Chapter 7 Production and Cost Basic Principles of Cost 1 Costs relate to a specific decision 2 Cost is always opportunity cost includes what you must give up 3 Cost is measured in dollars 4 Cost is a flow variable not a stock variable 5 Sunk costs are irrelevant the costs that are unavoidable and must be paid regardless of the decision at hand Categories of Cost A Explicit vs Implicit Cost Explicit Money directly paid Implicit Money that is part of the opportunity cost not money directly paid Explicit Costs Implicit Costs Labor Depreciation decrease in value of wealth Raw materials Forgone interest the money that could have been made by Rental payments Forgone rent the money that could have been made by renting out investing land to another individual Interest payments Forgone salary of owner the money the owner of a business could be making by working a normal job Example Suppose you start a business With 100 000 of start up capital you spend 10 000 on a location consultant and 90 000 on equipment You have the ability to lend out the 90 000 at 5 interest The 10 000 is now a sunk cost it is irrelevant because you can t get it back from the consultant and the 90 000 in equipment has an opportunity cost of 4 500 per year because you could invest the money elsewhere forgone interest B Accounting vs Economic Costs Accounting costs are explicit only excluding depreciation Economic costs are all explicit and implicit costs C Fixed vs Variable Fixed inputs Quantity cannot be changed as input changes e g quantity of dormitories for a university is a fixed input because it takes at least a year to increase the quantity of dorms as student enrollment increases Variable inputs Quantity can be changed as input changes e g quantity of security guards for a university is a variable input because they can be readily hired throughout the year as student enrollment increases D Short Run vs Long Run time horizons Short Run Time horizon over which at least one input is fixed if any inputs are fixed over this time period then it is considered short run Long run Time horizon over which all inputs are variable Costs in the Short Run time horizon Quantity TFC Total TVC Total TC AFC AVC ATC Marginal Cost output Fixed Variable Total Average Average Average per day Cost Overhead Cost Operating Cost Fixed Cost Variable Total Cost Fixed cost per unit Cost TVC Q TC Q AVC AFC Undefined Undefined Undefined 300 TFC Q 200 100 67 50 40 200 500 600 760 1 00 1 400 300 200 187 200 240 500 300 254 250 280 TC Q 100 160 240 400 Costs 0 300 400 560 800 1 200 0 1 2 3 4 5 200 200 200 200 200 200 AVC first falls and then rises Marginal cost cost of producing one more unit Distance between AVC and ATC is the Average Fixed Cost The Marginal Cost curve intersects the ATC and AVC curves at their minimums Why is Marginal Cost U Shaped Marginal Sandwich Production Labor of workers 0 1 2 3 4 5 Quantity sandwiches produced 0 3 8 14 19 22 Labor Cost 30 cents per minute 0 0 30 0 60 0 90 1 20 1 60 0 10 0 06 0 05 0 06 0 10 Marginal Cost amount paid per sandwich o Adding one more worker allows them to specialize making sandwich production more than double o When you add a fourth worker the efficiency begins to decline because with three workers you already have one worker for each step in the sandwich making process o Marginal Product of Labor MPL Change Quantity Change Number of Workers o From 0 3 workers there are increasing marginal returns to labor o From 3 workers onwards there are diminishing marginal returns to labor As quantity rises If Marginal Product of Labor MPL rises then Marginal Cost lowers increasing returns If Marginal Product of Labor lowers then Marginal Cost rises diminishing returns This is why the Marginal Cost is U Shaped o Eventually you have so many workers that productivity becomes negative Course 0 1 2 3 4 5 Q 0 1 2 3 4 5 Marginal University Grades Grade in Course Undefined A 4 0 C 2 0 F 0 D 1 0 C 2 0 Overall GPA Undefined 4 0 3 0 2 0 1 75 1 8 Whenever the next unit produced e g the next grade earned is higher than the average total cost e g the overall GPA then the average total cost overall GPA rises This occurs when you score a C in Course 5 Least Cost Rule LRTC 0 400 600 720 900 1 250 LRATC Long Run Average Total Cost LRTC Quantity 400 300 240 225 250 LRATC cost per unit lowers first and then rises while LRTC always rises When the short run and long run average total costs are the same then the firm would choose the same level of inputs in the short run that it would in the long run Why Why Long Run Average total cost is always less than or equal to Short Run Average total cost this is because in the long run when all inputs are variable a firm would always choose the combination of inputs with the smallest cost Economies of scale occur at low levels of output as quantity rises LRATC lowers ie Downward slope 1 Increasing opportunity for specialization 2 Spreading the costs of lumpy inputs an input that is needed in one big lump to produce a wide range of output E g One x ray machine will provided for 1 50 clients therefore the LRATC is high for low levels of output but lowers significantly with more output Diseconomies of scale occur at high levels of output as quantity rises LRATC rises i e Upward slope Problems of bigness Keeping track of employees to prevent them from stealing Bureaucratic decision making difficult to make changes Constant Returns to Scale occur when there is no change in LRATC as quantity rises flat curve The cost reducing phenomena from economies of scale get smaller and smaller e g opportunity for specialization gradually decreases Firms and Market Size Imagine 5 firms in a market each producing 6 000 units market size is 30 000 units This is an oligopoly market with a few firms They charge 2 000 to cover costs One firm drops its price to 1 990 to take customers from the other firms its quantity will rise from 6 000 to 10 000 and LRATC will fall economies of scale cost per unit drops to 1 000 Profits rise significantly it is now at its MES minimum efficient scale minimum of the LRATC curve The other firms now produce 5 000 because the other firm took their competition and their cost per unit rises to 2 500 Now they must increase price even more to cover production costs OR these other firms can raise their costs as well they can drop their prices and move …