1. 13 The Costs of Production P R I N C I P L E S O F F O U R T H E D I T I O N

11. EXAMPLE 1: Farmer Jack’s Production Function CHAPTER 13 THE COSTS OF PRODUCTION 0 0 500 1,000 1,500 2,000 2,500 3,000 0 1 2 3 4 5 No. of workers Quantity of output 3000 5 2800 4 2400 3 1800 2 1000 1 0 0 Q (bushels of wheat) L (no. of workers)

13. EXAMPLE 1: Total & Marginal Product CHAPTER 13 THE COSTS OF PRODUCTION 200 400 600 800 1000 MPL 0 3000 5 2800 4 2400 3 1800 2 1000 1 0 0 Q (bushels of wheat) L (no. of workers) ∆ Q = 1000 ∆ L = 1 ∆ Q = 800 ∆ L = 1 ∆ Q = 600 ∆ L = 1 ∆ Q = 400 ∆ L = 1 ∆ Q = 200 ∆ L = 1

14. EXAMPLE 1: MPL = Slope of Prod Function CHAPTER 13 THE COSTS OF PRODUCTION MPL equals the slope of the production function. Notice that MPL diminishes as L increases. This explains why the production function gets flatter as L increases. 3000 5 200 2800 4 400 2400 3 600 1800 2 800 1000 1 1000 0 0 MPL Q (bushels of wheat) L (no. of workers) 0 0 500 1,000 1,500 2,000 2,500 3,000 0 1 2 3 4 5 No. of workers Quantity of output

18. EXAMPLE 1: Farmer Jack’s Costs CHAPTER 13 THE COSTS OF PRODUCTION Total Cost 3000 5 2800 4 2400 3 1800 2 1000 1 0 0 cost of labor cost of land Q (bushels of wheat) L (no. of workers) 0 $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 $10,000 $8,000 $6,000 $4,000 $2,000 $0 $1,000 $1,000 $1,000 $1,000 $1,000 $1,000

19. EXAMPLE 1: Farmer Jack’s Total Cost Curve CHAPTER 13 THE COSTS OF PRODUCTION Q (bushels of wheat) Total Cost 0 $1,000 1000 $3,000 1800 $5,000 2400 $7,000 2800 $9,000 3000 $11,000

21. EXAMPLE 1: Total and Marginal Cost CHAPTER 13 THE COSTS OF PRODUCTION $10.00 $5.00 $3.33 $2.50 $2.00 Marginal Cost ( MC ) $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 Total Cost 3000 2800 2400 1800 1000 0 Q (bushels of wheat) ∆ Q = 1000 ∆ TC = $2000 ∆ Q = 800 ∆ TC = $2000 ∆ Q = 600 ∆ TC = $2000 ∆ Q = 400 ∆ TC = $2000 ∆ Q = 200 ∆ TC = $2000

22. EXAMPLE 1: The Marginal Cost Curve CHAPTER 13 THE COSTS OF PRODUCTION MC usually rises as Q rises, as in this example. $11,000 $9,000 $7,000 $5,000 $3,000 $1,000 TC MC 3000 2800 2400 1800 1000 0 Q (bushels of wheat) $10.00 $5.00 $3.33 $2.50 $2.00

26. EXAMPLE 2: Costs CHAPTER 13 THE COSTS OF PRODUCTION 7 6 5 4 3 2 1 0 TC VC FC Q $0 $100 $200 $300 $400 $500 $600 $700 $800 0 1 2 3 4 5 6 7 Q Costs FC VC TC 0 620 480 380 310 260 220 170 $100 520 380 280 210 160 120 70 $0 100 100 100 100 100 100 100 $100

27. EXAMPLE 2: Marginal Cost CHAPTER 13 THE COSTS OF PRODUCTION Recall, Marginal Cost ( MC ) is the change in total cost from producing one more unit: Usually, MC rises as Q rises, due to diminishing marginal product. Sometimes (as here), MC falls before rising. (In other examples, MC may be constant.) 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 MC TC Q 140 100 70 50 40 50 $70 ∆ TC ∆ Q MC =

28. EXAMPLE 2: Average Fixed Cost CHAPTER 13 THE COSTS OF PRODUCTION 100 7 100 6 100 5 100 4 100 3 100 2 100 1 $100 0 AFC FC Q Average fixed cost ( AFC ) is fixed cost divided by the quantity of output: AFC = FC / Q Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 0 14.29 16.67 20 25 33.33 50 $100 n.a.

29. EXAMPLE 2: Average Variable Cost CHAPTER 13 THE COSTS OF PRODUCTION 520 7 380 6 280 5 210 4 160 3 120 2 70 1 $0 0 AVC VC Q Average variable cost ( AVC ) is variable cost divided by the quantity of output: AVC = VC / Q As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 0 74.29 63.33 56.00 52.50 53.33 60 $70 n.a.

30. EXAMPLE 2: Average Total Cost CHAPTER 13 THE COSTS OF PRODUCTION ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 TC Q 0 Average total cost ( ATC ) equals total cost divided by the quantity of output: ATC = TC / Q Also, ATC = AFC + AVC 88.57 80 76 77.50 86.67 110 $170 n.a. 74.29 14.29 63.33 16.67 56.00 20 52.50 25 53.33 33.33 60 50 $70 $100 n.a. n.a. AVC AFC

31. EXAMPLE 2: Average Total Cost CHAPTER 13 THE COSTS OF PRODUCTION Usually, as in this example, the ATC curve is U-shaped. 88.57 80 76 77.50 86.67 110 $170 n.a. ATC 620 7 480 6 380 5 310 4 260 3 220 2 170 1 $100 0 TC Q 0 $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs

32. EXAMPLE 2: The Various Cost Curves Together CHAPTER 13 THE COSTS OF PRODUCTION 0 AFC AVC ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs

35. EXAMPLE 2: Why ATC Is Usually U-shaped CHAPTER 13 THE COSTS OF PRODUCTION 0 As Q rises: Initially, falling AFC pulls ATC down. Eventually, rising AVC pulls ATC up. $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs

36. EXAMPLE 2: ATC and MC CHAPTER 13 THE COSTS OF PRODUCTION 0 When MC < ATC , ATC is falling. When MC > ATC , ATC is rising. The MC curve crosses the ATC curve at the ATC curve’s minimum. ATC MC $0 $25 $50 $75 $100 $125 $150 $175 $200 0 1 2 3 4 5 6 7 Q Costs

38. EXAMPLE 3: LRATC with 3 Factory Sizes CHAPTER 13 THE COSTS OF PRODUCTION Firm can choose from 3 factory sizes: S , M , L . Each size has its own SRATC curve. The firm can change to a different factory size in the long run, but not in the short run. ATC S ATC M ATC L Q Avg Total Cost

39. EXAMPLE 3: LRATC with 3 Factory Sizes CHAPTER 13 THE COSTS OF PRODUCTION LRATC To produce less than Q A , firm will choose size S in the long run. To produce between Q A and Q B , firm will choose size M in the long run. To produce more than Q B , firm will choose size L in the long run. ATC S ATC M ATC L Q Avg Total Cost Q A Q B

40. A Typical LRATC Curve CHAPTER 13 THE COSTS OF PRODUCTION In the real world, factories come in many sizes, each with its own SRATC curve. So a typical LRATC curve looks like this: Q ATC LRATC

41. How ATC Changes as the Scale of Production Changes CHAPTER 13 THE COSTS OF PRODUCTION Economies of scale : ATC falls as Q increases. Constant returns to scale : ATC stays the same as Q increases. Diseconomies of scale : ATC rises as Q increases. LRATC Q ATC

48. The Complete Data for Example 2 CHAPTER 13 THE COSTS OF PRODUCTION 102.50 90 12.50 820 720 100 8 88.57 74.29 14.29 620 520 100 7 80 63.33 16.67 480 380 100 6 76 56.00 20 380 280 100 5 77.50 52.50 25 310 210 100 4 86.67 53.33 33.33 260 160 100 3 110 60 50 220 120 100 2 $170 $70 $100 170 70 100 1 n.a. n.a. n.a. $100 $0 $100 0 MC ATC AVC AFC TC VC FC Q 200 140 100 70 50 40 50 $70