BECON 1201/ BBI 1113/ BBI 1114 • Microeconomics LECTURE PRODUCTION & COST Costs & Output Decisions Faculty of Business Management & Globalization Tel : 603 8317 8833 (Ext 8407) Objectives • In this chapter, we will focus on the relationship between a firm’s technology and its production costs BECON 1201/ BBI 1113/ BBI 1114 Students will able to: To describe the production function Understand law of diminishing returns Understand economies and diseconomies of scale, short run & long run  We will analyze how factors of production are combine to produce goods & services Microeconomics WHAT ARE COSTS? • According to the Law of Supply: Supply – Firms are willing to produce & sell a greater quantity of a good when the price is high – This results in upward slopping supply curve • The Firm’s Objective - The economic goal of the firm is to maximize profits BECON 1201/ BBI 1113/ BBI 1114 Microeconomics DEFINATION OF PRODUCTION “Production means the process of using the factors of production to produce G&S.” “transformation of inputs into outputs” Production inputs things that a firm buys for use in prod, e.g land, labour, capital & entrepreneur outputs = what we get at the end of the production/finished products/G&S produced BECON 1201/ BBI 1113/ BBI 1114 Microeconomics CLASSIFICATION OF F.O.P LAND – natural resources/gift of nature; land surface, air, lakes, water, minerals, forests etc LABOUR – physical/mental activities undertaken by man in exchange for $ reward; lawyer, farmer, PM CAPITAL – That part of man-made wealth which is used to further produce wealth; machine, building; not all $ is capital- sewing machine & shirt ENTERPRENEUR – a person who combines the above, initiates the process of prod & bear the risk human ability & talent TECHNOLOGY – advancements in IT BECON 1201/ BBI 1113/ BBI 1114 Microeconomics THE PRODUCTION FUNCTION “specifies the maximum output that can be produced from any given amount of inputs” The prod function shows the technically efficient ways of combining inputs to produce output Relationship between inputs(F.O.P) & outputs (G&S) In math equation; Q = f(K,L,M, etc) Qty of output = f(capital, labour, raw material) • • Means Q depends on f.o.p f.o.p , Q Inputs is homogeneous – only qty differ not quality BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Total Revenue, Total Cost, and Profit • Total Revenue – The amount a firm receives for the sale of its output • Total Cost – The market value of the inputs a firm uses in production BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Total Revenue, Total Cost, and Profit • Profit is the firm’s total revenue minus its total cost Profit = Total revenue - Total cost Improving Inventory Control at Wal-Mart Better inventory controls have helped reduce firms’ costs BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Costs as Opportunity Costs • A firm’s cost of production includes all the opportunity costs of making its output of goods and services • Explicit and Implicit Costs – A firm’s cost of production include explicit costs and implicit costs • Explicit costs are input costs that require a direct outlay of money by the firm • Implicit costs are input costs that not require an outlay of money by the firm BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Economic Profit vs Accounting Profit Economists measure a firm’s economic profit as total revenue minus total cost (TR – TC), including both explicit and implicit costs Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs • When total revenue exceeds both explicit and implicit costs, the firm earns economic profit Economic profit is smaller than accounting profit BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Costs in the Long Run Economies of Scale Long-run average cost curve A curve showing the lowest cost at which the firm is able to produce a given quantity of output in the long run, when no inputs are fixed Economies of scale Economies of scale exist when a firm’s long-run average costs fall as it increases output BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Figure Average Total Cost in the Short and Long Run Average Total Cost ATC in short run with small factory ATC in short run with medium factory $12,000 ATC in long run BECON 1201/ BBI 1113/ BBI 1114 1,200 Microeconomics Quantity of Cars per Day Economies and Diseconomies of Scale • Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases • Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases • Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Figure Average Total Cost in the Short and Long Run Average Total Cost ATC in short run with small factory ATC in short run with large factory ATC in long run 10,000 Economies of scale BECON 1201/ BBI 1113/ BBI 1114 Constant returns to scale 1,000 Microeconomics Diseconomies of scale Quantity of Cars per Day Long run production costs • Long-run - time frame long enough for all factors of production (FOP) to be varied Firms can expand or reduce its operations by varying amounts of all resources - all FOP are variable - Long Run ATC BECON 1201/ BBI 1113/ BBI 1114 Microeconomics In the long-run, firms can double their resources but does output doubles as well??? Constant returns to scale given % increase in inputs resources) leads to same % increase in outputs (e.g 20% increase in raw materials leads to 20% increase in outputs) Increasing returns to scale (Economies of scale) a given % increase in inputs (resources) leads to larger % increase in outputs (e.g 20% increase in labor leads to 50% in output) Decreasing returns to scale (Diseconomies of scale) a given % increase in inputs (resources) leads to smaller % increase in outputs (e.g 40% increase in labor leads to 10% in output) BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Reason for Economies of Scale • Labor specialization - workers become specialized & efficient in assigned tasks • Managerial specialization - specializing in managerial functions to achieve efficiency • Efficiency of large machines - large firms can afford to adopt new techniques of production than small firms because of budget constraints • By-products - large firms have the techniques of converting by-products into useful products Reasons for Diseconomies of Scale • Problems of management coordination as firm becomes larger and complex • Due to specialization workers become alienated as their jobs become boring and repetitive BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Using Isoquants and Isocosts to Understand Production and Cost Isoquant A curve showing all the combinations of two inputs, such as capital and labor, that will produce the same level of output The Slope of an Isoquant Marginal rate of technical substitution (MRTS) The slope of an isoquant; represents the rate at which a firm is able to substitute one input for another, while keeping the Isoquants level of output constant BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Isocost Lines The Slope and Position of the Isocost Line Isocost line All the combinations of two inputs, such as capital and labor, that have the same total cost BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Choosing the Cost-Minimizing Combination of Capital and Labor The Position of the Isocost Line Choosing Capital and Labor to Minimize Total Cost BECON 1201/ BBI 1113/ BBI 1114 Microeconomics The Changing Input Mix in Film Animation A change in the price of labor relative to capital in the production of animated films led to a large reduction in the employment of animators BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Using Isoquants and Isocosts to Understand Production and Cost Choosing the Cost-Minimizing Combination of Capital and Labor Another Look at Cost Minimization MPL MPK  w r BECON 1201/ BBI 1113/ BBI 1114 Microeconomics Determining the Optimal Combination of Inputs Marginal Product of Capital Marginal Product of Labor Wage rate Rental price of machines 3000 copies 100 copies $50 per day $600 per day MPL 100 MPK 3000  2 copies per dollar, and  5 copies per dollar w $50 r $600 Summary • The goal of firms is to maximize profit, which equals total revenue minus total cost • When analyzing a firm’s behavior, it is important to include all the opportunity costs of production • Some opportunity costs are explicit while other opportunity costs are implicit • A firm’s costs reflect its production process • A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product BECON 1201/ BBI 1113/ BBI 1114 Microeconomics • A firm’s total costs are divided between fixed and variable costs Fixed costs not change when the firm alters the quantity of output produced; variable costs change as the firm alters quantity of output produced • The average-total-cost curve is U-shaped • The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC • A firm’s costs often depend on the time horizon being considered • In particular, many costs are fixed in the short run but variable in the long run BECON 1201/ BBI 1113/ BBI 1114 Microeconomics ... (2 x $2) + (6 x $1) = $12 = $10 Unit of output A B 4 Units of output A B 10 (7 x $2) + (6 x $1) = $20 (4 x $2) + (10 x $1) = $18 Units of output A B 6 14 (9 x $2) + (6 x $1) = $24 (6 x $2) + (14... WORKERS QUANTITY OF COPY MACHINES QUANTITY OF COPIES MARGINAL PRODUCT OF LABOR 2 2 2 62 5 1,325 2,200 2 ,60 0 2,900 3,100 62 5 700 875 400 300 200 BECON 1201/ BBI 1113/ BBI 1114 Microeconomics The Marginal... Microeconomics Figure Hungry Helen’s Total-Cost Curve Total Total-cost curve $80 70 60 50 40 30 20 10 10 20 30 40 50 60 70 BECON 1201/ BBI 1113/ BBI 1114 80 90 100 110 120 130 140 150 Microeconomics