# Understanding Production Costs. Principles of Microeconomics Module 4

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1 Understanding Production Costs Principles of Microeconomics Module 4

2 Firm Decisions: Short Run and Long Run A firm s decisions are grouped as: Short-run decisions time horizon over which at least one of the firm s inputs cannot be varied Long-run decisions time horizon long enough for a firm to vary all of its inputs Uses a Production Function to determine how much output it will produce from a given combination of inputs

3 Production Function Example: Q = 100 K + 25 L If the firm increases capital (K) it will increase production (Q) If the firm increases labor (L) it will increase production (Q)

4 Production Function Short Run: At least one input is fixed Fixed inputs: Land, machinery, labor with contracts Variable inputs: Labor, energy, fuel Long Run: All inputs are variable the firm can change the amount of each input that they use

5 Total Product Total product: Maximum quantity of output that can be produced from a given combination of inputs The total product curve shows how the quantity of output depends on the quantity of variable input, for a given quantity of the fixed input.

6 Total Product Assume Firm A has only one variable input: Labor. All other inputs are fixed. Labor Total Product = Output

7 Total Product Curve Total Total Product With each additional input: Firm A produces more output Total Product Curve is increasing

8 Marginal Product

9 Marginal Product of Labor Labor Output MPL

10 Marginal Product of Labor Labor Output MPL

11 Diminishing Marginal Returns to Labor Output is increasing at a decreasing rate if firm increases only one input Each worker adds to production, but less and less Labor Output MPL Total Total Product

12 Production Choices of Firms All firms have one goal in mind: MAX PROFITS PROFITS = TOTAL REVENUE TOTAL COST Two ways to reach this goal: Maximize total revenue Total Revenue = Price X Quantity Minimize total costs Total Costs = Fixed Costs + Variable Costs

13 Production Costs for Firms Fixed Costs: Costs that stay the same regardless of how much a firm produces Example: Rent paid for a store location

14 Production Costs for Firms Variable Costs: Costs that change based on how much a firm produces The more the firm produces, the more materials, workers, inputs it has to employ The cost of those inputs are variable costs Example: Wages paid to employees Cost of materials

15 Production Costs for Firms Total Costs: Sum of fixed and variable costs Total costs faced by the firm to produce Example: Rent + Wages + Cost of Inputs

16 Test your Understanding Suppose a firm has to pay a rental price of \$800 for a machine it uses in production. It also pays its workers \$25 each. Can you complete the following table? Machines Workers Cost of CAPITAL (Fixed Cost) Cost of LABOR (Variable Cost) TOTAL COST

17 Test your Understanding Rent Price of Capital = \$800 à FIXED COST Wages of workers = \$25 à VARIABLE COST Machines Workers Cost of CAPITAL (Fixed Cost) Cost of LABOR (Variable Cost) TOTAL COST

18 How Firms Analyze Production Costs To analyze the production decisions of a firm, recall that a firm conducts marginal analysis Decisions are based on per-unit calculations Therefore, need to calculate costs/unit: Average Variable Cost (AVC) = Variable Cost /Quantity produced Average Fixed Cost (AFC) = Fixed Cost /Quantity produced Average Total Cost (ATC) = Total Cost/ Quantity produced

19 Production Costs OUTPU T FIXED COST VARIABLE COST TOTAL COST FC/Q VC/Q TC/Q AFC AVC ATC Costs per unit of output produced

20 Average Cost Curves Cost Quantity Produced

21 Production Costs FC/Q VC/Q TC/Q OUTPU FIXED VARIABLE TOTAL T COST COST COST AFC AVC ATC Costs per unit of output produced

22 Marginal Cost Marginal Cost: Change in Total Cost when producing one more unit of the good MC = (TC2 - TC1)/(Q2-Q1) OUTP FIXED VARIABLE TOTAL UT COST COST COST AFC AVC ATC MC

23 Marginal Cost Marginal Cost: Change in Total Cost when producing one more unit of the good MC = (TC2 - TC1)/(Q2-Q1) OUTP FIXED VARIABLE TOTAL UT COST COST COST AFC AVC ATC MC

24 Marginal Cost Curve Cost Quantity Produced

25 Long Run vs. Short Run Total Cost In the short run: firm has both fixed and variable costs Managers must consider the firm should do over the course of the next week In the long run: all costs are variable because all inputs are variable and can change Managers have a long-term view when considering what the firm should do in the coming years

26 Costs in the Long Run Consider a small coffee shop, where the majority of customers come in to buy their daily cup of coffee. Currently, the shop serves about 200 customers and has only one location. It s considering whether or not to expand. 100 Customers Average Total Cost (Cost per coffee sold) 200 Customers 300 Customers 400 Customers 1 Location Locations Locations

27 Long Run vs. Short Run Total Cost ATC SRATC 1 SRATC 2 SRATC 3 LRATC 1 Output Economies of Scale: ATC is falling with increase in output

28 Long Run vs. Short Run Total Cost ATC SRATC 1 SRATC 2 SRATC 3 LRATC 1 Output Constant Returns to Scale: ATC is the same

29 Long Run vs. Short Run Total Cost ATC SRATC 1 SRATC 2 SRATC 3 LRATC 1 Output Diseconomies of Scale: ATC is rising with increase in output

30 Economies of Scale 1. Increasing Returns to Scale (Economies of scale): Occurs due to: Gains from specialization Minimum size requirements for certain types of equipment. 2. Constant Returns to Scale: Output range with constant LRATC Size may not matter and firms of the same size will be equally costeffective. 3. Decreasing Returns to Scale (Diseconomies of scale): Firms reach a point where bigness begins to cause problems One really large coffee shop serving 400+ customers Diseconomies of scale are more likely at higher output levels

31 Key Takeaways All firms are profit maximizing and therefore want to minimize their costs To make their production decisions need to consider ATC, AVC, AFC and MC NEXT: Merge cost curves with revenue to understand how different types of firms make production decisions

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