COSTS AND PRODUCTIVITY

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Chapter 5

• COSTS AND PRODUCTIVITY

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1. Opportunity Costs

• The correct measure of the costs of any action is
  what has been given up by taking that action
  instead of another. (Why accounting and law
  professors are paid more)
• The opportunity cost of any actionconsumption,
  production, leisure, government spendingis the
  value of the next-best alternative lost.
• Opportunity cost is precisely defined not by any
  alternative but by the next-best alternative.
• The opportunity cost of any resourceland, labor
  capital, materialsis the payment that that
  resource would receive in its next-best
  alternative use.

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1.1 Explicit and Implicit Costs

• When a firm requires resource it makes payments
  for the resources the skilled mechanic gets a
  weekly paycheck etc.
• An explicit cost (also called an accounting cost)
  is incurred when an actual payment is made for a
  resource.
• Firms also incur implicit costs in acquiring and
  using resources no actual payments are made no
  money changes hands, but these are real costs to
  the firm.
• An implicit cost is incurred when an alternative
  is sacrificed by the firm using a resource that
  it owns.

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1.2 Economic Profits

• Economic profit equals the firms revenues minus
  its total opportunity costs (explicit plus
  implicit costs).
• A normal profit is earned when total revenues
  equal total opportunity costs. An economic
  profit is earned when total revenues exceed total
  opportunity costs.

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2. The Short Run and Long Run

• The optimal (profit-maximizing) level of output
  depends on how opportunity costs change with the
  level of output.
• Business firms expand their volume of output by
  hiring or using additional resources.
• As more resources are employed, the opportunity
  costs of production increase.
• The opportunity cost of the resources used to
  produce output depend on their prices and their
  productivity.
• The higher the resource prices, the higher the
  opportunity costs of production.
• The lower the productivity of resources, the
  higher the opportunity costs of production.

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2. The Short Run and Long Run cont.

• Time plays a role in determining resource cost
  some resources can be increased or reduced more
  rapidly than others.
• Variable inputs increase with output.
• Fixed inputs cannot be changed in the relevant
  time frame.
• Economists distinguish between the short run and
  long run when considering the time necessary to
  change input levels.

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2. The Short Run and Long Run cont.

• The short run is a period of time too short for
  plant or equipment to be varied.
• Additional output can be produced only by
  increasing the variable outputs, usually labor
  and material.
• The long run is a period of time long enough to
  vary all inputs and for firms to enter and leave
  the industry.
• The long run is not a predetermined amount of
  calendar time a new assembly line may be
  installed in a few weeks.

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3. Diminishing Returns

• Ricardo, an English economist (1500s), noted
  that agricultural land was in fixed supply even
  though other factors of production like labor,
  could be increased, there were limits to the
  growth of agricultural output.
• As more variable inputs were added to the fixed
  amount of input, land, eventually these variable
  inputs would yield smaller and smaller additions
  to output. Why?
• As the fixed input became overcrowded with
  variable inputs, as more farmhands were added to
  already overcrowded farmland, their extra
  contribution to output would become smaller and
  smaller.

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3. Diminishing Returns cont.

• The marginal product (MP) of laboror of any
  variable factoris the increase in output that
  results from increasing the input by one unit.
• (Labor, output and Marginal product example)
• The law of diminishing returns states that as
  ever larger inputs of a variable factor are
  combined with fixed inputs, eventually its MP
  will decline.
• (Why wine is produced almost everywhere)

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4. Short-Run Costs

• The behavior of costs in the short run reflects
  the law of diminishing returns.

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4.1 Fixed and Variable Costs

• In the short run, some factors (such as plant and
  equipment) are fixed in supply even if the firm
  wanted to increase them, it would not be possible
  in the short run the cost of these fixed factors
  are fixed costs.
• Fixed costs (FC) do not vary with output
  variable costs (VC) do. Total costs (TC) are
  fixed costs plus variable costs TC FC VC.

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4.1 Fixed and Variable Costs cont.

• In the long run, all costs are variable and fixed
  costs are zero. In the short run, some costs are
  fixed.
• There is no way to change fixed costs fixed
  resources have no alternative use they are fixed
  and cannot be used elsewhere.
• Output can be expanded only by an increase in
  variable inputs and thus in variable costs.

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4.2 Marginal and Average Costs

• Productivity and costs are inversely related.
• The higher productivity, the lower costs
• The lower productivity, the higher costs.

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4.2.1 Marginal costs

• TC FC VC
• Since fixed costs are constant, as output
  increases both total costs and variable cost
  increase by the same amount.
• Marginal costs (MC) is the change in total cost
  (or, equivalently, in variable cost) divided by
  the increase in outputor, alternatively, the
  increase in costs per unit increase and output
  (Q) MC ?TC/?Q ?VC/?Q.

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4.2.2 Average cost

• While marginal costs look at the change in costs
  per unit change in output, average costs spread
  total, variable, or fixed costs over the entire
  quantity of output.
• Average variable cost (AVC) is variable cost
  divided by output.
• Average fixed cost (AFC) is fixed cost divided by
  output.
• Average total cost (ATC) is total cost divided by
  output, which also equals the sum of average
  variable cost and average fixed cost.

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4.3 The Cost Curves

• FC VC TC (Panel A, Panel B example)
• FC/Q VC/Q TC/Q
• AFC AVC ATC
• The law of diminishing returns dictates that
  marginal costs must eventually rise as output
  expands.
• Marginal cost equals ATC and AVC at their minimum
  values.

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5. Long Run Costs

• In the long run, enterprises do not have any
  fixed costs all costs are available the
  business is free to choose any combination of
  inputs to produce output.
• Once long run decisions are executed (the company
  completes a new plant), the enterprise again has
  fixed factors and fixed costs.
• In the long run, enterprises are free to select
  the cost-minimizing level of capital, labor, and
  land inputs their decisions are based on the
  prices the firm must pay for land, labor, and
  capital.

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5.1 Shift in Cost Curves

• See Acme Steel example

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5.2 The Long-Run Cost Curve

• In the long run, all costs are variable
  therefore, there is no distinction between
  long-run variable costs and long-run total
  coststhere is only long-run average costs.
• Long-run average cost (LRAC) is the average cost
  for each level of output when all factor inputs
  are variable.
• In the long-run, the enterprise is free to select
  the most effective combination of factor inputs
  because none of the inputs are fixed the
  long-run cost curve envelops the short-run cost
  curves, forming a long-run curve that touches
  each short-run cost curve at only one point.

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5.3 Economics and Diseconomies of Scale

• In the short run, the fact that some factors of
  production are fixed causes the short-run average
  total cost curve to be U-shaped.
• The law of diminishing returns does not apply to
  the long run because all inputs are variable.
• Why would long-run average costs (LRAC) first
  decline as output expands and then later increase
  as output expands even further? Firms experience
  first economies of scale, then constant returns
  to scale, and finally diseconomies of scale as
  output expands.

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5.3.1 Economies of Scale

• The declining portion of the LRAC curve is due to
  economics of scale.
• Economies of scale are present when an increase
  in output causes average costs to fall.
• Workers are able to specialize in various
  activities increase their productivity or
  dexterity through experience, and save time in
  moving from one task to another.

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5.3.1 Economies of Scale cont.

• Economics of scale occur because of the greater
  productivity of specialization in any of a
  variety of areas, including technological
  equipment, marketing, research and development,
  and management.
• As the output of an enterprise increases with all
  inputs variable average costs will decline
  because of the economies of scale associated with
  increased specialization of labor, management,
  plant, and equipment.

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5.3.2 Constant Returns to Scale

• Economies of scale will become exhausted at some
  point when expanding output no longer increases
  productivity.
• Constant returns to scale are present when an
  increase in output does not change average costs
  of production.

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5.3.3 Diseconomies of Scale

• As the enterprise continues to expand its output,
  eventually all the economies of large-scale
  production will be exploited and long-run average
  costs will begin to rise.
• The rise in long-run average costs as output of
  the enterprise expands is the result of
  diseconomies of scale.
• Diseconomies of scale are present when an
  increase in output causes average costs to
  increase.

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5.3.3 Diseconomies of Scale cont.

• Diseconomies of scale can be caused by various
  factors
• As the firm continues to expand, managers must
  assume additional responsibility, and managerial
  talents are spread so thin that the efficiency of
  management declines.
• The problem of maintaining communications within
  a large firm grows, and additional rules,
  regulations, and paperwork requirements become
  commonplace.
• As the output of an enterprise continues to
  increase, average cost will eventually rise
  because of the diseconomies of scale associated
  with the growing problems of managerial control
  and coordination.

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5.4 Minimum Efficient Scale

• Firms and industries differ in their patterns of
  LRAC they have different minimum efficient
  scales.
• The minimum efficient scale is the lowest level
  of output at which long-run average costs are
  minimized.
• Minimum efficient scale is an important
  determinant of industrial structure.
• In industries such as restaurants, commercial
  printing, etc., where firms reach their minimum
  efficient scale at low levels of output, the
  industry is populated by a large number of small
  firms.

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5.4 Minimum Efficient Scale cont.

• In industries such as automobiles and electricity
  generation, where minimum efficiency scale is not
  reached until there are very high volumes of
  output, the industry is populated by a small
  number of large firms.
• Minimum efficiency scale, therefore, plays an
  important role in determining the amount of
  competition in the industry.
• (Airbus versus Boeing example)