COSTS OF PRODUCTION

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COSTS OF PRODUCTION

• PRINCIPLES OF MICROECONOMICS

Dr. Fidel Gonzalez Department of Economics and
Intl. Business Sam Houston State University
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In this section of the semester, we will focus
our attention to the behavior of the firm. That
is, we want to know how firms behave and how
firms determine how much to produce. We first
start by defining what is the firms only
goal. The firm is in business to make the largest
possible profit. In other words, the firm is in
business to maximize profits. Since the firm is
in business to maximize profits we need to have a
definition of profits Profit Revenue -
Costs Profits are composed of revenue and costs.
The revenue is how much the firm receives from
the sale of its good. The cost is how much the
firm has to pay to produce the good. Since,
revenue and costs determine profit we need to
understand them to know how the firm behaves.
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• Revenue
• The firms revenue can be written as
• Revenue Price x Quantity
• That is, the revenue is the price charged for the
  good times the number of goods sold by the firm.
  Notice that the price is a price per unit. For
  example is the price for shirts is 4 and a firm
  sold 9 units of them, then the firms revenue is
  4 x 9 36.
• Now lets set Price P and Quantity Q
• We can now re-write the revenue as
• Revenue P x Q
• The revenue will behave in different ways
  depending of the type of market that the firms
  operates. There are four types of markets
  competitive, oligopoly, monopoly and monopolistic
  competition. Since we have not covered this
  markets yet we will leave the discussion of the
  revenue to when we cover each particular market.
• We now move to the other part of the profit
  costs.

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2) Costs All firms want to keep low costs
because that increases their profit. However, we
first need to define what we mean by costs. In
general, there are two types of costs explicit
and implicit. Explicit Cost costs that require a
monetary payment from the firm (there is an
outlay of money). The firm in this case is
actually paying someone. Implicit Cost costs
that DO NOT require a monetary payment from the
firm. The firm in this case is not paying money
for a good or service. Costs Explicit
Implicit From now whenever we talk about cost we
are consider both implicit and explicit cost.
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The difference between implicit and explicit is
important when we compute the profit. When
computing the profit accountants only consider
the explicit cost and economist consider both
implicit and explicit cost. Imagine a firm with
the following costs and revenue Implicit Cost
50 Explicit Cost 30 Revenue 100 Accountant
Profit Revenue Explicit Cost 100 30
70 Economic Profit Revenue Explicit Cost
Implicit Cost 100- 50 -30 20 The difference
is quite big between accountant and economic
profit. For this class, whenever we talk about
profit we are referring to the economic profit.
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Before we continue with more definitions of costs
we will talk about the technology of the
firms. Why? Because the technology of the firm
determines the way costs behave. For example,
cars used to be very expensive at the beginning
of the 1900s, this is because the technology
they used. Back then only a handful of people
could afford to buy cars. Nowadays, firms use a
different type of technology so cars are
cheaper. To summarize We will study the firm and
firms only concern is to maximize profits.
Profits are composed of revenue and costs. The
revenue P x Q and it depends on the type of
market the firms operates. The costs of the firm
depend on the technology of the firm, so we will
first cover technology and then move on to costs.
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Profit Total Revenue Total Cost
Costs depend on the technology or production
Revenue depends on the market structure
Study production or technology to understand cost
We will study market structures in the next slide
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3) Technology The technology of the firm is how
the firms uses inputs to produce and
output. Inputs are defined as the resources
that the firm uses to produce something else.
Examples of inputs are labor, electricity, raw
materials, buildings and so on. Output is what
the firm is actually producing (the final
product). Examples of outputs are cars,
computers, watches, and so on. For example a firm
uses the inputs cotton, labor and sewing machines
to produce the output t-shirts. Economists divide
inputs into three big categories capital (K),
labor (L) and natural resources (NR) Capital (K)
refers to physical machines, building and
equipment used in production. Capital DOES NOT
refer to the amount of money the firm has. Labor
(L) refers to the amount of workers. Natural
Resources (NR) refers to the raw material used
in production such as oil, electricity, cotton,
etc.
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Firms use inputs to produce and output. The
relationship between these two is called the
production function. Production Function the
relationship between the inputs and output. That
is, the production function tell us how many tons
of cotton, labor, sewing machines and workers are
necessary to produce certain amount of t-shirts.
Thus, the production function represents the
technology of production. The production function
is usually written as follows Q
f(K,L,NR) f(K,L,NR) can be read as depends on
K,L,NR. Therefore, Qf(K,L,NR) is read as the
output (Q) depends on K, L and NR. Notice that
f(K,L,NR) is NOT a multiplication or addition or
anything like that, it just says that Q depends
on L, K, and NR. In order to simplify things we
are going to forget about NR, this is just to
make our life easier. Therefore, we are going to
re-write the production function
as Qf(L,K) That is, output depends on labor and
capital.
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Production and Time Horizon
In the case of production the time horizon
matters. Firms usually have more constraints in
the long-run than in the short run. In fact, we
can say that in long-run everything is possible
for the firm while in the short-run only few
things can happen. For example, imagine that you
produce donuts and you get a huge order of donuts
for next week (3 million donuts). Most likely you
will not be able to do it. Why? Because you need
more machinery more supplies and more workers.
You can probably hire more people relatively
easy, say in a couple of days. But bringing new
machinery and equipment and having a bigger shop
will take months if not years. Thus, we usually
say that in the short-run some input are
variable. This means that in the short-run this
inputs some can be increased or reduced easily
(Labor for example) while others (Capital) cannot
be changed in the short-run. However, in the
long-run (that is in the distant future)
everything is possible. In that future you can
hire more workers but you can also build a bigger
factory with more equipment and machinery to make
donuts.
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Production and Time Horizon
This take us to the main distinction between
short and long run In the short-run at least
one input (usually capital) is fixed (that is one
input does not change). In the long-run ALL
inputs are variable (all inputs can be increased
or decreased). From now on, we are going to talk
about production in the short-run unless
otherwise is explicitly noted.
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Now, that we understand the production function
we are going to look at one numerical example and
then we will expand it later to include
costs. Example Consider a firm that produces
cars (Q) using capital (K) and Labor (L). Because
it is the short-run we are going to have capital
fixed. The following table show the different
amount of labor and capital that yield the
corresponding output.
Notice that when the firm has no Labor it
produces nothing but still has one unit of
capital because capital is fixed. When the firm
has one unit of labor and one unit of capital the
firm produces 1 unit of output (1 car). When the
firm has two units of labor and one unit of
capital the firm produces 3 units of output (3
cars) and so on.
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In addition, notice that output increases from
zero to 22 and then decreases as we increase the
number of workers. MPL is the marginal product of
labor. MPL is the amount of output that an extra
unit of labor will produce. The formula for the
MPL is the following
MPL tells the firm how much an extra worker will
produce and therefore it is important
information. If you are a firm owner and you are
thinking about hiring someone you have to
consider the MPL of that worker and compare it to
how much you will pay the worker to see if it is
worth it (we will talk about this in the topic,
but you can see now how MPL is important). MPL
increases reaches a high point and then
decreases.
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Why does MPL first increases and then
decreases? This happens because of
specialization. Consider the following
example. You have a lemonade stand and you have
all you equipment and a single table where you
must prepare the lemonade. When you hire your
first worker, he has to do everything cut the
lemons, squeeze them, pour the water, the sugar,
stir, put ice, serve the individual cups and
attend customers. Obviously having one worker is
better than having no worker. If you hire a
second worker the two workers can specialize a
litle bit. One person will take care of cutting
the lemons and squeeze them while other one will
pour the water and the sugar and attend
customers. This specialization makes the second
worker more productive. In our previous example,
the second worker produces 2 more units of output
while the first worker produces only one unit.
As you keep increasing the number of workers the
specialize more and more so that each worker
produces more than the previous worker and MPL
keeps increasing.
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However, at some point specialization reaches a
limit. The limit is reached when you have a lot
of people working in the same table. As you can
tell when you have more and more workers working
all in the same table and sharing the same
equipment they will be in each others way and
therefore they will not be as productive. When
this happens the advantage of specialization
start to decrease and MPL decreases. If you
adding worker you will actually reach a point
when adding an extra worker reduce output. This
is a worker that makes everyone slow down and
production decreases when you hire him. In our
previous example, this will be the tenth worker
and no rational firm will hire him. Why
specialization reaches a limit? The reason is
that capital is fixed. That is, you can only use
one table to produce lemonade and only one set of
equipment and machinery. However, if you cold
have more tables and equipment MPL will never
decrease. Therefore MPL will increase and later
decrease in the short-run because in the
short-run capital is fixed. Finally,the last
column of the previous example shows APL which is
the average product of labor. The a
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Finally, the last column of the previous example
shows APL. APL is the average product of
labor. APL tells us what is typical amount that a
worker will produce. The formula for APL is the
following
APL also increases and then decreases.
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Costs
Now, that we understand the production process of
the firm we can study the firms costs. We will
resume with the previous example we mentioned
before. In order to get the costs of the firm we
need to know the price of the inputs. In this
case, we need to know the price of labor and
capital. We will assume that the price of labor
is 50 and the price of capital is 20. Now we
need to obtain some definitions of costs 1)
Fixed Cost (FC) costs that do not vary with the
quantity produced. Examples of fixed costs are
buildings, expensive or heavy equipment, book
keeping and so on. 2) Variable Cost (VC) costs
that vary with the quantity produced. Examples of
variable costs are labor, raw materials,
electricity, and so on 4) Total Cost (TC) Fixed
Cost Variable Cost
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Costs
5) Average Fixed Cost (AFC) Fixed Cost /
Output AFC is the typical fixed cost of one unit
of output. 6) Average Variable Cost (AVC)
Variable Cost / Output AVC is the typical fixed
cost of one unit of output. 7) Average Total Cost
(ATC) Total Cost / Output ATC is the typical
fixed cost of one unit of output. Because the TC
VC FV then ATC AVC AFC 8) Marginal Cost
(MC) the change in the total cost from
producing one extra unit Using all these
different definitions of costs and the price of
labor and capital we obtain the table in the
following slide
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Costs
Price of Labor 50 Price of Capital 20
Production
Total Costs
Per unit costs
The previous table can be divided into three
parts. The production section, the total cost
section and the per unit section. As it turns out
all the relevant information can be obtained by
looking at the per unit costs. Hence, we will
graph the per unit cost and get a summary of the
important results.
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The graph of the per unit costs is the following
MC

ATC
AVC
AFC
Q
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Costs

• The previous table has a lot of information. Lets
  have a summary of the main points
• AFC is always decreasing.
• AVC decreases reaches a low point and then
  increases again.
• ATC decreases reaches a low point and then
  increases again.
• MC decreases reaches a low point and then
  increases again.
• When MC gt ATC then ATC is increasing
• When MC lt ATC then ATC is decreasing
• 6) MC crosses ATC and AVC at their lowest point