The Costs of Production

Chapter 12

The Costs of Production

Introduction

§  So far when we have talked about production we have grouped all firms that supply goods and services in an economy into the broad category of supply.

§  In this, and following chapters, we will look in more detail into the different types of firms that normally operate in an economy and into the different types of market arrangements that ensue.

§  Before analyzing how perfectly competitive firms and monopolies operate we need to define some basic concepts.

What are Costs?

§  Why does anybody go into business? Why do they set up a company, create a firm? To make money. In other words, to collect a profit.

Profits = Total Revenue – Total Cost

§  Profits are the difference between:

-  Sales revenue: the money made by selling the goods produced by the firm.

-  Production costs: the money used to pay workers, purchase raw materials, service machines…

Economic Profit versus Accounting Profit

§  There is a critical distinction between these two and this topic is a potential source of misunderstandings (especially for accounting students) that needs to be addressed early on:

-  Accounting Cost à explicit costs (all the production costs that an accountant can list)

(e.g.: wages and salaries, raw materials, rent, phone bill)

-  Economic Cost à explicit costs plus implicit costs (accounting plus opportunity cost)

(e.g.: production cost plus best alternative use of the firm's money)

§  Economic cost will always be larger than accounting cost.

§  Therefore, we can distinguish between:

-  Accounting Profit à revenue minus accounting costs

(It has to be positive for the firm to stay in business)

-  Economic Profit à revenue minus economic costs

(It should be zero at equilibrium)

§  When economic profit is zero that means that revenue covers both the production costs and the value of the best alternative use of our time, effort and money.

§  When economic profit is negative that may mean that revenue covers production costs but not the value of the best alternative use of our time, effort and money. That would not be optimal.

§  When economic profit is positive that means that revenue exceeds production costs and the value of the best alternative use of our time, effort and money. That would attract more firms to our market.

Production and Costs

§  In order to produce goods and services we need to use inputs such as:

-  Raw materials and energy

-  Land (natural resources, N)

-  Know-how (human capital, H)

-  Machines (physical capital, K)

-  Workers (labor, L)

§  The last two factors of production are the most important ones and we can represent how we use them to produce goods and services through the production function:

Y = A . F (K , L)

where: Y = Output = Production of goods and services

K = physical capital stock (machines, installations…)

L = labor employed (workers, managers…)

F = the production function itself, the expression that tells us how we combine L and K to produce Y.

A = total factor productivity (technology)

§  Note that A relates actual output with the production function and that it is independent from F, K and L. If A increases (technology improves) for the same uses of K and L we can obtain higher Y.

Short-Run and Long-Run

§  When we think about the future, when we make plans, we tend to use two different time-horizons: a very immediate one (short run) and a more distant one (long-run.)

-  Short-Run à a period of time between now and one year from today

(the time period during which we can't change the size of our fixed factor)

-  Long-Run à a period of time between now and more than one year from today

(the time period during which we can change the size of our fixed factor)

§  Keep in mind that the long-run horizon or goal (e.g.: graduation) is composed of multiple short-run horizons or goals (e.g.: passing this course) and so both are closely connected.

§  It is easy to see that not all of our factors of production can be increased or decreased instantly:

-  It takes many years to increase the human capital of workers (H)

-  It takes many months to exploit new natural resources (N)

-  It doesn't take that long to hire new workers (L)

-  It takes a while for new machines to be purchased, produced and delivered (K)

§  Therefore :

-  Physical capital (K) is considered a fixed factor of production in the short-run.

(e.g.: size of our production plant, number of operative machines)

-  Labor (L) is considered a variable factor of production in both the short and long-run.

(e.g.: number of full time and part time workers)

Diminishing Marginal Returns from Labor

§  Notice that as we keep on increasing output by increasing the size of our labor force the marginal productivity of our workers diminishes. This is called the law of diminishing returns.

“As we add more of any one input (holding the other inputs constant),

its marginal productivity will eventually decline.”

§  This law was stated by a famous English economist of the XVIII century called David Ricardo.

-  Example: You have to write a paper (Y) and start out only with a pencil (K). If you are given a typewriter (­K), you write more pages per hour (­Y) If you use a computer (­­K) you are even faster (­­Y) but if you are given two computers (­­­­K) to use at the same time your speed is not going to increase by that much (­­­Y)

-  Example: You have a piece of land (K) to farm where to harvest a crop (Y) You start out only with one worker (L). If another worker joins you (­L), the crop increases (­Y) If more workers join you (­­L), harvesting is faster and the crops larger (­­Y) but if the number of workers on that limited piece of land keeps on increasing (­­­­L) they will start obstructing each other and the increase in crops will not be as large (­­­Y)

§  Drawing some parallelisms with the law of diminishing marginal utility we can warn against a typical mistake: although total output increases by progressively smaller amounts, it never decreases. Therefore, marginal productivity can never be negative.

The Various Measures of Cost

§  Our discussions of costs (economic costs, that is) will be shaped by the distinctions between short and long run, variable and fixed inputs and the law of diminishing marginal returns.

Fixed, Variable, and Marginal Costs

-  Total Cost à The sum of fixed and variable costs.

-  Fixed Cost à The cost of acquiring your fixed factor.

This doesn't depend on the level of production.

(e.g.: the rent that you pay for your apartment, your car insurance)

-  Variable Cost à The cost of acquiring your variable factor.

This depends on the level of production.

(e.g.: the utilities' bill, your gas consumption)

-  Marginal Cost àBy how much total cost increases when output increases by one unit.

This depends on the diminishing marginal returns from factors.

NOTE:

Average Fixed Cost and Average Variable Costs

§  Average costs are simply the fixed and variable costs divided by the volume of output:

-  Average Fixed Cost à The fixed cost divided by the volume of output (AFC = FC / Y)

This will decrease as the production level increases.

-  Short-Run Average à The variable cost divided by the volume of output (SAVC = VC / Y)

Variable Cost This will first decrease and then increase as output increases.

-  Short-Run Average à The total cost divided by the volume of output (SATC = TC / Y)

Total Cost This will first decrease and then increase as output increases.

NOTE:

§  Why are the SAVC and SATC curves U-shaped?

-  As the output level gradually increases the AFC gradually decreases (bringing down SATC.)

-  As the output level gradually increases, labor increases (while capital is fixed) and that makes the firm run into diminishing marginal returns (increasing SAVC and SATC.)

§  Why does the MC curve intercept the SATC curve at its minimum?

-  If MC>SATC it must be that the SATC is increasing

(your college GPA increases when the grade from the last course that you took is above it)

-  If MC<SATC it must be that the SATC is decreasing

(your college GPA decreases when the grade from the last course that you took is below it)

Costs in the Short-Run and in the Long-Run

§  In the long-run we can increase the size of the capital stock (K), so employing the optimal combinations of labor and capital that produce maximum output level.

-  Sometimes bigger is better (economies of scale) and by producing more the per-unit costs can decrease: LAFC decrease very fast and there might be learning by doing that reduces LAVC.

(e.g.: car and airplane production, hospital services)

-  Sometimes bigger is worse (diseconomies of scale) and by producing more we run into coordination problems that increase the per-unit costs: LAVC increases.

(e.g.: the experiences of General Motors and IBM)

-  Sometimes size doesn't matter (constant economies of scale) and the long-run level of production does not affect the production costs.

§  In terms of the graph, the LATC curve is going to be delimited by the lower portions of the successive SATC curves obtained with different combinations of K and L.

§  Why do we observe economies of scale?

-  Some industries use indivisible (lumpy) inputs (e.g.: molds, blueprints, plant size...) that require large sunk investments or large fixed costs. Only large output levels bring down LAFC.

-  Some industries (or firms) benefit from specialization (e.g.: the original company branches out into subdivisions) that is only possible for large output levels.

-  Some firms (or industries) have a minimum efficient scale (e.g.: only large firms can operate in the market and collect a profit.) This is the case of utilities companies.

NOTE: the existence of this minimum efficient scale will give origin to natural monopolies.