LESSON 5. The Costs of Production: Supply

Transcription

1 LESSON 5 The Costs of Production: Supply Assigned Reading 1. Mankiw, N. Gregory, et al Principles of Microeconomics (6 th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 13: The Costs of Production Recommended Reading 1. Mankiw, N. Gregory, et al Study Guide to Accompany Principles of Microeconomics (6 th Canadian Edition). Toronto: Nelson Education Ltd. Chapter 13: The Costs of Production Learning Objectives After studying this lesson, students should be able to: 1. identify the items included in a firm's cost of production; 2. explain the difference between economic profit and accounting profit; 3. explain the relationship between the firm's production process and total costs; 4. define total, variable, fixed, and marginal costs; also average total cost, average variable cost, and average fixed cost; 5. explain the relationship between average total cost and marginal cost; 6. identify the shape of a typical firm's cost curves; 7. explain the law of (eventually) diminishing returns, and explain why this law means that marginal cost must eventually rise; 8. explain, using a diagram, why a firm's average cost curve is cut, at its minimum point, by its marginal cost curve; 9. explain the relationship between short-run and long-run costs; and 10. define economies of scale, diseconomies of scale, and constant returns to scale. 5.1

2 Lesson 5 Instructor's Comments The focus of this lesson shifts back to the market process, with attention directed to supply and the costs of production. This lesson looks at the firm's cost of production, revenue and profit, and distinguishes economic cost and profit from traditional accounting cost and profit. We will see that cost and profit take on very specific meanings in economics that differ from the everyday use of the terms. The analysis in this lesson will provide the tools necessary to understand how all firms, from the largest to the smallest, behave under different types of market conditions. The information from this lesson will help students understand why supply curves are upward sloping. Students should understand clearly the different types of costs and how costs affect profits. The importance of per unit costs is also developed. The cost concepts set out in this lesson are subtle in ways that may not also be clear. One key concept is the distinction between fixed and variable costs. Variable costs are defined as those that change as output changes. Fixed costs must be incurred whatever the output level. From a builder's point of view, it is obvious that the costs of materials and labour involved in construction are variable costs. These costs change with the size and quality, rising with each, of the building under construction. By decreasing or even halting production, the builder can avoid these costs. Other costs such as fees for appraisals, legal fees, survey work, and basic environmental assessments are likely to be fixed as they are the same for the lot, no matter what size building is constructed. The concepts of average and marginal cost of development are employed in many ways in real estate. Development can impose burdens on a growing community, requiring it to install additional infrastructure such as roads, schools, and parks. To deal with this, communities levy development cost charges (DCCs) to cover some or all of these costs. In British Columbia, there is a legal requirement that development charges must be related to the infrastructure costs associated with development. This law is designed to prevent municipalities from extorting developers for the permission to develop. One might think that it would make sense to charge a developer the marginal cost of development. In other words, if a developer built 200 units requiring $2,000,000 of infrastructure expenditures, then a development charge based on marginal cost would require a development charge for each unit of $10,000 (equal to $2,000,000 divided by 200). However, it is difficult to identify the marginal infrastructure associated with each specific project. Therefore, communities typically set development charges equal to the average cost of development for all projects expected to be completed over a certain time horizon, such as five years. In other words, if over the next five years a city expects the construction of 10,000 units that are predicted to require $120,000,000 in infrastructure on average, the development charge will then be set at $12,000 per unit. Review and Discussion Questions 1. What is the difference between fixed costs and variable costs? Can fixed costs ever be considered variable? Explain. 2. Explain the relationship between a firm's production function and its total cost. 3. Describe the difference between marginal cost and average total cost. Why are both of these costs important to a profit-maximizing firm? 5.2

3 The Costs of Production: Supply 4. The table below reflects the production function of a firm that uses both capital and labour in its production process. The numbers on the interior of the table are levels of output associated with the usage of capital and labour in the respective margins. For example, when the firm employs 3 units of labour and 4 units of capital, output is 48 units. Labour Capital (a) (b) (c) (d) If two units of capital are used in production, what is the marginal product of the third unit of labour? If four units of labour are used in production, what is the marginal product of the second unit of capital? Does marginal product of labour ever decrease for this firm? Explain your answer. Does marginal product of capital ever decrease for this firm? Explain your answer. (e) Assume that this firm is using three units of capital. If each unit of labour costs the firm $5, what is the marginal cost of output associated with increasing employment from three to four workers? 5. Graphically depict a typical U-shaped long-run average cost curve. On your graph, identify the regions associated with economies of scale, diseconomies of scale, and constant returns to scale. 6. Consider the following production function for a pet supply manufacturer, Linh's Lemming Runs: Number of workers hired: Output: Marginal product: (a) (b) Fill in the missing values for marginal product. With which worker does diminishing marginal product set in? When does marginal product actually become negative? Compare the two cases in terms of the effect on total output. 7. Your uncle, who farms 1,000 hectares in central Manitoba, has always claimed that he is losing money in farming. However, according to his tax returns, he earns a decent profit. Is someone not telling the truth, or does he simply need a better tax accountant? Why do you suppose he stays in agriculture if he is incurring losses as he claims? 5.3

4 Lesson 5 8. Consider the following cost information for a pizzeria: Q (Dozens) Total Cost Variable Cost 0 $300 $ (a) (b) What is the pizzeria's fixed cost? Construct a table in which you calculate the marginal cost per dozen pizzas using the information on total cost. Also calculate the marginal cost per dozen pizzas using the information on variable cost. What is the relationship between these sets of numbers? Comment. 9. Consider the following table of long-run total cost for three different firms: Quantity Firm A $60 $70 $80 $90 $100 $110 $120 Firm B Firm C Does each of these firms experience economies of scale or diseconomies of scale? 10. A real estate salesperson notices the following relationship between hours spent each week trying to sell houses and the number of sales per year. Hours per week Sales per year (a) (b) (c) What is the marginal product of each group of ten hours spent trying to sell houses? Use these data to graph the salesperson's production function. Explain its shape. The realtor has weekly fixed costs of $1,000. The opportunity cost of the salesperson's time is $50 per hour. Graph the salesperson's total weekly cost curve against annual sales. Explain its shape. 5.4

5 The Costs of Production: Supply ASSIGNMENT 5 CHAPTER 13: The Costs of Production Marks: 1 mark per question. 1. Which of the following statements is FALSE? (1) There are no fixed costs in the long run. (2) Total costs are equal to total fixed costs plus total variable costs. (3) In the short run all inputs are variable inputs. (4) A fixed cost is a cost that does not change as output changes. 2. Which of the following represents a fixed expense for a real estate office? (1) Security system fee (2) Paper used for printers (3) Business cards (4) Both (1) and (2) 3. Average total cost curves are u-shaped because: (1) average marginal costs decrease to a certain point and then increase again as output increases. (2) the average fixed cost decreases as output increases. (3) the average variable costs increase as output increases. (4) Both (2) and (3) are true. 4. If the long-run average total cost curve is falling, then: (1) diminishing marginal product is operating. (2) economies of scale are present. (3) constant returns to scale are present. (4) diseconomies of scale are present. THE NEXT FOUR (4) QUESTIONS REFER TO THE FOLLOWING TABLE: Quantity FC VC TC MC ATC AFC AVC W X Y Z 3 10 Assignment 5 continued on the next page 5.5

6 Lesson 5 5. The correct value for the box marked W is: (1) 20 (2) 10 (3) 5 (4) impossible to determine with the given information. 6. The correct value for the box marked X is: (1) 30 (2) 20 (3) 10 (4) impossible to determine with the given information. 7. The correct value for the box marked Y is: (1) 15 (2) 5 (3) 20 (4) The correct value for the box marked Z is: (1) 10 (2) 15 (3) 5 (4) impossible to determine with the given information. 9. Economies of scale: (1) lead to rising long-run average costs as output increases. (2) occur if output less than doubles when capital and labour double. (3) occur if output more than doubles when capital and labour double. (4) occur when management complexity brings rising average costs. 10. A firm's total cost equals the sum of fixed costs plus: (1) marginal costs. (2) variable cost plus marginal costs. (3) implicit costs plus variable costs plus marginal costs. (4) variable costs. 11. Constant returns to scale occur when: (1) long-run average total costs are constant as output increases. (2) marginal product of labour is falling. (3) the firm's long-run average cost curve is falling as output increases. (4) the firm's long-run average cost curve is rising as output increases. 5.6 Assignment 5 continued on the next page

7 The Costs of Production: Supply 12. When marginal cost is less than average total cost: (1) marginal cost must be falling. (2) average total cost is falling. (3) average total cost is rising. (4) average variable cost must be falling. 13. Diminishing marginal product of labour occurs when: (1) adding another unit of labour increases output, but not by as large a margin as the previously employed labour. (2) adding another unit of labour decreases output. (3) adding another unit of labour increases output, by more than the margin of previously employed labour. (4) none of the above. 14. What is the difference between economic and accounting profit? (1) Economic profit is only used by economists. (2) Economic profit considers implicit costs, while accounting profit does not consider implicit costs. (3) Economic profit considers implicit costs, but not explicit costs. (4) Economic profit considers explicit costs, but not implicit costs. 15. Comparing a company's short-run average total cost curve and long-run average total cost curve, the average total cost in the short run will be the average total cost in the long run. (1) equal to (2) larger than or equal to (3) smaller than or equal to (4) Impossible to determine from the information given. THE NEXT TWO (2) QUESTIONS ARE BASED ON THE FOLLOWING INFORMATION: Bill's Bones is an archeology company and retail outlet that "mines" and sells common fossils directly to the public. The structure of his firm's costs are as follows. Assignment 5 continued on the next page 5.7

8 Lesson The efficient scale of production for Bill's Bones occurs at: (1) Q = 100 (2) Q = 120 (3) Q = 150 (4) Q = At what level of output would marginal cost equal average variable cost? (1) Q = 175 (2) Q = 120 (3) Q = 100 (4) Q = An example of an explicit cost of production would be: (1) the cost of foregone labour earnings for an entrepreneur. (2) the cost of flour for a baker. (3) the value a business derives from using the owner's computer to keep payroll records. (4) none of the above. 19. What must be given up to obtain something else is known as: (1) implicit cost. (2) explicit cost. (3) opportunity cost. (4) trade cost. 20. Average variable cost equals average total cost when: (1) marginal cost is rising. (2) there are no fixed costs associated with production. (3) marginal cost is falling. (4) marginal cost equals fixed cost. 20 Total Marks Planning Ahead Note that Project 1 is due next week, on the same due date as Assignment 6. You should be well advanced into the work required for this project by now. 5.8 End of Assignment 5