# Chapter 12. The Costs of Produc4on

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1 Chapter 12 The Costs of Produc4on Copyright 214 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

2 What will you learn in this chapter? How to define total revenue, total cost, and profit. How to differen4ate between: Fixed and variable costs. Explicit and implicit costs. How to calculate economic and accoun4ng profit. How to define marginal product and show diminishing marginal product. How to define average and marginal cost. How to think about long- run and short- run costs. How to define returns to scale and its implica4ons. 12-2

3 Revenues, costs, and profits A firm s goal is to maximize profits: Profit = Total revenue Total cost Total revenue is the amount that a firm receives from the sale of goods and services and is calculated as the quan4ty sold mul4plied by the price paid for each unit: Total revenue = Quan4ty x Price = (Q 1 xp 1 ) + (Q 2 xp 2 ) + + (Q n xp n ) Total cost is the amount that a firm pays for inputs used to produce goods or services. While total revenue is simple to calculate, costs are more complex and harder to calculate. 12-3

4 Ac9ve Learning: Calcula9ng total revenue Suppose a firm produces two goods: Bouncy balls that sell for \$1. Gumball machines that sell for \$25. Last year the firm sold 1, balls and 1, gumball machines. Calculate total revenue. 12-4

5 Ac9ve Learning: Calcula9ng total revenue Suppose a firm produces two goods: Bouncy balls that sell for \$1. Gumball machines that sell for \$25. Last year the firm sold 1, balls and 1, gumball machines. Calculate total revenue. TR = 1, x \$1 + 1, x \$25 =\$35, 12-5

6 Fixed and variable costs A firm s total cost is defined as: Total costs = Fixed costs + Variable costs Fixed costs are costs that do not depend on the quan4ty of output produced. One- 4me, upfront payments before produc4on begins, like buying equipment. Ongoing payments, like monthly rents. Fixed costs are constant as quan4ty increases. Even if a firm produces nothing, it s4ll incurs a fixed cost. 12-6

7 Fixed and variable costs Variable costs are those that depend on the quan4ty of output produced. Includes raw materials as well as labor costs. Total variable costs increase with each addi4onal unit produced. If a firm produces nothing, variable costs are zero. 12-7

8 Fixed and variable costs This table provides the fixed and variable costs for a firm. Quan4ty of pills (millions) 1 Fixed costs (\$) 1,, 1,, Variable costs (\$) 1, Total costs (\$) 1,, 1,1, ,, 1,, 1,, 1,, 1,, 1,, 1,, 2, 3, 4, 5, 6, 7, 8, 1,2, 1,3, 1,4, 1,5, 1,6, 1,7, 1,8, As the quan4ty produced increases, the fixed costs remain constant and the variable costs increase. 12-8

9 Ac9ve Learning: Calcula9ng costs Fill in the table assuming fixed costs are \$1, and variable costs are \$2 per unit. Quan4ty 1 Fixed costs (\$) Variable costs (\$) Total costs (\$)

10 Ac9ve Learning: Calcula9ng costs Fill in the table assuming fixed costs are \$1, and variable costs are \$2 per unit. Quan4ty 1 Fixed costs (\$) 1, 1, Variable costs (\$) 2 Total costs (\$) 1, 1, , 1, 1, 1, 1, 1, 1, , 1,2 1,4 1,6 1,4 1,6 1,8 2, 2,2 2,4 2,6 12-1

11 Explicit and implicit costs A firm s opportunity cost of opera4on has two components. The first is composed of the fixed and variable costs. These are explicit costs that require a firm to spend money. The second is composed of forgone opportuni4es. These are implicit costs that represent opportuni4es that could have generated revenue if the firm had invested its resources in another way. To properly account for the total costs incurred by a firm, total cost includes both types of costs

12 Economic and accoun9ng profit When companies report their profits, they provide accoun7ng profits: Accoun4ng profit = Total revenue Explicit costs Accoun4ng profits may be a misleading indicator of how well a business is really doing. To account for implicit costs, economic profit further subtracts implicit costs: Economic profit = Accoun4ng profit Implicit costs 12-12

13 Economic and accoun9ng profit The following dialog illustrates why economic profits maeer. CEO: We have the opportunity to buy a new manufacturing facility. Is this a smart move for you company? Executive A: The new facility would cost \$6 million to buy and \$4 million to operate over the next decade, for a total cost of \$1 million. The medicines we could produce there would bring in revenue of \$13 million. We could make \$3 million in profits. Buy the factory! Executive B: But you re forgetting about all of the other things we could do with \$1 million. By my calculations, we could earn \$6 million in interest over the next 1 years of we invested the money. That means that the true cost of buying the facility is \$16 million, and the revenue would be only \$13 million. If we bought the factory, we could lose \$3 million! 12-13

14 Total produc9on, marginal product, and average product Firms create value by bringing together different ingredients to create a good or service that consumers want. A produc7on func7on is the rela4onship between the quan4ty of inputs and the resul4ng quan4ty of outputs. The increase in output that is generated by an addi4onal unit of input is the marginal product. The principle of diminishing marginal product states that the marginal product of an input decreases as the quan4ty of the input increases. The average product is total produc4on divided by the number of workers

15 Total produc9on and marginal product This table provides the total produc4on and marginal product from each addi4onal unit of labor. Labor (# employees) Total produc4on (# pizzas) Marginal product of labor (# pizzas) The first three workers have an increasing marginal product. Aier three workers, each addi4onal worker contributes less to total produc4on, reflected by decreasing marginal product. Note that even though marginal product of labor is decreasing, total produc4on is s4ll rising

16 Ac9ve Learning: Total produc9on, marginal product, and average product Fill in the table. At what point does marginal product start to diminish? Labor (# employees) 1 2 Total produc4on 2 45 Marginal product Average product

17 Ac9ve Learning: Total produc9on, marginal product, and average product Fill in the table. At what point does marginal product start to diminish? Labor (# employees) Total produc4on Marginal product Average product

18 Produc9on func9on The produc4on func4on can be represented visually. The marginal product is the slope of the total produc4on curve. Quantity of pizzas 1, Curve flattens as diminishing marginal product kicks in. Curve gets steeper as marginal product increases. Total production When output is very low, each addi4onal worker has a higher marginal product than the previous one. As more workers are added, marginal product starts to diminish Quantity of workers 12-18

19 Average and marginal product The principle of diminishing marginal product and average product can be represented visually. This establishes the rela4onship between marginal and average product. Quantity of pizzas Eventually, marginal product starts to decrease. 1. Initially, adding more workers increases marginal product Quantity of workers Average product Marginal product When an addi4onal worker s marginal product is greater than the exis4ng average product, the average product increases. When the marginal product curve crosses the average product curve, the average product also starts to decrease. When an addi4onal worker s marginal product is less than the exis4ng average product, the average product decreases

20 Costs of produc9on When a firm increases its output by adjus4ng its use of inputs, it incurs the costs associated with that decision. The rela4onships between output and costs are: Average fixed cost (AFC) = Fixed cost/quantity Average variable cost (AVC) = Variable cost/quantity Average total cost (ATC) = Total costs/quantity = AFC + AVC Marginal cost (MC) = Δ total cost/δ quantity 12-2

21 Costs of produc9on The table below provides the produc4on and costs of a pizza joint that requires a lease for \$3 and wages for workers at \$2 each. Labor (# workers) Total produc4on (# pizzas) Fixed costs (\$) Average fixed costs (\$/pizza) Variable costs (\$) Average variable costs (\$/ pizza) Total costs (\$) Average total costs (\$/pizza) Marginal product (# pizzas) 3 3 Marginal cost (\$/ pizza) , , , , , , , ,6 2. 1, , , , ,

22 Cost curves Cost func4ons can be represented visually. Cost (\$) 2,5 2, 1,5 1, 5 TC , Quantity of pizzas VC Because of diminishing marginal product, variable costs increase more as each additional pizza is added. Fixed costs, on the other hand, stay the same regardless of how many pizzas are produced. The total cost curve is the sum of variable and fixed costs. FC The VC curve ini4ally becomes less steep, reflec4ng the increasing marginal product of the first few employees. As the principle of diminishing marginal product kicks in, the variable cost curve gets gradually steeper. Adding FC and VC yields TC

23 Cost curves Average costs can be represented visually. Cost/pizza (\$) ATC AVC AFC , Quantity of pizzas AFC trends downward. Same cost spread out over more units of output. AVC is U- shaped. First decreases and then increases, reflec4ng the marginal product of inputs. ATC curve is U- shaped. Decreases in AFC and increases with AVC

24 Cost curves Marginal cost can be represented visually. Cost / pizza (\$) MC , Quantity of pizzas The MC curve is U- shaped and is the inverse shape of the marginal product curve. Every addi4onal unit of input costs the same, regardless of its contribu4on to produc4on. As marginal product of labor ini4ally increases, MC decreases. As marginal product diminishes, the MC increases

25 Marginal and average cost curves The rela4onship between marginal and average total cost can be established visually. Cost/pizza (\$) MC ATC 5 1, Quantity of pizzas When the MC of producing another unit is less than the ATC, producing an extra unit decreases the ATC. When the marginal cost of producing another unit is more than the average total cost, producing an extra unit will increase the ATC. The MC curve intersects the ATC curve at its lowest point

26 Summarizing costs The following summarizes various costs. Cost Total cost (TC) Fixed cost (FC) Variable cost (VC) Descrip4on The amount that a firm pays for all of the inputs (fixed and variable) that go into producing goods and services Calcula4on TC = FC + VC Costs that don t depend on the quan4ty of output produced Costs that depend on the quan4ty of output produced Explicit cost Costs that require a firm to spend money Implicit cost Costs that represent forgone opportuni4es Average fixed costs Fixed costs divided by the quan4ty of output AFC = FC / Q (AFC) Average variable costs (AVC) Variable costs divided by the quan4ty of output AVC = VC / Q Average total costs (ATC) Total costs divided by the quan4ty of output ATC = TC / Q Marginal cost (MC) The addi4onal cost incurred by a firm when it produces one addi4onal unit of output MC = DTC / DQ 12-26

27 Ac9ve Learning: Costs Fill in the table, assuming that a lease for a building is \$3 and workers wages are \$1 each. Labor (# workers) Total produc4on (# pizzas) 165 Fixed costs (\$) Average fixed costs (\$/pizza) Variable costs (\$) Average variable costs (\$/ pizza) Total costs (\$) Average total costs (\$/pizza) Marginal cost (\$/pizza) 12-27

28 Ac9ve Learning: Costs Fill in the table, assuming that a lease for a building is \$3 and workers wages are \$1 each. Labor (# workers) Total produc4on (# pizzas) Fixed costs (\$) Average fixed costs (\$/pizza) Variable costs (\$) Average variable costs (\$/ pizza) Total costs (\$) , , , , , AFC declines as output increases. AVC declines and then rises as output increases. MC declines and then rises as output increases. Average total costs (\$/pizza) Marginal cost (\$/pizza) 12-28

29 Costs in the long run Costs that are fixed may be adjusted in the long- run. For example, factory sizes can be adjusted to increase or decrease capacity. In the short- run, fixed inputs can not be adjusted. The long- run is the 4me required for a firm to vary all of its costs, if so desired. The long- run depends on firm and produc4on types. The cost curves considered so far are short- run cost curves. When a firm adjusts one of its long- run costs, the en4re fixed cost curve shiis, as it is more efficient and can produce higher output

30 Returns to scale The rela4onship between costs and output is based on the scale of produc4on. The planet size or scale of produc4on to produce a certain amount of output. If increasing the scale of produc4on to obtain higher output lowers the minimum of the average total cost, then economies of scale occur. If increasing the scale of produc4on to obtain higher output raises the minimum of the average total cost, then diseconomies of scale occur. Constant returns to scale occur when the minimum of the average total cost does not depend on the quan4ty of output. When the average total cost is at its minimum, an efficient scale is achieved. 12-3

31 Ac9ve Learning: Economies and diseconomies of scale Match each segment of the long- run ATC with its respec4ve scale or produc4on (economies, constant, and diseconomies). Average total cost Long-run ATC Output 12-31

32 Ac9ve Learning: Economies and diseconomies of scale Match each segment of the long- run ATC with its respec4ve scale or produc4on (economies, constant, and diseconomies). Average total cost When cost per unit goes down as output increases, there are economies of scale. When cost per unit increases as output increases, there are diseconomies of scale. Long-run ATC When cost stays constant as output increases, there are constant returns to scale. Economies of scale Constant returns to scale Diseconomies of scale Output 12-32

33 Long- run ATC The long- run ATC curve is constructed by combining all possible short- run ATC curves. Short- run ATC curves are iden4fied by changing the scale of produc4on. Average total cost Smaller firms Short-run ATCs faced by firms of varying sizes Larger firms Long-run ATC Short- run ATC curves cover a smaller range of output. By increasing or decreasing scale of produc4on, firms can move along the long- run ATC curve from one short- run ATC curve to another. Output 12-33

34 Summary The pursuit of profits drives every firm s decision- making process, including how much to produce and whether to stay in business. Profit is the difference between cost and revenues. This chapter inves4gates the rela4onships between inputs, outputs, and costs by studying a firm s profitability

35 Summary Fixed costs are those that don t depend on the quan4ty of output produced. Variable costs are those that do depend on the quan4ty of output produced. Costs include both implicit and explicit costs. Firms are able to adjust scale of produc4on over 4me. Thus, some costs are fixed in the short run, but become variable in the long run. A firm s long- run cost curve reflects the increased flexibility of fixed costs

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