Unit III:

The Costs of Production

& Theory of the FirmCHAPTERS 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 Links

Produced

Marginal

Product

1

2

3

4

5

6

7

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

0102030405060708090

100110120130140150160

0 1 2 3 4 5 6 7Number of Workers Hired

Quantity of output

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

Mortgage for a toy factory Screws for toys

Fixed Cost Variable Cost

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

Economic ProfitAccounting Profit

AFC, AVC, ATC, and MC

Curves

The MOTHER of cost graphs!

Average Fixed

Cost Fixed costs ÷ Quantity of

output

Average Variable

Cost Variable costs ÷ Quantity of

output

Average Total

Cost Total cost ÷ Quantity of output

Marginal CostThe 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 2nd 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 cost, the

workers.

This is the short

run

Demand for your product

increases, so you decide to hire

more workers.

Did the size of the

factory change?

No.

Did the amount of wage workers change? Yes.

So this is a short

run cost. There is

at least one fixed

cost (factory) and one variable cost (workers)

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.

Did the size

of your

factor

change?

Yes.

Does this

change the

fixed cost of

the factory?

Yes.

When fixed

cost

changes,

this is a long

run decision

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

questions?

Best explanation

http://www.reffonomics.com/textbook2/microec

onomics2/swiftfile/costofdoingbusiness/longrunatccurve1.swf