Contemporary Economics: An Applications Approach. Production. Production Function. Chapter 4: Production and the Costs of Production

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1 Contemporary Economics: An Applications Approach By Robert J. Carbaugh 4th Edition Chapter 4: Production and the Costs of Production Copyright 2005 by South-Western, a division of Thomson Learning. All rights reserved. Production Production is the use of resources to make outputs of goods and services available for human wants. Flash from the past What are resources? Carbaugh, Chap. 4 2 Production Function The relationship between the physical output and the quantity of the resources used in the production process. A cookie recipe is a production function. Carbaugh, Chap

2 Short Run A period where at least one input is fixed and the others can be varied. Carbaugh, Chap. 4 4 Fixed Inputs vs. Variable Inputs Fixed Inputs any resource for which the quantity can t be varied during the period in question E.g. land, size of factory, number of markers Variable Inputs quantities that can change in the short run E.g. labor, materials, the paper Carbaugh, Chap. 4 5 Now the Long Run A period where all inputs are variable. NO FIXED INPUTS! How long is the long run? Well, it depends on the business. Krispie Kreme can change the number of franchises in a matter of months, but to construct a new factory for GM could take a while Carbaugh, Chap

3 Production Functions Short-run production functions (cont d) product 5800 product curve TP Marginal product Marginal product curve Increasing marginal returns Diminishing marginal returns MP Labor input Labor input Carbaugh, Chap. 4 7 Law of Diminishing Marginal Returns The law says that marginal product decreases as additional units of the variable resource is added. Carbaugh, Chap. 4 8 Productivity Improvements When we look at total product and marginal product, we held Technology Quality of human resources Amount of capital equipment constant. Carbaugh, Chap

4 Productivity Improvements (contd.) But what if we allowed those to change also? It will shift the product curves! Technology Education Training Investment R&D Carbaugh, Chap Costs in the Short Run fixed costs: costs that don t vary with the output (a.k.a. overhead costs) E.g. costs of machinery, rent, taxes They remain constant in the short run variable costs: costs that change at the rate the output changes E.g. labor, materials, electricity Carbaugh, Chap Cost costs are the sum of the value of all resources used over a given period to manufacture a product TC = TFC + TVC Carbaugh, Chap

5 Average Costs Most managers though, care about the perunit or average costs. Average fixed costs: TFC/Q Average variable costs: TVC/Q ATC: TC/Q or TFC/Q + TVC/Q AFC + AVC Carbaugh, Chap Marginal Costs Managers are also concerned with the margin, so Marginal Cost = TC/ Q Carbaugh, Chap Average Costs Hypothetical short-run cost schedules cost Cost Costs Average total cost variable cost Average variable cost 50 fixed cost Marginal cost Output per day Output per day Carbaugh, Chap

6 Shifts in the Short Run Cost Curves Before, we assumed Technology Resource prices Taxes were constant. But what if they changed? Carbaugh, Chap Now the Long Run Look All costs are now variable, they can change. Long Run Average Cost Curve: shows the minimum cost per unit of producing each output level when any proper size factory could be built. Carbaugh, Chap Understanding Costs Cost schedules include the market value of all resources used in the production process. So Cost = Explicit Costs + Implicit Costs Carbaugh, Chap

7 Explicit vs. Implicit Costs Explicit Costs: Payments made to others as the cost of running the business E.g. wages, rent Implicit Costs: The value of the resources used in production for which no monetary payment is made E.g. wages forgone, interest forgone Carbaugh, Chap Accounting vs. Economic Profit Accounting Profit = TR Explicit Costs Economic Profit = TR (Explicit Costs + Implicit Costs) Accounting profit underestimates the costs and thus overestimates the profits Carbaugh, Chap Can there be $0 Economic Profit? Yes! It is called normal profit. Normal profit is when TR = Explicit Costs + Implicit Costs E.g. Wages forgone Carbaugh, Chap