Production and Cost

1
Chapter 12

• Production and Cost

2
The Firms Goal

• Just like consumers maximize utility, firms
  maximize profits
• How do we know firms do this?
• Firms not maximizing profits either will go out
  of business or be bought by another firm that can
  put the the assets to better use.

3
What Does Profit Maximization Mean?

• Maximizing accounting profits?
• Maximizing economic profits?
• Whats the difference between these concepts?

4
Accounting Profits
Sams Smoothies Income
Statement Sales 150,000 Cost of
supplies 20,000 Labor 22,000 Interest on
loan 3,000 Depreciation 10,000 Total
accounting cost 55,000 Accounting
Profit 95,000
5
Economic Profits
Sams Smoothies Sales 150,000 Cost of
supplies 20,000 Wages 22,000 Interest
3,000 Total Explicit Costs 45,000
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Economic Profits (Continued)
Sams Smoothies Sams foregone
wages 50,000 Sams foregone interest
1,000 Economic Depreciation 4,000 Total
Implicit Costs 55,000 Total Opportunity
Cost 100,000 Economic Profit 50,000
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The Short and Long Run

• Short runa time frame in which some of a firms
  resources are fixed
• Plant size
• Amount of equipment
• Long runa time frame in which the amount of all
  inputs can be varied, sometimes called the firms
  planning horizon

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Short Run Production Concepts

• Total ProductTotal quantity of output produced
  in a given period of time
• Marginal ProductAmount of additional output from
  hiring one more worker
• Average ProductAmount of output on average
  produced by each worker

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Total Product Qf(L)
OutputQ
Total Product Curve
LaborL
10
Marginal Product
Q
Marginal Product Curve
L
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Decreasing Marginal Returns?
Suppose that each successive worker hired is just
as capable as the one before. It will still
happen that each successive workers contribution
to output will get smaller and smaller.
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Average Product
Q
Average Product Curve
L
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Coal Mine Example
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Short Run Cost Concepts

• Total CostFixed Variable Costs
• Fixed CostCosts that would be present even if
  Q0 insurance, equipment rental, taxes.
• Variable CostCosts that vary with Q labor,
  materials.

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Total, Fixed, and Variable Costs
Cost
Total Cost
Variable Cost
Fixed Cost
Output
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Average Cost Curves
Average Total Cost
Cost
Average Variable Cost
Average Fixed Cost
Quantity
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U-Shaped ATC Curve

• Spreading fixed cost over a larger output
• Decreasing marginal returns to variable inputs
  (labor)

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Marginal Cost

• Definitionextra cost associated with producing
  one more unit of output
• MC?TC/?Q ?VC/?Q
• Remember that ?FC/?Q0

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Relationship Between Average Total Cost and
Marginal cost
Average Total Cost
Marginal Cost
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Relationship Between Average Total Cost and
Marginal Cost
Why Does the marginal cost curve intersect the
average total cost curve where average total cost
is at a minimum?
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ExampleFree Throw Shooting
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Profit Maximization and Costs

• Does a firm maximize profits at the point where
  average total costs are minimized?

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Profit Maximization
Average Total Cost
Marginal Cost

Price
Q0
Q1
Quantity
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Profit Maximization--Examples

• Adding to a service territory (newspapers)
• Standby passengers on an airplane
• Bringing idle capacity into production (coal
  mines)

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Shifts in cost Curves

• Technological change
• Prices of factors of production (inputs)

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Reduction in Input Costs
MC0

MC1
Price
Quantity
Q0
Q1
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Costs in the Long Run

• All inputs are variable in the long run
• No need to distinguish between fixed and variable
  costs
• This is the firms planning horizon

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Returns to Scale

• Increasing returns to scale (economies of scale)
• Specialization of labor
• Decreasing returns to scale (diseconomies of
  scale)
• Constant returns to scale

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Long Run Average Cost Curve
Cost
Increasing Returns to Scale
Decreasing Returns to Scale
Constant Returns to Scale
Quantity
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Competitive Firms Supply Curve
This would be the portion of the marginal cost
curve that lies above average variable cost