WEEK 5 - Chapter 13: The Costs of Production Flashcards
What is a firm’s objective?
We begin with the firm’s objective. To understand what decisions a firm makes, we must understand what it is trying to do.
It is conceivable that Poh started her firm because of an altruistic desire to provide the world with cakes or, perhaps, out of love for the cake business. More likely, however, Poh started her business to make money.
Economists normally assume that the goal of a firm is to maximise profit and they find that this assumption works well in most cases.
What is profit?
The amount that the firm receives for the sale of its output is called its total revenue (for a firm).
Profit is a firm’s total revenue minus its total cost. That is:
Profit = Total revenue - Total cost
A firm’ objective is to make their profit as large as possible.
What is total revenue and total cost?
total revenue (for a firm) - the amount a firm receives for the sale of its output
total cost - the amount a firm pays to buy the inputs into production
Costs as opportunity costs.
When measuring costs at any firm it is important to keep in mind one of the Ten Lessons from Economics in chapter 1 – the cost of something is what you give up to get it.
Recall that the opportunity cost of an item refers to all those things that must be forgone to acquire that item. When economists speak of a firm’s cost of production, they include all the opportunity costs of making its output of goods and services.
A firm’s opportunity costs of production are sometimes obvious and sometimes less so.
Costs as opportunity costs example.
When Poh pays $1000 for flour, that $1000 is an opportunity cost because Poh can no longer use that $1000 to buy something else.
Similarly, when Poh hires workers to make the cakes, the wages she pays are part of the firm’s costs. These costs are explicit.
In contrast, some of a firm’s opportunity costs are implicit. Imagine that Poh is a skilled painter and could earn $100 per hour from her artwork. For every hour that Poh works at her cake factory she gives up $100 in income and this forgone income is also part of her costs.
The total cost of Poh’s business is the sum of her explicit and implicit costs.
Implicit and explicit costs.
This distinction between explicit and implicit costs highlights an important difference between how economists and accountants analyse a business.
Economists are interested in studying how firms make production and pricing decisions, so they include all opportunity costs when measuring costs.
In contrast, accountants have the job of keeping track of the money that flows into and out of firms. As a result, they measure the explicit costs but often ignore the implicit costs.
Economic profit vs accounting profit.
How an economist views a firm: revenue = economic profit - total opportunity costs (implicit costs + explicit costs)
How an accountant views a firm: revenue = accounting profit - explicit costs
The difference between the methods of economists and accountants is easy to see in the case of Poh’s Cake Factory.
When Poh gives up the opportunity to earn money by painting, her accountant will not count this as a cost of her cake business. Because no money flows out of the business to pay for this cost, it never shows up on the accountant’s financial statements.
An economist, however, will count the forgone income as a cost because it will affect the decisions that Poh makes in her cake business.
For example, if Poh’s earnings from her artwork rose from $100 to $500 per hour, she might decide that running her cake business is too costly and choose to shut down the factory in order to become a full-time artist.
Long-run vs short-run.
long run - the period of time needed for all factors of production to become variable
short run - a period of time during which at least one factor of production is fixed
What is the production function?
production function - the relationship between quantity of inputs used to make a good and the quantity of output of that good.
What is marginal product?
The increase in output that arises from an additional unit of input.
What is diminishing marginal product?
The property whereby the marginal product of an input declines as the quantity of the input increases.
Eg. At first, when only a few workers are hired, they have easy access to Poh’s kitchen equipment. As the number of workers increases, additional workers have to share equipment and work in more crowded conditions. Eventually, the factory is so crowded that the workers start getting in each other’s way. Hence, as more workers are hired, each additional worker contributes fewer additional cakes to total production.
What is that total cost curve?
Our goal in the next several chapters is to study firms’ production and pricing decisions.
For this purpose, the most important relationship is between quantity produced and total costs.
Figure 13.3 graphs these two columns of data with the quantity produced on the horizontal axis and total cost on the vertical axis. This graph is called the total-cost curve.
The total cost curve gets steeper as the amount produced rises, whereas the production function gets flatter as production rises. These changes in slope occur for the same reason. High production of cakes means that Poh’s kitchen is crowded with many workers. Because the kitchen is crowded, each additional worker adds less to production, reflecting diminishing marginal product. Therefore, the production function is relatively flat.
But now turn this logic around: When the kitchen is crowded, producing an additional cake requires a lot of additional labour and is thus very costly. Therefore, when the quantity produced is large, the total-cost curve is relatively steep.
Now com
What are the various measures of costs?
. Total cost (fixed + variable costs) . Fixed cost . Variable cost . Average fixed cost . Average variable cost . Average total cost . Marginal cost
What are fixed costs?
Costs that do not vary with the quantity of output produced.
Eg. Rent
What are variable costs?
Costs that vary with the quantity of output produced.
Eg. Coffee beans, milk and sugar at a coffeeshop.
Workers salaries
