Unit III: The Costs of Production & Theory of the Firm CHAPTERS 13-17
First, lets review marginal returns
How many workers should you hire?
Remember rationale thinkers think marginally!! Marginal = 1 additional unit Go from To.
Let s make
What resources do you have? There will be three factories Each factory gets the following to work with 1 desk One pair of scissors One tape stapler Workers
How do you produce the links? Fold a piece of paper 2 times (hot dog style) Cleanly cut the 4 folded strips Wrap a strip in a circle and staple it Take the next strip and place it through the previously made ring, and staple it to interconnect the two paper rings Do this as many times as you can
Special Rules Each factory begins with one worker Production periods last 60 seconds Each factory must have a quality control inspector Watches the other, competing factories Every resource must be used during production (including workers, they must have a job!) Everything must be cleaned after each round.
What everyone will do during this activity In a table, list how many acceptable links were created for each production round. Workers 1 2 3 4 5 6 7 Links Produced Marginal Product
Increasing Marginal Product An increase in output per input added Costs decreasing per input added Short run Diminishing Marginal Product A decrease in output per input added Costs increasing per input added Long Run
The Production Function
Production Function Relationship between quantity of inputs used to make a good and the quantity of output of that good.
Remember what happens to marginal product when you add more inputs
Diminishing Marginal Product
Is there a graph for that?
Production Function Quantity of output 160 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 0 1 2 3 4 5 6 7 Number of Workers Hired
Pick a card any card
How much do you think that would cost to begin that business? List all the expenditures you would need to make your product Estimate how much money you believe all of these expenditures will cost (ask me for help if needed) Add all of your expenditures and that is your total cost!
Did you forget these.
Could cost up to millions of dollars!!!
The Costs of Production The money that is given up when producing a product. explicit and implicit Costs fixed vs. variable Costs fixed costs are constant variable costs change with each additional unit of production
Fixed Cost Variable Cost Mortgage for a toy factory Screws for toys
The Costs of Production The money that is given up when producing a product. explicit and implicit Costs fixed vs. variable Costs fixed costs are constant variable costs change with each additional unit of production Total Cost fixed cost + variable cost this is always the firms opportunity cost
Firm s Main Objective? To maximize profits!
Revenue is NOT profit! Total Revenue The amount a firm receives for the sale of its output. Total Cost The market value of the inputs a firm uses in production. Profit The firm s total revenue minus their total cost Firms want to maximize profit!
Economic Profit vs Accounting Profit Economic profit total revenue minus total cost, including both explicit and implicit costs. Accounting profit total revenue minus only the firm s explicit costs. Economists, or rationale thinkers, base profit on economic profit
Quick Quiz You re a farmer that gives banjo lessons on the side for $20 an hour. One day, you spend 10 hours planting $100 worth of seeds. What is your opportunity cost? What cost would your accountant measure? If these seeds yield $200 worth of crops, do you earn an accounting profit? Do you earn an economic profit? $200 - $100= $100 $200 - $300 = -$100 Accounting Profit Economic Profit
AFC, AVC, ATC, and MC Curves The MOTHER of cost graphs!
Average Fixed Cost Average Variable Cost Average Total Cost Fixed costs Quantity of output Variable costs Quantity of output Total cost Quantity of output Marginal Cost The increase in total cost that arises when one additional unit is produced
Marginal Cost Costs our firm $100 to make 1 tablet If we wanted to make two tablets, it would costs our firm $110 because of the extra parts needed for the additional tablet (VC) So, the marginal cost of producing the 2 nd tablet is $10
Figuring Them Out... Before we graph these curves, lets practice figuring out each cost. Problem Set 4.2 Now, lets graph them
Problem Set 4.2 Questions 1. What happens to AFC as output increases? Why? 2. What shape is the MC, ATC, and AVC? Why? 3. From what range of output is the ATC decreasing? 4. From what range of output is the ATC increasing? 5. Where does MC intersect the ATC and AVC curves? 6. What output level is the most efficient? Why?
Problem Set 4.2 Questions 1. The AFC decreases. Fixed costs are constant, so as a firm produces more quantity, their average fixed costs will decrease. 2. U shaped. Because these costs decrease initially (short run) and eventually increase (long run); the Law of Diminishing Marginal Returns! 3. 1-7 4. 8 infinite 5. At their lowest point 6. Where MC = ATC (ATC at it s lowest point)
Marginal Cost When do you think diminishing marginal returns sets in? Any output level greater than where MC = ATC Why?
To help you better understand, let s think of people in a room and height If the next person who enters the room is taller than the previous average, the average will rise If the next person who enters the room is shorter than the pervious average, the average will fall If the next person who enters the room is exactly the same than the previous average, the average will stay the same.
Same applies with marginal and average costs! If MC is less than the previous average cost, the averages fall If MC is greater than the previous average cost, the averages rise If MC is exactly the same as the previous average costs, the averages stay the same
Intersects at ATC and AVC at their lowest points To the left of the intersection is increasing marginal returns To the right is decreasing marginal returns
Short Run vs. Long Run Costs and Economies of Scale
What is the difference? Short run cost decision There is at least one fixed cost and one variable cost Long run cost decision ALL costs are variable Let me help you understand this
Suppose you are a business owner and you have a factory and wage workers You have at least one fixed cost: the factory You have at least one variable cost: the worker You are currently in the short run
Suppose that your factory is only operating at 75% capacity. Factory Floor Space
Suppose that your factory is only operating at 75% capacity. You have at least one fixed cost, the factory, plus at least one variable This is the cost, short the workers. run
Demand for your product increases, so you decide to hire more workers. So Did this the is size a short of the run factory cost. change? There is at No. least one fixed cost Did the (factory) amount and of wage one variable workers cost change? (workers) Yes.
Your factory is now at full capacity and demand for your product is still increasing. So, you either expand your current factory or build a new one.
Once you decide to expand your factory or build a new one, your fix costs changes. Therefore, it s no longer a fixed cost but a variable cost. When Does fixed this Did the size cost change the of fixed your changes, cost of factor this the is factory? a long change? run Yes. decision Yes.
REVIEW: Short Run or Long Run Cost? Portillo s is doing excellent business in Naperville and is thinking of building a new Portillo s in Plainfield Long Run Harvard is planning to hire more professors Short Run People catch on that Red Robin is overrated so the store in Plainfield may shut down Long Run
What does this say about long run costs for all firms? Any
Best explanation http://www.reffonomics.com/textbook2/microec onomics2/swiftfile/costofdoingbusiness/longrunat ccurve1.swf