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1 The Production and Cost

2 The Role of the Firm l The firm is an economic institution that transforms factors of production into consumer goods. It l Organizes factors of production. l Produces goods and services. l Sells produced goods and services.

3 The Firm s Objective The economic goal of the firm is to maximize profits.

4 A Firm s Profit Profit is the firm s total revenue minus its total cost. Profit = Total revenue - Total cost Total cost includes all of the opportunity costs of production

5 Economic Profit vs. Accounting Profit How an Economist Views a Firm How an Accountant Views a Firm Revenue Economic profit Implicit costs Explicit Costs Total opportunity costs Accounting profit Explicit costs Revenue

6 Costs and Profit l Explicit costs: Monetary payments the firm makes for the use of resources owned by others. (What do we mean?) l Implicit costs: Opportunity costs of using the firm s own self-owned, self-employed resources. (What do we mean?) l Normal profit: The implicit cost of entrepreneurial talent. l Economic profit: Total revenue minus economic costs.

7 Technology and Production Function l Technology: Production process that defines how a firm can combine or convert inputs into outputs. l Production function: Is a function that describes the efficient combination of inputs to produce a certain level of output (the maximum amount of any output a producer can get most efficiently, given a certain level of inputs; or the minimum amount of inputs required to produce a level of output).

8 Technology and Production Function l Marginal product is the additional output that will be forthcoming from an additional unit of input, other inputs remaining constant. l Average product is calculated by dividing total output by the quantity of the input.

9 A Production Table Number of workers Total output Marginal product Average product

10 Graphical Representation of TP, AP, and MP curves Output TP Number of workers (a) Total product Output per worker AP Number of workers MP (b) Marginal and average product

11 The Law of Diminishing Marginal Productivity l Both marginal and average productivities initially increase, but eventually they both decrease. l This means that initially the production function exhibits increasing marginal productivity. l Then it exhibits diminishing marginal productivity. l Finally, it exhibits negative marginal productivity.

12 The Law of Diminishing Marginal Productivity Number of workers Total output Marginal product Average product Increasing marginal returns Diminishing marginal returns Diminishing absolute returns

13 The Law of Diminishing Marginal Productivity Output Increasing marginal returns Diminishing marginal returns Diminishing absolute returns TP Number of workers (a) Total product Output per worker Diminishing marginal returns Diminishing absolute returns Number of workers MP (b) Marginal and average product AP

14 Fixed Costs, Variable Costs, and Total Costs l Fixed costs are those that are spent and cannot be changed in the period of time under consideration. l In the long run there are no fixed costs since all costs are variable. l In the short run, a number of costs will be fixed. l Workers represent variable costs those that change as output changes.

15 Family of Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC

16 Family of Total Costs Quantity Total Cost Fixed Cost Variable Cost \$ 3. \$3. \$

17 Average Costs l Average fixed cost equals fixed cost divided by quantity produced. AFC = FC/Q l Average variable cost equals variable cost divided by quantity produced. AVC = VC/Q l Average total cost can also be thought of as the sum of average fixed cost and average variable cost. ATC = TC/Q ATC = AFC + AVC

18 Marginal Cost l Marginal cost is the increase (decrease) in total cost of increasing (or decreasing) the level of output by one unit. MC = (Changein total cost) (Change in quantity) = ΔTC ΔQ

19 The Cost of Producing Earrings Output FC VC TC MC AFC AVC ATC

20 Total Cost Curves Total cost \$ TC = VC + FC L O M Quantity of earrings TC VC FC

21 Average and Marginal Cost Curves l The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. l Each of these curves is U-shaped. l The average fixed cost curve slopes down continuously. l It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

22 The U Shape of the Average and Marginal Cost Curves l The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. l Marginal and average productivities fall and marginal costs rise. l When average productivity of the variable input falls, average variable cost rises. l The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

23 Per Unit Output Cost Curves Cost \$ MC ATC AVC AFC Quantity of earrings

24 Relationship Between Marginal and Average Costs l To summarize: If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.

25 Relationship Between Marginal and Average Costs l Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost. If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

26 Relationship Between Marginal and Average Costs Costs per unit \$ ATC Area A AVC Area B Area C MC MC A Q Q B ATC AVC Quantity

27 Costs in the Long Run For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run some costs are fixed. In the long run fixed costs become variable costs.

28 Average Total Cost in the Short and Long Runs... Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Quantity of Cars per Day

29 Economies and Diseconomies of Scale Average Total Cost ATC in long run Economies of scale Constant Returns to scale Diseconomies of scale Quantity of Cars per Day

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