THE COSTS OF PRODUCTION. J. Mao

Transcription

1 THE COSTS OF PRODUCTION J. Mao

2 Revenue, Costs, and Profit We assume that a firm s goal is to maximize profit. Profit = Total Revenue - Total Costs Costs refer to opportunity costs Explicit costs require an outlay of finances n Example: Rent, payment on machines, labor costs, etc. Implicit costs are costs that do not require the transfer of finances n Example: the time cost of producing on good verses another, the value of foregone investment, etc.

3 Explicit Costs vs. Implicit Costs Suppose the market interest rate is 5 percent. If you invest $30000 in your business Accounting cost (explicit cost): $0 Economic cost (opportunity cost): $1500/yr in foregone interest income Suppose you use $10000 of your own money and borrow $20000 Accounting cost: $1000/yr in interest payment Economic cost: $1500/yr

4 Economic Profit vs. Accounting Profit Accounting Profit = total revenue minus total explicit costs Economic Profit = total revenue minus total costs (including explicit and implicit costs) Accounting profit ignores implicit costs, so it s higher than economic profit

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 Economic Profit vs. Accounting Profit: Example The market rent on office space has just increased by $500/mo Determine the effects on accounting profit and economic profit if... you rent your office space you own your office space

7 Economic Profit vs. Accounting Profit: Example Assume interest rate = 0 You rent your office space Explicit costs increase by $500/mo. Both accounting profit and economic profit fall by $500/mo. You own your office space Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500 per month (you could have rented out this space instead of using it)

8 Economic Profit vs. Accounting Profit: Example Assume interest rate = 1% per month You rent your office space Explicit costs increase by $500/mo. Implicit costs increase by $5/mo (you could have deposited the $500 in a bank to earn interest) Accounting profit falls by $500/mo. Economic profit falls by $505/mo. You own your office space Explicit costs do not change. Implicit costs increase by $505/mo (you could have rented out the space to earn $500 and then deposited the money in a bank to earn interest) Accounting profit does not change. Economic profit falls by $505/mo

9 Caroline s Cookie Factory

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11 Marginal Product of Labor If the farmer hires one more worker, his output rises by the marginal product of labor The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. Marginal Product of Labor (MPL) = ΔQ/ΔL

12 Why MPL Diminishes Output rises by a smaller and smaller amount for each additional worker. Why is this? Caroline s factory has one kitchen. Consider 5 worker sharing the kitchen Now consider 5000 workers sharing the kitchen Because capital (kitchen) is fixed in the short run, MPL tends to diminish as L rises

13 Why MPL Diminishes Brook s Law - Adding manpower to a late software project makes it later. This law, coined by computer scientist Fred Brooks, demonstrates the principle that adding more labor will have diminishing effects. In adding more people, there are more channels of communication. These channels increase exponentially by n(n 1)/2

14 Why MPL Diminishes Jan Bill Jan 0 0 Bill 1 0 Jan Bill Jake Jan Bill Jake Jan Bill Jake Betsy Jan Bill Jake Betsy Jan Bill Jake Betsy Wilber Jan Bill Jake Betsy Wilber

15 Is MPL Always Decreasing? No. At low levels of production, there can be increasing MPL Specialization of tasks At higher levels of production, we can expect decreasing MPL Coordination problems, fixed resource constraints

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17 Conrad s Coffee Shop

18 The Various Measures of Cost Fixed Costs (FC) do not vary with the quantity of output produced Example: rent, equipment cost Variable Costs (VC) vary with the quantity produced Example: wages, cost of additional materials Total Cost (TC) = FC + VC

19 The Various Measures of Cost Average Fixed Cost (AFC) = FC/Q Average Variable Cost (AVC) = VC/Q Average Total Cost (ATC) = TC/Q = AFC + AVC How much does it cost to make the typical cup of coffee? Marginal Cost (MC): the increase in total cost that arises from an extra unit of production MC = = ΔTC/ΔQ How much does it cost to increase production of coffee by 1 cup?

20 The Cost Curves of Conrad s Coffee Shop

21 The Cost Curves of Conrad s Coffee Shop Rising marginal cost and average variable cost reflect diminishing marginal product. Average fixed cost always declines as output rises because the fixed cost is spread over a larger number of units. Average total cost (= AFC + AVC) is U-shaped The quantity of output that minimizes average total cost (the bottom of the U-shape curve) is sometimes called the efficient scale of the firm.

22 Is Marginal Cost Always Increasing? No. Marginal cost can be decreasing or constant at low levels of production, but will eventually rise with the quantity of output See the discussion on MPL

23 Typical Cost Curves

24 Typical Cost Curves When MC < ATC, ATC is falling. When MC > ATC, ATC is rising. When MC < AVC, AVC is falling. When MC > AVC, AVC is rising. The MC curve crosses both the ATC and the AVC curves at their minimum

25 Typical Cost Curves TC = FC + VC MC = dt C dq = dv C dq dav C dq = d VC Q dq = dv C dq ) MC = dv C dq 1 Q VC Q 2 > 0 VC > AV C = Q dat C dq = d TC Q dq = dt C dq 1 Q TC Q 2 > 0 ) MC = dt C dq > AT C = TC Q

26 Exercise

27 Exercise

28 Short Run and Long Run Cost The division of total costs between fixed and variable costs depends on the time horizon Fixed costs in the short run can be variable costs in the long run. Car manufacturers factories are fixed in the short run but variable in the long run Carolyn s kitchen is fixed in the short run but variable in the long run Long-run cost curves are flatter than short-run curves fixed resource constraints are relaxed in the long run so marginal cost rises more slowly

29 Short Run and Long Run Cost