1 End2.Profit4 Costs 5 Ln. Run Costs6.Surplus Begin 3 S&L Run Production and Cost in the Firm...

1End2.Profit 4 Costs 5 Ln. Run Costs 6.SurplusBegin 3 S&L Run

Production and Cost in the Firm• Session 6 : CHAPTER 7• Tips for Navigation in the presentation:

The link “ ” in the top left appears on every slide and operates as a hyper link to the slide “Lecture Outline”

• Navigation Bar to main topics• Two thoughts to start with:

• Corn & Beef• Formulas


1.1 Production and Cost in the Firm• Rising demand for Ethanol has increased the price of beef

because both goods use corn as an input in their production


1.2 Summary of Formulas

Label Abbreviation FormulaVariable Input (Labor) LTotal Production qAverage Product AP q / LMarginal Product MP chg q / chg LLabor Cost VC Fixed Cost FCTotal Cost TC VC + FCMarginal Cost MC chg TC / chg qAverage Total Cost ATC TC / qAverage Variable Cost AVC VC / qAverage Fixed Cost AFC FC / qAverage Total Cost ATC ATC = AFC + AVC


Session 6 Lecture Outline

• 1. First Slide• 2 Profit Measures• 3 Short and Long Run• 4 Short Run Costs• 5 Long Run Costs• 6 Surplus: Producer & Consumer • 7. End of Presentation


2.0 Profit Measures• 2.0 Profit Measures:

– 2.1 Explicit & Implicit Cost (Dn)– 2.2 Economic Profit (Table)– 2.3 Accounting, Economic, Normal Profit (Dn)– 2.4 Self-Evaluation Exercise


2.1 Explicit and Implicit Costs• Explicit costs– Refer to the firm’s actual cash payments for resources

wages, rent, taxes, etc.

• Implicit costs– The opportunity costs of using resources owned by the

firm or provided by the firm’s owners– Require no cash payment and no entry in the firm’s

accounting statement, which records its revenues, explicit costs, and accounting profits


2.2 a Economic Profit• Here is a stylized example that makes the distinction

between explicit and implicit costs and the difference between “accounting profit” and the economists alternative measure “economic profit” .

• Wanda Wheeler currently earns $50,000 in her current job– She decides to start her own business– She withdraws $20,000 from her savings account, hires an assistant

(at $21,000), and uses a spare bay in her garage that had been renting for $1,200 a year

– The next slide shows these numbers in a table


2.2b Economic Profit• Accounting profit equals total revenue minus explicit costs used to determine a firm’s

taxable income• However, this ignores the opportunity cost of Wanda’s own resources

– Her forgone salary of $50,000– Annual interest of $1,000 from the savings used to start the business– Rental income of $1,200

• Economic profit equals total revenue minus all costs, both explicit and implicit– Accounting profit of $64,000 less implicit costs of $52,200 economic profit of $11,800

Total revenue $105,000Less explicit costs: 41,000

Assistant's salary -21,000Material and equipment -20,000

Equals accounting profit $64,000

Less implicit costs: 52,200Wanda's forgone salary 50,000Forgone interest on savings -1,000Forgone garage rental -1,200

Equals economic profit $11,800


2.3 Normal Profit• There is one other profit measure to consider: the

accounting profit required to induce the firm’s owners to employ their resources in the firm

• Alternatively, the accounting profit just sufficient to ensure that all resources used by the firm earn their opportunity cost normal profit occurs when economic profit = $0– Accounting profit = $64,000– Normal profits = $50,000 + $1,200 + $1,000 = $52,200 (aka implicit

costs, aka opportunity costs)– Economic profit = $11,800– When economic profits are greater than zero, an incentive for others

to enter the market– When economic profits are $0, markets are in equilibrium

• Then firms are earning normal profits


2.4 Self-Evaluation Exercise• Just do Question 1


3.0 Click to next slide for 3.0 Outline


3.0 Short&Long Run, Marginal Product

• 1 Fixed and Variable Resources (Dn)• 2 Law of Diminishing Marginal Returns (Dn)• 3 Total & Marginal Product (Table,Graph)• 4 Summary of Product Formulas ()• 5 Self-Evaluation Exercise ()


3.1 Fixed and Variable Resources• Resources can be divided into two categories– Variable resources can change quickly to change the output rate– Fixed resources resources which cannot be easily changed

• This provides us the distinction between the short run and the long run– Short run at least one resource is fixed– Long run all resources are variable

Holland Tunnel 1927: 1 Tube (WPA Project)

Lincoln Tunnel 1934: 2 Tubes (WPA Project)

NY & NJ Hudson River Crossings


3.2 Law of Diminishing Marginal Returns• As more of a variable resource is combined

with a given amount of a fixed resource, marginal product eventually declines

• This is the most important feature of production in the short run dictates the shape of the production function and the cost curves

Holland Tunnel: with and without traffic


3.3a Total and Marginal Product• For the present, suppose we focus on the short-

run link between resource use and the rate of output

• Suppose the company’s fixed resources are already in place and consist of a warehouse, a moving van, and moving equipment

• The only variable resource is labor

• The next slide provides our illustration


3.3b Total and Marginal Product TableLabor measured in worker-days (1 worker for one day)Output measured in tons of furniture moved per day.Tons of furniture moved, or total product, at each level of employment is shown in the center columnRelationship between the amount of resources employed and total product is called the firm’s production function.Last column shows the marginal product of each worker

Units of Labor and Tons of Furniture Moved

Units of the Total Marginal Variable Product Product Resource (tons moved (tons moved(worker-days) per day) per day)

0 0 - 1 2 2 2 5 3 3 9 4 4 12 3 5 14 2 6 15 1 7 15 0 8 14 -1


3.3c Total and Marginal Product Graph

Because of increasing marginal returns, marginal product increases with each of the first three workers total product is increasing at an increasing rate.

However, once decreasing returns set in – adding the 4th worker – marginal product declines total product continues to increase but at a decreasing rate.

As long as marginal product is positive, total product increases where marginal product turns negative, total product starts to fall.


3.4 Summary of Product Formulas• These are the Product Formulas you need to

remember

Label Abbreviation FormulaVariable Input (Labor) LTotal Production qAverage Product AP q / LMarginal Product MP chg q / chg L


3.5 Self Evaluation Exercise

Formulas


4.0 Short Run Costs• 4.0 Short Run Costs

– 4.1 Fixed Cost & Short Run (Dn, MC) – 4.2 Total Cost & Marginal Cost, (Table & Graph)– 4.3 Average Cost & Marginal Cost (Table & Graph)– 4.4 Summary of Formulas ()– 4.5 Self-Evaluation Exercise (Table, Graph)


4.1a Fixed Cost & the Short Run

Holland Tunnel 1927: 1 Tube (WPA Project)

Lincoln Tunnel 1934: 2 Tubes (WPA Project)

NY & NJ Hudson River Crossings

• Two components of total cost in the short run– Fixed costs: the payment for plant and equipment. It must

be paid even if no output is produced, it does not vary when output varies

– Variable cost: the cost of variable resources – labor and raw materials.


4.1b Marginal Cost & the Short Run• Marginal Cost: the change in total cost as output

increases. It tends to decline at first and then eventually increase

Holland Tunnel: with and without traffic


4.2 a Total & Marginal CostTons Moved Fixed Variable Marginal per Day cost Workers Cost Total Cost Cost (q) (FC) per Day (VC) TC=FC+VC MC=TC/ q (1) (2) (3) (4) (5) (6)

$0 $200 0 $0 $200 - 2 200 1 100 300 50.00 5 200 2 200 400 33.33 9 200 3 300 500 25.00 12 200 4 400 600 33.33 14 200 5 500 700 50.00 15 200 6 600 800 100.00

Notice that fixed costs – column (2) – remain constant at $200 per day regardless of output.

Column (3) shows the amount of labor needed to produce each rate of output based on the the productivity figures introduced previously.

The variable and total cost associated with each level of output are shown in columns (4) and (5), respectively.

TC = FC + VC

Since total cost is the opportunity cost of all resources employed by the firm, it includes a normal profit but not an economic profit. Marginal cost is provided in the last column.

Marginal cost is simply the change in total cost divided by the change in output MC = ΔTC / Δq Changes in MC reflect changes in marginal productivity of the variable resource employed


4.2b Total and Marginal Cost CurvesSince total cost does not vary with output, the fixed cost curve is a horizontal line at $200.

Variable cost is zero when output is zero the variable cost curve starts at zero, then increases slowly then sharply.

The total cost curve sums the variable and fixed cost curves.

Marginal cost declines until the 9th unit of output and then increases reflecting labor’s increasing and then diminishing marginal returns.

The change in total cost resulting from a one-unit change in production equals marginal cost the slope of the total cost curve at each rate of output equals the marginal cost at that rate of output.


4.3a Average Cost• The average total cost is the per unit of

output

• There are average cost measures corresponding to total cost, fixed cost and variable cost

• The next slide presents a table of data for a hypothetical firm


4.3b Average & Marginal Cost Data

• Average variable cost, AVC, equals variable cost divided by output AVC = VC / q

• Average total cost, ATC, equals total cost divided by output ATC = TC / q• Both average variable cost and average total cost first decline as output expands,

then increase

Tons Moved Variable Marginal Average Average per Day Cost Total Cost Cost Variable Cost Total Cost (q) (VC) TC=FC+VC MC=TC/ q AVC=VC/q ATC=TC /q (1) (2) (3) (4) (5) =(2) / (1) (6)=(3) / (1)

0 $0 $200 $0.00 - 2 100 300 50.00 $50.00 $150.00 5 200 400 33.33 40.00 80.00 9 300 500 25.00 33.33 55.55 12 400 600 33.33 33.33 50.00 14 500 700 50.00 35.71 50.00 15 600 800 100.00 40.00 53.33


4.3c Average and Marginal Cost CurvesMarginal cost declines as output expands because of increasing marginal returns to labor so long as marginal cost is below average cost, average cost falls as output expands.

At higher rates of output, marginal cost increases

Where marginal cost exceeds average cost, marginal cost

pulls up the average. Because marginal cost first pulls down average cost and then pulls up average cost, each average cost curve has a U shape.

Notice also that the rising marginal cost curve intersects both the average variable and average total cost curves at their minimums.

Marginal cost

Average total cost

Average variable cost

The distance between the average variable and average total cost gets smaller as output increases because average fixed costs decline as output increases

$150

125

100

75

50

25

0 5 10 15 Tons per day


4.4 Summary of Cost Formulas• These are the cost formulas you need to

remember

Label Abbreviation FormulaVariable Cost VC Fixed Cost FCTotal Cost TC VC + FCMarginal Cost MC chg TC / chg qAverage Total Cost ATC TC / qAverage Variable Cost AVC VC / qAverage Fixed Cost AFC FC / qAverage Total Cost ATC ATC = AFC + AVC


4.5a Self-Evaluation: Cost Tables• The cost tables will

be in the homework

Formulas


4.5b Self-Evaluation: Cost Graphs• Click the Grey Numbered Buttons to try Questions 2 to 4


5.0 Long Run Costs• 5.0 Long Run Costs • 5.1 No Fixed Costs (Dn)• 5.2 Planning Horizon (Graph)• 5.3 Economies & Diseconomies of Scale (Graph)


5.1 Costs in the Long Run• Thus far we have focused on how costs vary

as the rate of output expands in the short run for a firm of a given size

• In the long run, all inputs that are under the firm’s control can be varied there are no fixed costs

5.2: Short-Run Cost Curves and the Long-Run Planning Curve

33

The appropriate size or scale for the new plant depends on how much the firm wants to produce.

For example, if q is the desired rate of output in the long run, the average cost per unit is lowest with a small plant. If the desired output rate is q', the medium plant size ensures lowest cost.

Generally, for any output less than qa average cost is the lowest when the plant is small, for output rates between qa and qb, for the medium plant, and when output exceeds qb, the large plant has the lowest average costs.

Output per periodq' qb0 q q a

Co

st p

er u

nit

a b

S' L

L'

M'

SM

Cost per unitThe long-run average cost curve connects portions of the three-short run average cost curves that are lowest for each output rate S,a,b, and L'

Begin

End2.0 Profit 4.0 Costs 5.0 Ln. Run Costs 6.0 Surplus3.0 S&L Run


5.2: Short-Run Cost Curves and the Long-Run Planning CurveThe appropriate size or scale for the new plant depends on how much the firm wants to produce.

For example, if q is the desired rate of output in the long run, the average cost per unit is lowest with a small plant. If the desired output rate is q', the medium plant size ensures lowest cost.

Generally, for any output less than qa average cost is the lowest when the plant is small, for output rates between qa and qb, for the medium plant, and when output exceeds qb, the large plant has the lowest average costs.


5.3 Economies of Scale

Output per period

B

Long-runaverage cost

Economies of scale

Constantaverage

cost

Diseconomiesof scale

A

0

Cost per UnitThe rate of production must reach quantity A for the firm to achieve the minimum efficient scale, which is the lowest rate of output at which long-run average cost is a minimum.

From output A to rate B, average cost is constant. Beyond output rate B, diseconomies of scale increase long-run average cost.


6.0 Surplus• 6.0 Surplus:

– 6.1 Consumer Surplus (Graph )– 6.2 Producer Surplus (Graph )


6.1 : Consumer Surplus

0 100,000 120,000 200,000

surplus

surplus

m

Quantity per period

Consumer surplus is shown by the blue shaded area, which is the area below the demand curve but above the market clearing price of $10.

Dollars per unit

Producers also derive a net benefit, or a surplus, from market exchange because the amount they receive for their output exceeds the minimum amount they would require to supply that amount in the short run.

Recall that the short-run market supply curve is the sum of that portion of each firm’s marginal cost curve at or above the minimum point on its average variable cost curve point m on the market supply curve S.

Producer

Consumer

D

S

e$10

5

Area below the demand curve and above the price


6.2 : Producer SurplusPoint m implies a price of $5 with each firm willing to supply 100,000 units. At prices below $5, quantity supplied is zero because firms could not cover variable costs and would shut down.

If the price increases to $6, firms increase their quantity supplied until their marginal cost equals $6 output increases from 100,000 to 120,000, and total revenue increases from $500,000 to $720,000. Part of the increased revenue covers the higher marginal cost of production. However, the balance of the increased revenue is a bonus to producers, who would have been willing to supply 100,000 units for only $5 producer surplus is shown by the red shaded area.

Consumer surplus

m

Quantity per period

Dollars per unit

0 100,000 120,000 200,000

$10

5

Producer surplus

D

S

6

e

Area above the supply curve and below the price


END OF PRESENTATION• Pics linked to topics in lecture

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