The Costs of Production and the Benefits of Marginal Analysis

1. The Costs of Productionand the Benefits of Marginal Analysis

2. In this chapter, look for the answers to these questions: What is the difference between fixed and variable costs? What is the law of diminishing marginal returns, and how does it effect your business’s bottom line? How are costs different in the short run vs. the long run? What are “economies of scale”?

3. Total Revenue, Total Cost, Profit the amount a firm receives from the sale of its output the market value of the inputs a firm uses in production 0 Profit = Total revenue – Total cost

4. Fixed and Variable Costs Fixed costs(FC) do not vary with the quantity of output produced. examples: cost of equipment, contractual agreements, loan payments, rent Variable costs (VC) vary with the quantity produced. examples: cost of materials, labor, energy Total cost (TC) = FC + VC 0

5. Marginal Product If a firm hires one more worker, its output rises by the marginal product of labor. The marginal productof any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. Notation: ∆ (delta) = “change in…” Examples: ∆Q = change in output, ∆L = change in labor Marginal product of labor (MPL) = ∆Q ∆L 0

6. Marginal Factor Cost of Labor • When a firm hires a new worker: • Its output rises by MPL (marginal product of labor), but • Its costs rise by the wage the worker is paid MFC (marginal factor cost) • When the MPL = MFC, the firm has hired the optimal number of workers, additional workers will detract from net profits

7. Real World Example: In 2005, Splashdown Water park chose to outsource their concession business after five straight years of losses: splashdown

8. Why MPL Diminishes Splashdown’s concessions rise by a smaller and smaller amount for each additional worker. Why? As the park adds workers, the average worker has less equipment to work with and will be less productive. In general, MPL diminishes as L rises because each worker has less capital to work with. Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)

9. Law of Diminishing Marginal Returns Q Point of diminishing marginal returns Labor MPL

10. Splashdown’s Concession Stand :Marginal Cost MC = ∆TC ∆Q Recall, Marginal Cost (MC)is the change in total cost from producing one more unit: Q TC MC 0 $100 $70 1 170 50 2 220 40 3 260 Usually, MC rises as Q rises, due to diminishing marginal product. Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.) 50 4 310 70 5 380 100 6 480 140 7 620

11. Economic Profit vs. Accounting Profit Accounting profit = total revenue minus total explicit costs Economic profit = total revenue minus total costs (including explicit and implicit costs) Accounting profit ignores implicit costs, so it’s higher than economic profit. 0

12. Costs: Explicit vs. Implicit Explicit costs require an outlay of money,e.g., paying wages to workers. Implicit costs do not require a cash outlay,e.g., the opportunity cost of the owner’s time. Remember one of the Ten Principles:The cost of something is what you give up to get it. This is true whether the costs are implicit or explicit. Both matter for firms’ decisions. 0

13. Calculating costs from a Production Chart Fill in the blank spaces of this table. Q VC TC AFC AVC ATC MC 0 $50 n/a n/a n/a $10 1 10 $10 $60.00 2 30 80 30 3 16.67 20 36.67 4 100 150 12.50 37.50 5 150 30 60 6 210 260 8.33 35 43.33 13

14. Costs in the Short Run & Long Run Short run: Some inputs are fixed (physical capital and natural resources). Long run: All inputs are variable (firms can build more factories, or find additional natural resources).

15. A Typical LRATC Curve ATC LRATC Q In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this:

16. How ATC Changes as the Scale of Production Changes ATC LRATC Q Economies of scale: ATC falls as Q increases. Constant returns to scale: ATC stays the same as Q increases. Diseconomies of scale: ATC rises as Q increases.

17. How ATC Changes as the Scale of Production Changes Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs. Constant Economies of scale are where you want to be.