Econ 12, Foldvary

Mankiw, Chapter 13, Costs of Production

Why does production have a cost?

Because of scarcity.

Output has a cost because inputs are scarce and have opportunity costs.

Profit

The goal of most firms is to maximize profit.

What is profit?

Revenue minus cost.

Profit is a return to which factor? Any factor.

Revenue is all the income a firm receives.

Usually from sales. Other sources: government subsidies. Gifts. Theft.

Revenue from sales = prices times quantities.

Costs can be explicit or implicit.

An explicit cost is a cost recorded by a bookkeeper or accountant.

Expenses paid for with money are explicit. But recorded depreciation is also explicit.

An implicit cost is a non-recorded opportunity cost.

The accounting profit = revenue minus explicit costs.

The economic profit = revenue minus both explicit and implicit costs.

If you are self-employed, the highest foregone income from your assets and labor are implicit costs.

If you want to maximize profits or benefits, you need to look at the economic, not accounting, profit.

Production

Short run: when one input is fixed, or very costly to change.

Fixed costs do not vary with output. Variable costs change with output.

Long run: when all inputs are variable.

(Long and short runs have a different meaning for market equilibrium.)

The production function: Q=f(I), I is a vector of inputs.

It is physical, not financial.

It shows the maximum amount of output Q one can get from inputs I given current production methods and government policies (f).

Q is the total product, or output.

The average product is the total product divided by the number of units.

The marginal product of a factor is the extra output obtained when an input is increased and all other factors as well as the production methods do not change.

In a graph, the slope of the total product is the marginal product.

A fundamental axiom of economics is the Law of Diminishing Returns:

as more units of an input are added when at least one factor is fixed, eventually the marginal product of the units declines.

Like a kitchen where we keep adding cooks.

This is called "diminishing marginal product".

After adding more inputs, the marginal product becomes negative.

The marginal product curve crosses the average product at its peak.

Where does a profit-maximizing firm produce?

Where average product is declining and marginal product is positive.

Relation of cost to product

If the output from some amount of inputs becomes greater,

what happens to the cost of producing the original amount.

For example, if with 5 workers we can produce 20 dinners in a restaurant, what if productivity doubles, and the 5 workers can now produce 40 dinners with the same hours?

Then if we just want to produce 20 dinners, we can do it in half the time.

Doubling the output per worker cuts the cost of production in half.

So when the marginal product of a factor is increasing, this implies that the marginal cost is decreasing.

The marginal and average product curves are therefore mirror images of one another.

Average cost = total cost / units.

Average fixed cost declines to but does not quite reach zero as output expands.

Average short-run total cost tends to be U-shaped because the average fixed cost declines and the marginal cost eventually increases.

Marginal cost crosses average of total cost at its minimum.

The long run

All costs become variable, and the firm can expand all inputs.

But with a greater size, the technology can change to become more productive.

Scale is the size of an enterprise or operation such as a factory.

Economies of scale means that with a lager scale and mass production, the average product increases. Diseconomies of scale means that average product decreases.

When average total cost does not change with more output, this is a constant return to scale.

When average product increases, average cost decreases.

The long-run average cost curve tends to decrease and then increase.

It eventually can increase because of greater costs of management, coordination and overhead.

The antidote is to decentralize operations.

All short-run cost curves lie above and tangent to the long-run cost curve.