D089 Unit 3 Module 5 Notes and Assessment PDF

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D089 Principle of Economics Unit 3 Module 5 Notes and assessment study guide...

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Unit 3 Module 5: Production and Costs XVI.  

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Production and Costs Introduction o Making profits is goal of majority of firms Understanding Profit o Private Enterprise  Ownership of businesses by private individuals  Each business, regardless of size or complexity, tries to earn Profit  Financial gain, especially difference between amount earned and amount spent buying, operating, or producing product or service o Profit = Total Revenue – Total Cost  To earn profit, Firm combines inputs of labor, capital, land, and entrepreneurship to produce outputs Total Revenue o Income firm generates from selling its products  Firms influence amount of revenue they earn by making decisions about price and quantity  Total Revenue = Price x Quantity Total Costs o Amount firm pays for producing and selling its products  Firms influence their costs when they choose to produce certain quantity of output and select a production process  Production process defines how inputs are combined to make an output o Each input increases firm’s cost  Sum of all costs is total cost Accounting Profit versus Economic Profit o Accountants and Economist calculate profits differently  They have different purposes for using profit information  Accountants want to know exactly how much profit firm earned so they can answer questions about things like taxes and cash flows

 Economists want to know if firm’s owners are satisfied with the return they receive from the business o Knowing whether return is sufficient allows an economist to assess stability of market and to predict entry or exit of new firms o In order to meet different goals, economists and accountants include different types of costs in their profit calculations  Economists use a total cost measure that reflects business owner’s opportunity cost  Considers value of all resources used, even if resources are owned by business and don’t receive specific payment o Means economists include Implicit Costs when calculating total costs  Opportunity costs of resources already owned by firm and used in business  i.e., expanding factory onto land already owned  Economic Profit = Total Revenue – Explicit Cost – Implicit Cost  Accountants use total costs includes on Explicit Costs  Money a firm must pay out to settle its bills and pay its employees  Accounting Profit = Total Revenue – Explicit Cost  Implicit and Explicit Costs o Explicit Costs  Payments made to cover firm’s bills  Sometimes called out-of-pocket costs  i.e., wages paid to employees, rent, etc. o Implicit Costs  Opportunity cost of using resources already owned by firm  Four Primary Sources  Forgone wages are used to measure value, or opportunity cost, of time owners dedicate to supporting their business o In using their time, they give up opportunity to earn money in different job

 Forgone Interest is opportunity cost of using owner’s money for business o When people use all of their savings to start a business, they sacrifice interest this money would have earned  Depreciation is cost of firm using its own capital o Firm’s physical assets lose value from its use in production  Measures opportunity cost associated with this wear and tear  Normal Profit is the return to the entrepreneur for taking risks and making decisions o No formal salary associated with challenge of entrepreneurship  Owner expects to be rewarded with profit o Economic Profit evaluates owners’ return relative to their other opportunities  When positive, business is earning larger return than it could expect to earn by pursuing any available alternative  When negative, means more rewarding option is available  Zero means that business is paying all its bills and providing owner with return that is just as good as available alternative  Considered a good outcome  Calculating Implicit Costs o First Step  Calculate known Explicit Costs  i.e., Opening a Stained-Glass Store o Store Rent: $30,000 o Assistant Salary: +$22,000 o Total Explicit Costs: $52,000 o Step Two  Subtract Explicit Costs from the revenue gives the accounting profit  Revenues: $200,000  Explicit Costs: -$52,000  Accounting Profit: $148,000

o Calculations only consider explicit costs  To open store, one must quit current job which would be implicit cost  i.e., salary $100,000 o Step Three  Economic Profit = Total Revenues – Explicit Costs – Implicit Costs  Economic Profit = $200,000 - $52,000 - $100,000 o Economic Profit = $48,000  Understanding Costs o Products cost depends on inputs required to make product and on price of inputs  To make most profit, firms want to choose combination of inputs to produce desired quantity of output for lowest possible cost  Companies cannot choose price of inputs  Set of possible input combinations from which firm can choose depends on decision’s planning period  Two planning periods are used in economics o Long run  i.e., 10-year plans  no restrictions on what input combinations are possible  planners are free to consider ideal options regarding things like building size, number of trucks, or number of accountants  all inputs are variable o all costs will be variable as well o no fixed costs o Short run  Inputs will already be determined with no time to make changes  Known as fixed inputs

 With both fixed and variable inputs, firms will have both fixed and variable costs o Costs that do change with level of output  i.e., labor is considered variable input and capital a fixed input o Production constrained by productive capacity of fixed input o Law of diminishing marginal returns  Anytime one input is fixed, adding additional units of variable resources will result in smaller and smaller gains in the output  Law of Diminishing Marginal Returns and Variable Costs o Law of Diminishing Marginal Returns causes variable costs to rise at an increasing rate as the firm increases its output  Lesson Summary o Profit equals total revenue minus total cost. Total revenue equals price multiplied by quantity o There are two types of costs: implicit and explicit. Explicit are out-ofpocket costs; implicit costs represent opportunity costs o Accounting profit is determined by subtracting the explicit costs from the revenue, while economic profits require subtracting both explicit and implicit costs from revenue o In short run, there is at least one input that cannot be changed, called a fixed input o Fixed costs are costs that do not change with the level of production. Firms have fixed costs in the short run

o In short run, firms experience law of diminishing marginal returns. Marginal product of labor decreases as additional units are added to the fixed input o Based on law of diminishing marginal returns, variable cost rises at an increasing rate as firms increase the output o In long run, all inputs are variable

XVII. Short Run Costs  Introduction o Fixed input impacts cost and limits quantity of output firm is capable of making o Total Cost = Total Variable Cost + Total Fixed Cost  TC = TVC + TFC  Fixed Costs o Occurs only in short run o Expenditures that do not change with level of production  i.e., rent on factory or retail space  during duration of lease rent is same regardless of how much you produce o Level of fixed costs varies according to specific line of business  i.e., manufacturing computer chips requires expensive factory, whereas a local moving and hauling company can get by with almost no fixed costs at all if it rents trucks by the day when needed  Variable Cost o Occurred in act of producing  More you produce, higher the variable cost  Labor is treated as variable cost  Also includes raw materials and expenses for operating machinery  Total Costs o Fixed costs shown in graph are always shown as vertical intercept of total cost curve  Appear as horizontal line on graph

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o Total costs show effect of diminishing marginal returns with a steeper increase in total cost with additional employees o Changes in total cost are driven by changes in variable cost Average Cost o Average cost of production is the per-unit cost of producing a given quantity  Defined as total cost divided by quantity of output produced  Average Cost = Average Fixed Cost o Average Fixed Cost =  AFC = Average Variable Cost o Average Variable Cost =  AVC = Average Total Cost o Average Total Cost = = + Marginal Cost o Allows company to evaluate how much it will be paying to produce one additional unit of output  Not cost per unit of all units being produced but only cost of next one (or few) o Calculated by dividing change in total cost by change in quantity  Marginal Cost =  MC = The Relationship between the Marginal Cost Curve and the Average Cost Curve o Marginal cost curve is generally upward sloping because diminishing marginal returns implies that additional units are more costly to produce  Marginal cost curve intersects average cost curve precisely at bottom of average cost curve  Reason intersection occurs at this point is built into economic meaning of marginal and average costs o If marginal cost of production is below average cost for producing previous units then producing one more additional unit will reduce average costs

overall and average total cost curve will be downward sloping in that zone  Likewise, if marginal cost for producing an additional unit is above average cost for producing earlier units then producing a marginal unit will increase average costs overall and average total cost curve must be upward sloping in that zone  The point of transition, between where marginal cost is pulling average total cost down and where it is pulling it up, must occur at the minimum point of the average total cost curve  The Pattern of Cost Curves o Pattern of costs varies among industries and even among firms in same industry  Lesson Summary o Fixed costs do not change in the short run production. When a firm increases production, the fixed costs can be allocated over more output, and the per-unit fixed cost decreases o Variable cost is based on factors such as labor and cost of materials. Variable costs increase as number of units produced increases o The total cost is made up of fixed and variable costs. The total cost increases as production increases while the average total cost decreases initially as production increases. This is because the fixed cost is allocated over more output units until it reaches a point of diminishing marginal returns due to the congestion effect o Marginal cost is calculated by dividing the change in the total cost by the change in output for each possible change in output. Marginal costs are typically rising o The average cost is calculated by dividing variable costs by the total output at each level of output. Average variable costs are typically Ushaped o When the marginal cost is below the average cost, the average total cost is falling. When the marginal cost is above the average total cost, the average total cost is rising

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Long Run Costs and Economies of Scale Introduction o In Long Run all inputs are variable  Creates two decisions for firm  Firm needs to identify cost minimizing combination of labor and capital based on its level of production  Firm decides on its optimal scale or the size it would like to be Long Run Costs o Long run refers to a planning period, not a moment in time o When planning for long run, firms compare alternative production technologies  Alternative methods of combining inputs to produce outputs  Firm searches for production technology that allows it to produce desired level of output at lowest cost Choices of Production Technology o Capital and labor can often substitute for each other  Can choose between an options of more employees or more machinery to produce same amount of products Shapes of LRAC Curves o Long Run Average Cost (LRAC) Curve identifies lowest possible average cost for any level of output  Firms can choose to operate on any average cost curve  SRA Curves are the average total cost curve in the short term.  Shows the total of the average fixed costs and the average variable costs The Relationship of the Short Run and the Long Run Cost Curves o LRAC Curve shows cost of producing each quantity in the long run when firm can choose its level of fixed costs and thus choose SRACs Economies of Scale o Once firm determines least costly production technology, it can consider optimal scale of production  To change scale, firm multiplies its cost minimizing laborcapital combination by a chosen scale factor

 If a firm is currently using 10 units of labor and 4 units of capital wants to double in size, it can scale up by multiplying its inputs by a factor of 2 o Firm will increase labor usage to 20 units and its capital usage to 8 units o Impacts both firm’s output and its costs  Called using scale economies o Economies of Scale  A proportionate savings in costs gained by an increased level of production  A firm experiences Economies of Scale when, as quantity of output goes up, average cost goes down  Occurs when a firm scales input up by a certain factor and generates an increase in output that exceeds that factor o i.e., firm’s output triples when inputs are doubled  doubling inputs doubles costs but because output more than doubles, per-unit costs fall o Constant Returns to Scale  When an increase in inputs (capital and labor) causes the same proportional increase in output  Expanding all inputs proportionately does not change the average cost of production  Diseconomies of Scale o Features that lead to an increase in average costs as a business grows beyond a certain size.  Long run average cost of producing each individual unit increases as total output increases  When output increases by factor of 1.5 when inputs are increased by double  Lesson Summary o Economies of scale refer to a situation where the cost per unit is less expensive the more that is produced o A firm’s ability to exploit economies of scale is limited by the market’s demand for its products

o The LRAC curve shows the lowest possible average cost of production, allowing all the inputs to production to vary so that the firm is choosing its production technology o If the LRAC has a flat segment at the bottom, so that a range of different quantities can be produced at the lowest average cost, the firms competing in the industry will display a range of sizes o If the quantity demanded in the market of a certain product is much greater than the quantity found at the bottom of the LRAC curve where the cost of production is lowest, many firms will compete in the market. If the quantity demanded in the market is less than the quantity at the bottom of the LRAC, there will likely be only one firm

MODULE 5: PRODUCTION AND COSTS: QUIZ Shore Lightning Inc. is the manufacturer of LED light bulbs used in stadium scoreboards around the world. They are looking into opportunities in England and Thailand. Based on their analysis, they think the two options will deliver the following annual results: England

Thailand

Revenues

$750,000

$600,000

Labor/Material Costs

$200,000

$150,000

Profit

$550,000

$450,000

The daily costs for the opportunity in England are broken down as follows: Labor Cost: $2.50 per light bulb Material Cost: $4.50 per light bulb Machine Cost: $1.50 per light bulb Daily fixed costs: $2,000 Over the next 10 years, the company wants to expand the amount of technology it uses in order to reduce its labor costs in the production of light bulbs. They believe that the new technology will allow them to triple the output of light bulbs daily with only a slight increase in the amount of labor hours. Labor per light bulb will decrease from the current rate of $2.50 to $1.50 per light bulb because of the increase in production.

Question 1 What is the opportunity cost of operating in Thailand instead of England? $100,000 $550,000 $450,000 $50,000 Correct! The opportunity cost is the profit in England minus the profit in Thailand.

Question 2 What is the total daily variable cost to produce 500 light bulbs? $4,250 $2,000 $6,250 $1,250 Correct! The total variable cost equals labor ($2.50 x 500) plus material ($4.50 x 500) plus machine ($1.50 x 500).

Question 3 What is the average daily fixed costs to produce 1,000 light bulbs? $2.00 $4.50 $2.50 $10.50 Correct! The average daily fixed costs equal $2,000 in daily fixed costs divided by 1,000 light bulbs.

Question 4 Which factor is important for the company to remember about costs in the long run when looking at different technologies? Labor is fixed, but material costs are variable. Labor is variable, but material costs are fixed. All costs are variable. Machine costs are fixed. Correct! In the long run, all costs are variable.

Question 5 The firm is able to take advantage of cost-saving technologies as it expands its output and reduces labor costs from $2.50 to $1.50 per light bulb. What does this advantage represent? Diseconomies of scale Economies of scale Optimal scale of production Constant returns to scale Correct! When outputs of light bulbs triples with a slight increase in labor hours, the average labor cost per light bulb decreases from $2.50 to $1.50....