized capital each piece of capital equipment is responsible for a special task. (3) specialized management each person in management is assigned a specific role. #2 constant returns to scale a situation which occurs in the long run in which a business expands all inputs by a certain percentage and the output increases by the same percentage. #3 decreasing returns to scale (diseconomies of scale) a situation which occurs in the long run in which a business expands all inputs by a certain percentage and the output increases by a smaller percentage. Two main reasons that give rise to diseconomies of scalethis occurs for two main reasons: 1) management difficulties business expands to a point that there are difficulties coordinating operations. 2) limited natural resources 5

6 Page 105 Generally: Large businesses are found in industries which benefit from economies of scale while smaller businesses are more prominent in industries involving constant or decreasing returns to scale. increasing returns to scale decreasing returns to scale economies of scope the cost advantage related to a single business producing different products. gives larger businesses another advantage over smaller ones. constant returns to scale Long Run Average Cost (LRAC) the lowest possible short run average cost curve at each possible level of output. 6