Chapter 9 notes

Chapter 8 - Cost of Production

Chapter 8 focuses on the economists approach to production costs. Business students are advised be careful not to confuse the concepts in Chapter 8 with what they may have learned in a Business Accounting course. This chapter does not deal with how much of a given product a firm should produce in order to maximize profits. That comes in Chapters 9, 10 and 11. Chapter 8 deals exclusively with the relationships between resource quantities and output and between output and cost.

Explicit and Implicit Costs:

Economic costs are the the payments a producer must make and the incomes it must forego in order to produce some output. Explicit costs are out-of-pocket cash payments made to others for the use of resources. They may be viewed as accounting or book costs (wages and salaries paid to employees, payments for raw materials, rent or lease payments, utility bills, etc). Implicit costs are opportunity costs or income foregone for the use of self-owned or self-employed resources. One implicit cost is a normal profit, which is that amount of profit necessary to keep the entrepreneur's talent or skills in that particular enterprise. If the owner or entrepreneur does not earn at least a normal profit, she will take her entrepreneurial skills to some different enterprise. This is an abstract idea that is often difficult for students to understand. In order to provide examples, the author assigns a dollar value as normal profit, but in the real world, there is no way to quantify a normal profit. In theory, however, we assume that there is some minimum payment that the owner expects if she is to continue in the current enterprise. Be careful. An entrepreneur does not go into a business hoping to earn a normal profit, but rather to maximize profits.

Economic profit (sometimes referred to as pure profit) = Total Revenue - Total Cost and total cost includes both explicit and implicit costs (including a normal profit). Therefore, a firm could be earning zero economic profit, but still be earning a normal profit.

Long Run and Short Run:

The short run refers to that period of time in which one of the factors of production is fixed. Because in many cases the fixed factor is capital or plant size, the short run is often referred to as "fixed plant." The producer may vary his output by applying different amounts of the other factors to the fixed plant. The long run or variable plant time is that period of time necessary in order to vary all factors. Remember, the "plant" is a term of art referring to the factor that is fixed in the short run. As with many of the terms in economics, it connotes factory production. However, the "plant" could be the size of a restaurant or the number of acres of land that a farmer has to plant.

Short-run Production Function:

Here, we assume that a producer uses only two resources, capital and labor. Capital is fixed in the short run, and the producer varies her output by increasing or decreasing the number of units of labor applied to the fixed capital.

The law of diminishing returns states that, as successive units of the variable factor (labor) are applied to a fixed factor (capital), beyond some point the extra or marginal product attributed to each additional unit of labor will decline. Note that this is the same idea that we dealt with in Chapter 7's diminishing marginal utility. The difference is that in Chapter 7, we assumed that diminishing returns began with the second unit consumed. In Chapter 8, we assume that initially, as the producer hires additional workers, the returns (increased output) to each added worker increase up to a point. But, beyond some point, the marginal product of additional workers declines. Read carefully pages 147-150 and focus on the relationship between Total Product (TP), Marginal Product (MP), and Average Product (AP) described in Figure 8.2. Here is the key! When MP is positive and increasing, TP is increasing at an increasing rate. When MP is positive and decreasing, TP is increasing at a decreasing rate. When MP is zero, TP is at its maximum. When MP is negative, TP is declining AP will be equal to MP at the maximum AP.

Short-run Production Costs: The short-run production function in the last section must now be coupled with resource prices to determine per unit and total cost of producing various levels of output.

Because, in the short-run some of the factors of production are fixed and others vary with output, the total cost of producing some output must be the sum of fixed costs and variable costs. Spend some time with Figure 8.3. Note that TFC does not change with output. TVC does increase with output, first at a decreasing rate and then at an ever increasing rate. Why?? Note also that at any level of output, the vertical distance between TC and TVC is TFC.

Total Cost = Total Fixed Costs + Total Variable Costs

Per-unit or average costs are important to producers especially in making comparisons with product price. In Chapter 9, we will see that price is always equal to average revenue. Do not make this more complicated than is necessary!! An average is an average. So, Average Fixed Cost (AFC) is simply Total Fixed Cost divided by output (Q). Similarly, Average Variable Cost (AVC) is Total Variable Cost divided by output (Q). And, Average Total Cost (ATC) is Total Cost divided by output.

AFC =

AVC =

ATC =

A very crucial concept remains. Marginal Cost is the additional cost of producing one more unit of output. It is the change in Total Cost when producing one more unit of output.

MC =

Note that the U-shape of the MC curve is a consequence of the law of diminishing returns. If all units of labor are hired at the same wage, the marginal cost of each extra unit of output will fall as long as the marginal product of each additional worker is rising. When marginal product begins to fall, marginal cost will increase. See Figure 8.6

Shifts of the cost curves: Read the left column on Page 154-155 carefully. Note that if fixed costs increase, the ATC curve will shift up, but the AVC and MC curves will not change. Why? However, if the price of labor or some other variable input increases, AVC, ATC, and MC curves will shift up. What about improved production technology?

Long-run Production Costs:

Suppose a restaurant owner starts with a restaurant which seats 50 people and a kitchen of some fixed size. In the short-run she can vary the number of customers fed by varying the number of cooks and wait staff, but the restaurant and kitchen size represent her fixed plant. If she knocks out a wall, adds tables and enlarges the kitchen, she now has the capacity to feed more. She has moved from one short-run situation to another, but with a larger fixed plant. Every time she knocks out the wall to enlarge the restaurant (plant), she faces a new short-run ATC profile. For a time, these larger restaurants will allow the owner to take advantage of economies of size or scale and average total cost may fall. But, beyond some point, these economies of scale are exhausted. If she continues to enlarge her restaurant, average total cost begins to increase. She runs into diseconomies of scale or size.

Look at Figure 8.7. Each of the red curves represents short-run ATC. Each time the owner knocks out the wall to enlarge the restaurant, she moves to a new short-run situation, only with a larger restaurant. The blue curve represents is an envelope which encompasses all of the short-run situations. It is the owners long-run ATC.

Figure 8.9 depicts three possible long-run ATC curves faced by firms in different industries. In some industries, firms exhaust the economies of scale at a relatively small output. These industries are populated by a relatively large number of firms producing a relatively small output. In other cases, economies of scale exist over a large output. In these industries, there are a dew very large firms, and in the case of the natural monopoly, only one firm can be large enough to take advantage of the economies of scale.

The minimum efficient scale (MES) refers to the lowest level of output, or the smallest size at which a firm can minimize long-run average cost.

Applications:

1. Exercise #1 will be provided in class as hard copy.

2. Jane quit her job at IBM where she earned $50,000. a year. She cashed in $50,000 in corporate bonds that earned 10% interest annually and used the proceeds to buy a minibus and set up a commuter service between Lincoln and Omaha, Nebraska. She has 1000 customers who will pay $400 each year to use the service. Jane will use $280 from each commuters payment for gas, maintenance, insurance, depreciation, etc. Answer the following based on the above facts:

(A) What are Jane's total revenues?

(B) What are her explicit costs?

(D) What is her economic profit/loss?

3. Your author claims the relationship between marginal product and average product is a mathematical necessity. In your own words (please don't mimic the text), explain this relationship and its mathematical necessity. Now, do the same for the relationship between marginal cost and average total cost.

4. It is sometimes said that production in the long run is simply a series of short run options. Explain.

5. What is minimum efficient scale (MES)? What insights does it provide about the size of firms in an industry?

6. What is the economic meaning of the saying "Don't cry over spilt milk," and its implications for economic decision-making?