Microeconomics

Module 7: Production and Costs

Why It Matters: Production and Costs

• The theory of the firm seeks to understand what motivates firms to make the operating
decisions that they do
• Two main takeaways:
1. There are several different ways to look at production and costs, just like there are several different
ways to look at a student’s learning in a course
2. There is an inverse relationship between production and costs
• Do not confuse cost with price. From the firm’s perspective, cost is what they pay for the
inputs necessary to produce the product. Price is what the firm receives for selling the
product.
• Cost is a negative and price is positive; they are not the same thing.
What is Production?

• A firm (or business) combines inputs of labor, capital, land, and raw or finished component
materials to produce outputs
• If the firm is successful, the outputs are more valuable than the inputs
• Production involves a number of important decisions that define the behavior of firms. These
decisions include, but are not limited to:
• What product or products should the firm produce?
• How should the products be produced
• How much output should the firm produce?
• What price should the firm charge for its products?
• How much labor should the firm employ?
 What is Production? Cont.

• The answers to these questions depend on the production and cost conditions facing each firm
• The answers also depend on the structure of the market for the product(s) in question
• Market structure is a multidimensional concept that involves how competitive an industry is. It is
defined by questions such as these:
• How much market power does each firm in the industry possess?
• How similar is each firm’s product to the products of other firms in the industry?
• How difficult is it for new firms to enter the industry?
• Do firms compete on the basis of price, advertising, or other product differences?
Factors of Production
• Production is the process (or processes) a firm uses to
transform inputs (e.g. labor, capital, raw materials) into
outputs, i.e. the goods or services the firm wishes to sell
• Consider pizza making. The pizzaiolo (pizza maker)
takes flour, water, and yeast to make dough

• Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce
• He or she rolls out the dough, brushes on the pizza sauce, and adds cheese and other
toppings
• Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the
good
The Factors of Production
• Natural Resources (Land and Raw Materials): The ingredients for the pizza are raw
materials
• Labor: Labor means human effort, both physical and mental, the pizzaiolo was the primary
example of labor here
• Capital: physical capital, the machines, equipment, and buildings that one uses to produce the
product, the capital includes the peel, the oven, the building, and any other necessary
equipment
• Technology: refers to the process or processes for producing the product, How does the
pizzaiolo combine ingredients to make pizza? How hot should the oven be? How long should
the pizza cook?
• Entrepreneurship: Production involves many decisions and much knowledge, even for
something as simple as pizza. Who makes those decisions? Ultimately, it is the entrepreneur
The Production Function
• A mathematical expression or equation that explains the relationship between a firm’s inputs
and its outputs:

• By plugging in the amount of labor, capital and other inputs the firm is using, the production
function tells how much output will be produced by those inputs
• Different products have different production functions
• The amount of labor a farmer uses to produce a bushel of corn is likely different than that
required to produce an automobile
• Firms in the same industry may have somewhat different production functions, since each
firm may produce a little differently
• We can describe inputs as either fixed or variable
Fixed Inputs

• Fixed inputs are those that can’t easily be increased or decreased in a short period of time
• If one owns a pizza restaurant, the building is a fixed input
• Once the entrepreneur signs the lease, he or she is stuck in the building until the lease
expires
• Fixed inputs define the firm’s maximum output capacity
• This is analogous to the potential real GDP shown by society’s production possibilities curve
• Fixed inputs do not change as output changes
Variable Inputs

• Variable inputs are those that can easily be increased or decreased in a short period of time
• In the pizza example, the pizzaiolo can order more ingredients with a phone call, so
ingredients would be variable inputs
• The owner could hire a new person to work the counter pretty quickly as well
• Variable inputs increase or decrease as output changes
Short Run and Long Run
• Economists also differentiate between short and long run production
• The short run is the period of time during which at least some factors of production are
fixed
• During the period of the pizza restaurant lease, the pizza restaurant is operating in the short run, because
it is limited to using the current building
• The long run is the period of time during which all factors are variable
• Once the lease expires for the pizza restaurant, the shop owner can move to a larger or smaller place
Short Run
•• Note
  that there is another important distinction between
fixed and variable inputs
• In the short run, since the firm’s fixed inputs are fixed,
the only way to vary a firm’s output is by changing its
variable inputs
• Example: tree-cutting with a two-person crosscut saw
• Since by definition capital is fixed in the short run, our
production function becomes

• This equation simply indicates that since capital is fixed,

then changing the amount of output (e.g. trees cut down
per day) depends only on changing the amount of labor
employed (e.g. number of lumberjacks working)
Marginal Product

• Marginal product is the additional output of one more worker

• Mathematically, Marginal Product is the change in total product divided by the change in
labor:

• Since 0 workers produce 0 trees, the marginal product of the first worker is four trees per
day, but the marginal product of the second worker is six trees per day
• Suppose we add a third lumberjack to the story. What will that person’s marginal product be?
The Law of Diminishing Marginal
Product
• As we add workers, the marginal product
increases at first, but sooner or later additional
workers will have decreasing marginal product
• There may eventually be no effect or a negative
effect on output
• Law of Diminishing Marginal Product is a
characteristic of production in the short run
• Why does diminishing marginal productivity
occur?
• Because of fixed capital
Costs and Profit

• Private enterprise, the ownership of businesses by private individuals

• Firms come in all sizes
• Profit = Total Revenue – Total Cost
• Total revenue is the income brought into the firm from selling its products
• It is calculated by multiplying the price of the product times the quantity of output sold: Total Revenue =
Price x Quantity
• A firm’s revenue depends on the demand for the firm’s products
Costs
• Explicit costs are out-of-pocket costs, that is, payments that are actually made
• Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs
• Implicit costs are more subtle, they represent the opportunity cost of using resources already
owned by the firm
• Example: working in the business while not getting a formal salary, or using the ground floor of a home
as a retail store
• Implicit costs also include the depreciation of goods, materials, and equipment that are
necessary for a company to operate
Profit

• Accounting profit means total revenue minus explicit costs (cash concept)
• The difference between dollars brought in and dollars paid out
• Economic profit is total revenue minus total cost, including both explicit and implicit costs
• The difference is even though a business pays income taxes based on its accounting profit, whether or
not it is economically successful depends on its economic profit
Costs in the Short Run
• For every factor of production (or input), there is an associated factor payment
• Factor payments are what the firm pays for the use of the factors of production
• From the firm’s perspective, factor payments are costs
• From the owner of the factor’s perspective factor payments are income
• Factor Payments include:
• Raw materials prices for raw materials
• Rent for land or buildings
• Wages and salaries for labor
• Interest and dividends for the use of financial capital (loans and equity investments)
• Profit for entrepreneurship
Circular Flow Diagram
Average and Marginal Costs
• The cost of producing a firm’s output depends on how much labor and capital the firm uses
• We can measure costs in a variety of ways
• Each way provides its own insight into costs
• Two ways to measure per unit costs
• Average cost is the cost on average of producing a given quantity

• Marginal cost is the cost of producing one more unit (or a few more units) of output
Average and Marginal Cost Curves
Fixed and Variable Costs

• Fixed costs are the costs of the fixed inputs

• They do not change regardless of the level of production, at least not in the short term
• Example: the rent on a factory or a retail space.
• Variable costs are the costs of the variable inputs
• They are incurred in the act of producing, the more you produce the greater the variable cost
• Labor is treated as a variable cost, since producing a greater quantity of a good or service typically
requires more workers or more work hours
Average Costs and Curves

• The cost of producing a firm’s output depends on

how much labor and capital the firm uses
• Average total cost is total cost divided by the
quantity of output
• Example: the total cost of producing 40 haircuts
at “The Clip Joint” is $320, the average total cost
for producing each of 40 haircuts is $320/40, or
$8 per haircut
• Average variable cost obtained when variable cost is
divided by quantity of output
• Example: the variable cost of producing 80
haircuts is $400, so the average variable cost is
$400/80, or $5 per haircut
Lessons From Alternative Measures of Cost

• Fixed costs are often sunk costs that, once incurred, cannot be recouped

• Sunk costs should typically be ignored, since this spending has already been made and
cannot be changed
• Profit margin tells a firm for any level of output are they making money or losing money
• Profit is defined as revenues minus costs
• Total Profit = total revenue – total cost
 Production in the Long Run
• In the long run, all factors (including capital)
are variable, so our production function is:
Table 2. Long Run Production Function for Typing

• Consider a secretarial firm that does typing for Labor (#

1 2 3 4 5 5
hire using typists for labor and personal Typists)
computers for capital Total
For K = 1
Product 5 6 8 8 8 8
PC
(Letters/hr)
Marginal
5 2 1 0 0 0
Product

Total
For K = 3
Product 5 10 15 17 18 18
PC
(Letters/hr)
Marginal
5  5  5  2  1  0
Product
Long Run Costs and Production Technology

• The long run is the period of time when all costs are variable
• Depends on the specifics of the firm in question
• In planning for the long run, the firm will compare alternative production technologies (or
processes)
• In this context, technology refers to all alternative methods of combining inputs to produce
outputs
• An improvement in production technology leads to a reduction in production cost
 Economies of Scale
• Economies of scale refers to the situation where, as the quantity of output goes up, the cost per unit
goes down
• This is the idea behind “warehouse stores” like Costco or Walmart
• A small factory like S produces 1,000 alarm clocks at an average cost of $12 per clock
• A medium factory like M produces 2,000 alarm clocks at a cost of $8 per clock
• A large factory like L produces 5,000 alarm clocks at a cost of $4 per clock
Shapes of Long-Run Average Cost Curves

• Short run firms are limited to operating on a single average cost curve (corresponding to the level of
fixed costs they have chosen)
• In the long run when all costs are variable, they can choose to operate on any average cost curve
• The long-run average cost (LRAC) curve is actually based on a group of short-run average cost
(SRAC) curves, each of which represents one specific level of fixed costs
• More precisely, the long-run average cost curve will be the least expensive average cost curve for any
level of output
Diseconomies of Scale

• Diseconomies of scale is the long-run average cost of producing output increases as total
output increases
• A firm or a factory can grow so large that it becomes very difficult to manage
• Not many overly large factories exist in the real world, because with their very high production costs,
they are unable to compete for long against plants with lower average costs of production
• Diseconomies of scale can also be present across an entire firm, not just a large factory
• The leviathan effect can hit firms that become too large to run efficiently, across the entirety
of the enterprise
The Size and Number of Firms in an Industry

• The shape of the long-run average cost curve has implications for how many firms will
compete in an industry
• whether the firms in an industry have many different sizes, or tend to be the same size
• Example: one million dishwashers are sold every year at an average cost of $500 each and
the long-run average cost curve for dishwashers
• If some firms built a plant that produced 5,000 dishwashers per year or 25,000 dishwashers
per year
Quick Review
• What is the difference between the types of inputs in the production process?
• Explain the concept of a production function
• What is the difference between fixed and variable inputs?
• What is the difference between total and marginal product?
• What is diminishing marginal productivity?
• What is the difference between explicit costs and implicit costs?
• How do you calculate accounting and economic profit?
• What is the relationship between production and costs, including average and marginal
costs?
• Analyze short-run costs in terms of fixed cost and variable cost
More Quick Review
• What is average total costs and average variable costs and how do you calculate them?
• How do you calculate and graph marginal cost?
• What is the relationship between marginal and average costs?
• What is profit margin?
• How does long run production differs from short run production?
• What is the impact of production technology on long run total costs?
• What are economies of scale, diseconomies of scale, and constant returns to scale?
• How does the shape of the long-run average cost curve affect the number of firms that an
industry can sustain and the market structure in the industry?