MIC ECON Lec 03 – Production Costs

CHAPTER 3:

PRODUCTION COSTS

LEARNING OBJECTIVE The purpose of this chapter is to analyze how costs of production change as output is changed. First the concept of economic costs is investigated. Short run patterns of total, average and marginal costs are derived on the basis of the law of diminishing returns. Long run cost patterns are briefly outlined.

OPPORTUNITY COST All costs in economics are said to be opportunity costs because anytime a resource is used for any purpose, it implies that some other good cannot be produced with that quantity of the resource, that some other resource is not used for the given production instead, and that revenues from other production are foregone. Thus, costs are either explicit cost for the resource used or implicit costs from alternative use of the resource.

 When a student takes a course in economics, the cost of taking the course is more than just the money spent on tuition, textbooks and study aids. For instance, the time devoted to studying could have been used to work in a supermarket and earn a nice salary. That salary is not an out-of-pocket cost, but an opportunity cost, which is a real cost nevertheless.

NORMAL PROFIT Among the implicit costs of a firm, normal profit is the most important cost which must be met. Normal profit is that income the business owner, or entrepreneur, would receive if he/she were engaged in some other activity or employment. Thus, if the business owner does not derive what he/she feels he/she deserves, then he/she may well close the business.

 The owner of a small retail specialty store uptown should expect the store to generate at least as much income as what he/she could earn working as a manager for the department store downtown. Otherwise, the reasonable decision would be to close the store.

PURE PROFIT Pure profit, also known as economic profit, is the excess of revenues over all costs of the firm, explicit as well as implicit (i.e. opportunity) costs (one of which is normal profit). Pure or economic profit, thus, differs from accounting profit since in accounting profit only out-of-pocket explicit costs are taken into consideration.

 As opposed to normal profit, pure profit is a reward for taking the risk in running a business, and sometimes it can be negative. Thus, the owner of a store will see ups and downs in total profit due to changes in pure profit, which occasionally eats up some of the normal profit.

SHORT RUN The short run time framework for a firm is that time period during which some of its resources, and thus costs, are fixed. A typical example of a fixed cost for most firms is rent or the salary of key personnel (such as the president of the company). The number of days, months or years which constitutes the short run differs greatly from firm to firm.

 Most commercial rentals require a lease (a contract to rent for several months or years). Setting up a business also often requires installation of fixtures, furniture or equipment. Over the duration of the lease, the business would lose a lot of money if it had to change location. Thus, space is pretty much fixed over that period of time.

LONG RUN The time framework is considered to be long run when all the costs of a firm can be changed to some extent. For instance, the factory size can be modified. In the long run, there are no truly fixed costs: all costs are variable.

 At the expiration of the rental lease, a business can move to a more desirable location, which can be larger or smaller. Thus, in the long run, not even the working space of the business has to remain the same: everything can change.

DIMINISHING RETURNS The law of diminishing returns shows the observable occurrence that if variable inputs are increased beyond a certain point the incremental (or marginal) quantity produced (or returns) starts to decrease. Starting from a very low level of production, firms usually will benefit from increasing efficiency at first, but the gains dissipate and production becomes less efficient when the size capacity of the firms is overutilized.

 In a restaurant, the first employees that need to be hired are probably the manager, the cook and the waiter or waitress. Without them the restaurant would be very inefficient. Other help can be hired later: maitre d’, somellier, cashier, kitchen attendants, etc. If there are too many waiters in the restaurant or too many cooks in the kitchen, they may spill or spoil the broth.

LAW OF DIMINISHING RETURNS The law of diminishing return takes place only in the short run. It is entirely due to the presence of some fixed resource, and the need to overutilize that fixed resource.

FIXED COSTS Fixed costs are those costs over which a firm has no control. They are usually tied to fixed inputs or resources. The fixed costs must be paid, otherwise the firm may have to close down.

total-fixed-costs

 Rent is a typical fixed cost. It does not change from month to month (or from year to year) over the period of the lease, no matter what the volume of output may be.

VARIABLE COST Variable costs are those costs which a firm can change at will. They pertain to inputs or resources which are not fixed.

total-variable-costs

 Salaries, especially those of extra help and part-time employees are typical variable costs. Many other expenses are also variable: freight and postage, telephone in excess of the basic rate, maintenance and cleaning, and energy consumption. All these change with the volume of production.

TOTAL COST Total cost is the sum of all costs: fixed and variable. The total cost curve is represented graphically as an upsloping curve: costs increase as output volume increases. The curve is generally S shaped, reflecting the increasing efficiency starting from a low level of production, and then a decreasing efficiency as the volume of production goes beyond the point of diminishing returns.

total-costs

 The total cost of the restaurant increases as the number of meals increases (which is the volume of output here). When the restaurant becomes overcrowded and the law of diminishing returns sets in, the total cost increases very fast because employees become less efficient.

AVERAGE FIXED COST Average fixed cost is calculated by dividing total fixed cost by the quantity produced. AFC=TFC/Q. The average fixed cost curve is represented graphically as an ever decreasing curve asymptotic to the horizontal axis.

average-fixed-cost

 The rent paid by the restaurant is divided (or allocated), among more and more meals as the volume of production increases. The average cost per meals attributable to the fixed rent decreases as the number of meals increases.

AVERAGE VARIABLE COST Average variable cost is calculated by dividing total variable cost by quantity produced. AVC=TVC/Q. The average variable cost curve is graphically represented by a U shaped curve reflecting the increasing then decreasing efficiency in production as volume changes.

average-variable-costs

 Starting from a few meals and customers, a restaurant can improve its efficiency and decrease its average variable cost per meal as it increases it volume. After having expanded too much, the average variable cost starts to rise as employees start to get in each others way when the restaurant is too crowded.

AVERAGE TOTAL COST Average total cost is calculated by dividing total cost by the quantity produced. ATC=TC/Q. It can also be obtained by adding up average fixed cost and average variable cost at each level of production. The average total cost curve is represented graphically as a U shaped curve with a steep decreasing portion and a mildly increasing portion. These are attributable to the fixed and variable cost patterns.

average-total-costs

 The pattern of the average total cost of the restaurant is a combination of the pattern of average fixed costs and average variable costs. As output increases, average total cost decreases then increases with diminishing returns.

MARGINAL COST Marginal cost is calculated by dividing the change in total cost by the change in quantity. MC=(change in TC)/(change in Q). The marginal cost curve is represented graphically by a U shaped curve reflecting the increasing then decreasing efficiency as volume increases.

 The marginal, or additional, cost per meal changes more than the average total cost for each meal. The cost of one additional meal start to increase before average total cost does.

MARGINAL COST GRAPH The shape of the marginal cost curve can be explained by the pattern of total cost: it is due to the law of diminishing returns. The trough (or minimum) of the marginal cost curve corresponds to the point of diminishing returns. Marginal cost itself is also the slope of the tangent to the total cost curve.

marginal-costs

MINIMUM AVERAGE TOTAL COST Marginal cost curve intersects the average total cost curve at its minimum (or trough). One may verify that this must necessarily be true by observing that – if marginal cost is below average cost, average cost decreases, – if marginal cost is above average cost, average cost increases, Average cost remains the same only if marginal cost is neither above nor below.

minimum-average-costs

ECONOMIES OF SCALE Economies of scale, or economies of large scale, result from gains in efficiency as the size of production is increased along with appropriate changes in fixed resources to utilize the available resources more fully. Economies of scale can only occur in the long run.

 Economies of scale are observable in most manufacturing. Automobile production is especially sensitive to volume. A single car (for instance, those constructed for car racing) can cost millions of dollars. But, when the same features are incorporated in millions of parts, the cost becomes affordable. Recent studies indicate the minimum production of a line of cars is 100,000 units.

ECONOMIES OF SCALE CAUSES The major causes for the presence of economies of scale are – division of tasks and labor specialization minimizing labor cost, – more intensive use of highly skilled personnel, – more intensive use of capital (for instance, with shifts), – ability to utilize by-products rather than discard them.

ECONOMIES OF SCALE GRAPH Economies of scale are observed graphically by a pattern of lowering of the marginal and average total cost curves. The envelope of the short run average total cost curves can be looked upon as a long run cost curve.

DISECONOMIES OF SCALE Diseconomies of scale take place when the size of a firm is excessive. A firm may indeed increase its size to take advantage of economies of scale, but the gains disappear when the firm reaches a certain size. Diseconomies of scale belong to the long run and must be clearly distinguished from diminishing returns which occur in the short run. It is often argued that diseconomies of scale are rarely – if ever – observed in industry because firms would cut back on their size.

 General Motors is still made of several divisions which have never been integrated into a single production. There may be many reasons for this. An apparent one is that keeping the divisions separate stimulates some amount of competition among them, and thus avoids diseconomies of large scale.

DISECONOMIES OF SCALE CAUSES Some of the possible causes of diseconomies of scale are – difficulties in control and supervision, – slow decision making due to excessive size of administration, – lack of employee motivation.

 

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