Ch 13: The Costs of ProductionFriday, November 14, 20147:10 PM -According to the law of supply, firms are willing to produce and sell a greater quantity of a good when the price of the good is higher, and this response leads to a supply curve that slopes upward.-Industrial organization: the study of how firms' decisions about prices and quantities depend on the market conditions they faceWhat Are Costs?-Total Revenue, Total Cost, and ProfitoEconomists normally assume that the goal of a firm is to maximize profitoEx: Caroline's Cookie FactoryoTotal Revenue: the amount a firm receives for the sale of its outputs (cookies)-The quantity sold times the price at which it is soldoTotal Cost: the market value of the inputs a firm uses in production (flour, sugar, workers, ovens, etc.)oProfit: Total revenue minus total cost-Costs as Opportunity CostsoRemember: The cost of something is what you give up to get it. oOpportunity cost of an item refers to all those things that must be forgone to acquire that item. oExplicit costs: input costs that require an outlay of money by the firmoImplicit costs: input costs that do not require an outlay of money by the firmoThe total cost of the business is the sum of the explicit and implicit costsoEconomists include both explicit and implicit costs when measuring a firm's costs while accountants measure explicit costs and usually ignore the implicit costs-The Cost of Capital as an Opportunity CostoAn important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. -Suppose Caroline used $300,000 of her savings to buy the cookie factory. If she had left this money in her savings account instead that pays an interest rate of 5%, she would have earned $15,000 a year. To own her factory, she has given up $15,000 a year in interest income. This forgone $15,000 is one of the implicit opportunity costs of her businessoAn economist views the $15,000 in interest income as a cost of her business, even though its an implicit costoAn accountant, however, will not show this $15,000 cost because no money flows out of the business to pay for it-Economic Profit versus Accounting ProfitoEconomic profit: total revenue minus total cost, including both implicit and explicit costsoAccounting profit: total revenue minus total explicit cost How an EconomistViews a Firm:How an AccountantViews a Firm: Economic ProfitAccountingProfit Economic profit is smaller than accounting profitImplicit Costs Revenue Total Opportunity CostsRevenueExplicit costsExplicitCosts Production and Costs-Firms incur costs when they buy inputs to produce the goods and services that they plan to sell-Assumption: the size of Caroline's factory is fixed and that she can vary the quantity of cookies produced only by changing the number of workers she employsoThis assumption is realistic in the short run but not the long run.-The Production Function: the relationship between quantity of inputs used to make a good and the quantity of output of that goodoRemember: Rational people think at the marginoMarginal product: the increase in output that arises from an additional unit of inputoDiminishing marginal product: the property whereby the marginal product of an input declines as the quantity of the input increasesoThe slope of the production function measures the marginal product of a worker. As the number of workers increases, the marginal product declines, and the production function becomes flatter.-From the Production Function to the Total-Cost CurveoTotal-cost curve: graphs the relationship of the quantity produced and the total costsoThe total-cost curve gets steeper as the amount produced rises. oWhen the Caroline's kitchen is crowded, producing an additional cookie requires a lot of additional labor and is thus very costly. Therefore, when the quantity produced is large, the total-cost curve is relatively steep. Production functionTotal-cost curveQuantity ofOutputTotalCostNumber of Workers HiredQuantity ofOutput The Various Measures of Cost-Conrad's Coffee Shop with a total-cost curve similar to Caroline's-Fixed and Variable CostsoFixed costs: costs that do not vary with the quantity of output produced-Include rent the firm pays because this cost is the same regardless of how much coffee he produces. Could include a full-time bookkeeper he hired to pay bills because regardless of the production, their salary is still fixedoVariable costs: costs that vary with the quantity of output produced-Costs of coffee beans, milk, sugar, paper cups, etc. The more cups of coffee produced, the more of each of these items he needs to buy. Also, if he needs to hire more workers to make more coffee, the salaries of the workers are variable costs. oA firm's total cost is the sum of fixed and variable costs-Average and Marginal CostoAs the owner, Conrad has to decided how much to produce. -How much does it cost to make the typical cup of coffee?-How much does it cost to increase production of coffee by 1 cup?oThese questions are important to understanding how firms make production decisionsoAverage total cost: total cost divided by the quantity of output-ATC = TC / QoBecause total cost is the sum of fixed and variable costs, average total cost can be expressed as the sum of average fixed cost and average variable costoAverage fixed cost: fixed cost divided by the quantity of outputoAverage variable cost: variable cost divided by the quantity of outputoMarginal cost: the increase in total cost that arises from an extra unit of production-MC = ΔTC / ΔQoAverage total cost tells us the cost of a typical unit of output if total cost is divided evenlyover all units produced. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output. -Cost Curves and Their ShapesoRising Marginal Cost (MC)-Conrad's marginal cost rises with the quantity of output produced. This reflects the property of diminishing marginal product. -When the quantity of coffee produced is already high, the marginal product of an extra worker is low, and the marginal cost of an extra cup of coffee is large. oU-Shaped Average Total Cost (ATC)-Average total cost always declines as output rises because the fixed cost is spread over a larger number of units. Average variable cost typically rises as output increases because of diminishing marginal product. -Efficient scale: the quantity of output that minimizes average total cost.