Production, Costs and Profit

Chapter 19

Purpose of Production: Profit

n Profit = Total Revenues - Total Costs

n Profit = TR - TC

n Total Revenues (TR):

n dollars received when goods are sold

n Total Costs (TC):

n dollars (and all other opportunity costs) paid to create goods and make them available for sale

Explicit Costs

n Obvious payments for the use of resources

n backed up by a paper trail

n …plus depreciation

n erosion of the value of capital as it is used in production

Implicit costs

n The value of the entrepreneur’s time, talent and effort plus the use of owner’s assets

n The owner’s opportunity cost of being in the business

n Money payment is not necessary

Implicit Costs = Normal Profit

n The minimum return necessary to justify the use of the owner’s time, talent, assets, and effort.

Accounting profit

n Accountants includes explicit costs only.

n Accounting profit = TR - Explicit costs

Economic profit

n The entrepreneur includes both explicit and implicit costs when making a decision.

n Economic profit = (TR - Explicit costs) - Implicit costs

Accounting, Economic, and Normal Profit (chart)

Entrepreneur’s Long-Run Decisions

n Start up or expand a business?

n Continue to operate a business?

n Shrink or close down a business?

Decision making using economic profit

n If economic profit = zero, the business receives enough TR to:

n pay all the bills,

n cover depreciation, and

n get the minimum return necessary to justify the use of the owner’s time, talent, assets, and effort

n The owner will continue to operate the business

Decision making using economic profit

n If economic profit > zero,

n Consumers like the product. To get it, they will pay more than the firm’s costs (TR > TC)

n Owner gets more than the minimum return necessary to keep interested in operating the firm

n Owner may expand the business

n Others may enter as competitors

Decision making using economic profit

n If economic profit < zero, economic losses exist

n Consumers no longer like this product as they did before. They no longer pay enough to cover the costs (TR < TC).

n Owner receives less than the minimum return necessary to keep interested in operating the business at this level

n Owner may shrink or close down the business

Relating The Profit Measures

n Accounting profit

n = TR - Explicit costs only

n Economic profit

n = (TR - Explicit costs) - Implicit costs

n = (TR – Explicit costs) - Normal profit

n = Accounting profit - Normal profit

Economic Profit (chart)

Economic Profit goes to zero (chart)

Production Time Periods

n Short run

n One input must be fixed

n …usually the capital input

n Long run

n All inputs are variable

Short Run

n Capital input is fixed (Fixed Input)

n All other inputs are variable (Variable inputs)

n Owner can increase/decrease the quantity produced (Q) by changing the variable inputs

n The daily production decision.

Long Run

n All inputs, including capital, are variable in the long run

n Owner can add or close down a factory

n The time needed to build a new factory equals the length of the short run

n Investment decisions are made for the long run

Short Run decision making

n The production decision:

n How much (Q) to produce using existing capital input?

n The labor and materials inputs can be increased or decreased to get a desired production

Marginal Physical Product (MPP)

n The change in output that results from increasing the labor input by one (all other inputs remain fixed)

n …sometimes called Marginal Product (MP)

Diminishing Marginal Returns

n Keep increasing the labor input and, eventually, the MPP will begin to decrease.

n Too many workers trying to use too few pieces of capital goods in too small a workspace

Example: Diminishing Marginal Returns (chart)

Marginal Cost (MC)

n The increase in total costs caused by a one unit increase in production.

n MC = change in TC/change in output

Relating MC to MPP (2 charts)

Relating MC to MPP

n Start-up range:

n Q increases

n MPP increases

n MC decreases

n Operating range:

n Q increases

n MPP decreases

n MC rises

Total Costs (TC)

n TC = The cost of all resources used to produce a good or service

n TC = Total Fixed Costs + Total Variable Costs

n TC = TFC + TVC

Fixed Costs (TFC)

n TFC = Payments for the fixed inputs

n TFC do not change as quantity produced (Q) changes

n TFC must be paid even if Q = 0

Variable Costs (TVC)

n TVC = Payments for the variable inputs

n TVC increase as quantity produced (Q) increases and vice versa.

n At start up (low levels of Q), TVC rise fast as Q increases

n In the production range (middle levels of Q), TVC rise more slowly as Q increases

n Near maximum capacity (at high levels of Q), TVC rise faster as Q increases

Fill in the blanks below (chart for in-class calculation)

Total Cost (chart)

TC, TFC, and TVC

n TFC plots out as a straight line.

n Both TVC and TC rise fast at first, then rise more slowly through the operating range, then rise faster again near maximum capacity

The Production Cost Model

n All production firms face these costs.

n AFC = Average fixed costs = TFC/Q

n AVC = Average variable costs = TVC/Q

n ATC = Average total costs = TC/Q

n MC = Marginal cost = (change in TC/change in Q)

Calculating the Production Model (chart)

Calculate AFC = TFC/Q (chart)

Calculate AVC = TVC/Q (chart)

Calculate ATC = TC/Q (chart)

Calculate MC = change in TC/change in Q (chart)

Calculate MC = change in TC/change in Q (chart)

Production Cost Model (chart)

Shape of the AFC curve:

n TFC does not change as Q increases.

n Thus, AFC (= TFC/Q) is high when Q is small and decreases fast as Q increases

n Shaped like a ski slope

Shape of the AVC curve:

n AVC (= TVC/Q) starts at high values when Q is small, decreases to a minimum point as Q increases, then rises again as Q approaches maximum production capacity

n A bowl shaped curve

Shape of the ATC curve:

n ATC = AFC + AVC

n Both AVC and AFC are high at low values of Q, so ATC is high also

n Both AVC and AFC decrease as Q increases, ATC does also, ultimately reaching a minimum point

n Beyond its minimum, ATC increases rapidly as Q approaches capacity

n A bowl shaped curve also

Shape of the MC curve:

n MC decreases at low levels of Q, hits a minimum point, then rises as Q increases

n MC crosses upward through both AVC and ATC at their minimum points

n A hook shaped curve

Average Cost and Marginal Cost Curves (chart)

Sunk Cost

n A cost incurred in the past that cannot be changed in any current decision.

n All sunk costs must be ignored when making a decision.

Long run decision making

n The investment decision:

n How large should the capital input (factory) be?

n Also called its “scale”

n Economies of scale - ATC decreases as size increases

n Diseconomies of scale - ATC increases as size increases

Economies of scale

n ATC decreases as size increases

n A firm will increase the size of the factory as long as ATC falls

n Sources of economies of scale:

n Setting up an assembly line process

n Introducing specialization

n Buying variable inputs in bulk at lower prices

Diseconomies of scale

n ATC increases as size increases

n A firm should stop increasing its size when ATC begins to rise

n Sources of diseconomies of scale:

n Span of control too large

n Management levels are created, forming costly bureaucracy

n Decision making separates from production

Long Run ATC

n The ideal sized factory operates at the lowest ATC.

n It achieves all the economies of scale and none of the diseconomies of scale.

Long Run ATC

n A firm should choose the firm’s size to attain all economies of scale and none of the diseconomies of scale.