Economics 1: Lectures 11-13

Production, Costs and Profits

Ioana R. Moldovan
University of Glasgow
Outline

1. Production, costs, and profits - An Overview

2. The short-run

3. The long-run
Production, Costs, and Profits

Production

Factor inputs:

labour - effort of people (L)

capital - buildings and equipment (K)

land

intermediate inputs - goods (produced by others) used in the production

entrepreneurship

Production function: describes the technological relationship between inputs and out-
puts.
Q = f (factor inputs)
Costs

There are costs associated with the production of goods and services:

wages and other personnel related costs

costs of capital acquisition and usage (depreciation)

costs related to the use of land

costs with the purchase of intermediate inputs

opportunity cost of the owners investment capital and also managerial skills

Opportunity Costs: reflect the value of best forgone alternative. Sometimes these
costs are implicit but they must be counted (e.g. opportunity cost of financial capital,
of risky investment, of time).
Profits
(Q) = R (Q) C (Q)

where: (Q) : profit of producing Q,

R (Q) : revenues from selling Q, and

C (Q) : costs of producing Q

accounting profits - based on actual explicit costs
Profits =

economic (pure) profits - based on opportunity costs

Economic Profits as Signal: Positive economic profits signal that returns in a particular
market are larger than in other markets. This leads to a movement of resources into this
particular industry. Similarly, resources move out of an industry which shows negative
economic profits.
The Time Horizon

Short run: at least one of the inputs cannot be adjusted (most often K)

Long run: all inputs can be adjusted

Very long run: the technology (production function) can be changed

Note: the time horizon is industry/sector specific

The Short Run

Production uses only capital and labour & the amount of capital is assumed fixed:
 
Q = f K, L
Look at how the amount of goods produced per time period (Q) varies with changes in
the variable input (L), i.e. see what happens to production as more workers are being
employed (or morehours
 are being spent working), given the technology (f ) and the
amount of capital K available.
Total Product (TP) = total amount of goods produced during a certain time period
by all the inputs the firm uses
 
T P = Q = f K, L

TP (Q)

0 L

Figure 1: Total product as a function of varying labor input

Average Product (AP) = total product per unit of the variable input (here: amount
produced per worker).

TP
AP =
L

It can be measured as the slope of the straight line from the origin to the corresponding
point on the total product curve. (See dotted lines in Figure 2.)

Marginal Product (MP) = the change in the total product due to the use of one more
(or one less) unit of the variable input (here: we consider changes in labour).
T P
MP =
L

In a very precise way, it can be measured as the slope of the tangent to the production
function at every point (See the illustration in Figure 3.)
 T P (Q )

Q3
Q2

Q1

0 L1 L2 L3 L

Figure 2: The total product function. The slopes of the dotted lines represent the values of the average
product at each point.

Note that, initially, as more workers are being employed, the average product increases.
The maximum average product happens when the number of workers equals L2 (the
straight line from the origin to the point corresponding to L2 is the steepest). As the
number of workers exceeds L2, output still increases but output per worker declines.The
average product curve is illustrated in Figure 4.
 T P (Q )

0 L* L

Figure 3: The total product function. The slopes of the the tangent to the curve indicate the marginal
product, measured in a very precise way.

Note that as more workers are being employed, the marginal product increases but then
it eventually starts to decrease. This can be seen in Figure 4. The maximum marginal
product occurs when the number of workers equals L.
 AP,
MP B

MP AP

0 L* L2 L

Figure 4: Average product and marginal product, varying with the amount of labor used
in production.

A: Point of diminishing average product

B: Point of diminishing marginal product

The law of diminishing returns: increasing the quantities of a variable input,
for a given quantity of the fixed input, the marginal product and the average
product of the variable input will eventually decrease.

Marginal Product and Average Product Curves:

MP = AP when AP is at its maximum.

AP curve slopes upwards as long as the MP curve is above the AP curve.

If an additional worker causes an increase in output that exceeds the average product
of the existing workers, then it must lead to a rise in the average product.

Note that it does not matter whether the MP curve is itself sloping upwards or down-
wards.
Marginal & Average Products: Numerical Example - Exams and Grades

Points per exam (=MP) Total Average

Exam #1 6 6 6/1 = 6
Exam #2 8 6 + 8 = 14 14/2 = 7
Exam #3 7 14 + 7 = 21 21/3 = 7
Exam #4 5

The extra 8 points you receive for Exam #2 represent the marginal increase in total
points that the one extra exam brought.

The average grade after the first exam was 6 points. The second exam brought 8 extra
points (8 > 6) and the average increased to 7.

How well do you have to do in Exam #3 to keep your average at 7? > Need 7 extra
points in Exam #3.

T otal P oints = 14 + 7 = 21

T otal P oints 21
Average = = =7
# of exams 3
What happens if in Exam #4 you get only 5 points? > Your average grade will drop!

T otal P oints = 21 + 5 = 26

T otal P oints 26
Average = = = 6.5 < 7
# of exams 4

The average decreased because the marginal change (5) was smaller than the existing
average (7).
Optional Proof

Want to show that

If MP > AP1, then AP2 > AP1 (i.e.AP is increasing)

Proof:
Q1
Initially have : L1 and AP1 = = Q1 = AP1 L1
L1
Increase L1 by 1 unit :
Q2
L2 = L1 + 1 and AP2 = = Q2 = AP2 L2
L2
Then, by the definition of the marginal product:
Q Q
MP = = = Q = Q2 Q1 = AP2 L2 AP1 L1
L L2 L1

= MP AP1 = AP2 L2 AP1 (L1 + 1) = (AP2 AP1) L2

It then follows that:

MP > AP1 MP AP1 > 0 AP2 AP1 > 0 AP2 > AP1
Costs in the Short-Run

Total Cost, T C (Q) : the total cost of producing a given amount of output Q

Fixed Costs, T F C: costs associated with the fixed input. They do NOT vary with
output. They are sometimes called overhead or unavoidable costs.

Variable Costs, T V C (Q) : costs that vary with output (increase if we want to
produce more, decrease if we want to produce less). They are associated with the
variable inputs in production. Often, they are called direct or avoidable costs.

T C (Q) = T F C + T V C (Q)

Note that, in the long-run, there should be no fixed costs!

Total Cost Curves

Total TC
Costs

TVC

TFC

0 Q
Average and Marginal Costs

Average Total Cost, AT C (Q) : the total cost per unit of output produced.

T C (Q) T F C T V C (Q)
AT C (Q) = = +
Q Q Q

= AF C (Q) + AV C (Q)

Average Fixed Costs, AF C (Q) : measure of fixed cost per unit of output. Be-
cause the TFC does not vary with output, it means that the AF C is decreasing with
output (i.e. as more is being produced, the fixed cost is distributed over more units of
good).

Average Variable Costs, AV C (Q) : measure of variable costs per unit of output.
Average and Marginal Costs - Contd

Marginal Cost, MC (Q) :

Is the change in total costs that results from raising production by one unit.

T C (Q)
MC (Q) = = marginal cost of producing the Qth unit
Q

Equivalently, the marginal cost can be expressed in terms of the change in the total
variable cost of producing the Qth unit. This is because Total Fixed Costs are, well,
fixed and therefore the change in Total Costs equals the change in Total Variable Costs

TC = TFC + TV C

  F C
+ T V C = T V C
T C = T
=0
Marginal & Average Costs: Numerical Example - Workers and Output

K = amount of capital (PK = $10) L = labour input (PL = $20)

TFC = Total Fixed Cost, TVC = Total Variable Cost, TC = Total Cost

AFC = Average Fixed Cost, AVC = Average Variable Cost, ATC = Average Total Cost

Inputs Output Total Costs Average Costs Marginal Cost

K L Q TFC TVC TC AFC AVC ATC MC
10 0 0 100 0 100
10 1 50 100 20 120 2.0 0.4 2.4 0.4
10 2 160 100 40 140 0.625 0.25 0.875 0.182
10 3 250 100 60 160 0.4 0.24 0.64 0.22

See Table 6.2, Chapter 6, Lipsey & Crystal, for a more elaborate example!
Average and Marginal Cost Curves
The average cost is given by the slope of the ray from the origin to a point on the total
cost curve. The marginal cost is given by the slope of the tangent to the total cost
curve at a certain point.

Total TC
Costs

TVC

0 Q1 Q2 Q3 Q
AC,
MC
MC
ATC

AVC

AFC

0 Q2 Q* Q
Remarks:

At any level of output, the difference between AT C and AV C equals the AF C.

The marginal cost curve cuts the AT C and AV C curves at their lowest points and

MC < (below) AV C = AV C

W hen :

MC > (above) AV C = AV C

MC < (below) AT C = AT C

W hen :

MC > (above) AT C = AT C

Generally, when the marginal change is larger than the average, then the average in-
creases. The opposite occurs when the marginal change is smaller than the average.
This was illustrated with: (i) marginal and average products, and (ii) marginal and
average costs.

The output level produced with the minimum average total cost is called CAPACITY.
The Long-Run

Cost Minimization

In time, the firm can adjust the amount of each input used in production, they can vary
the combination of inputs. In principle, firms want to use factor inputs in ways that are
both technically efficient and economically efficient.

Being technically efficient means that firms do not want to use more of all inputs than
it is necessary. By knowing the technology available, firms can identify the set of input
combinations that are technically efficient.

Then, the remaining objective is to choose the combination of inputs (among the tech-
nically efficient ones) that allows the firm to produce a given level of output at the
lowest possible cost = Cost Minimization

Choice depends on the price and productivity of inputs.

The Principle of Substitution

Costs are minimized when the following condition holds:

MPK MPL
=
PK PL
or
MPK PK
=
MPL PL
where MPK and MPL represent the marginal product of capital and labour, respec-
tively, while PK and PL are the prices of capital and labour.

Firms can adjust the quantities of inputs used according to market prices. They substi-
tute one input for another until the ratio of their marginal products equals the ratio of
their prices.

Changes in the relative prices of factor inputs will induce incentives to reallocate re-
sources - use relatively more of the cheaper input and relatively less of the more expensive
input.
Cost Curves in the Long Run

When all inputs can be varied, there is a least-cost method of producing any level of
output. This means that, taking as given the current technology available and the prices
of factor inputs, there is a minimum achievable cost for each level of output. If this
cost is expressed in terms of cost per unit of output produced, we obtain the Long-Run
Average Cost. If we graph the long-run average cost against the level of ouput, we
obtain the Long-Run Average Cost (LRAC) curve.

The LRAC curve is the boundary between cost levels that are attainable (given technol-
ogy and factor input prices) and those that are unattainable.
LRAC Curve

AC

Economies of scale Diseconomies of scale

LRAC
C1

0 Q1 Qm Q
Returns to Scale and the Shape of the LRAC Curve

Long run costs can vary due to varying input prices and changing technologies. For now,
assume that input prices remain constant.

Qm = minimum efficient scale. It is the level of output at which per unit long run costs
are minimized.

Decreasing Costs: When output is below Qm, the firm can increase production
and decrease per unit costs. Technologies with such properties exhibit economies of
scale. With fixed input prices, the reduction in per unit cost can occur only if output
increases by more relative to the increase in the use of inputs. It is said that, over that
range of output, the firm enjoys increasing returns.

Increasing Costs: When output is above Qm, the firm can choose to increase
production but it encounters higher per unit costs. With fixed input prices, the increase
in per unit cost occurs as a consequence of the fact that output increases by less relative
to the increase in the use of inputs. It is said that, over that range of output, the firm
faces decreasing returns. And there are diseconomies of scale possible sources:
difficulties with managing and controlling the firms activities as its size increases.
Constant Costs: This means that increasing output does not change the per
unit cost. Such a situation arises when the LRAC curve has a flat portion over a
range of output around Qm. With constant input prices, it means that output must
be increasing exactly in proportion to the increase in inputs. The technology exhibits
constant returns to scale.

Sources of increasing returns:

geometrical relations: e.g. volume vs. area

one-time cost: e.g. R&D for a given product

technology of large scale production: large scale productions can use more special-
ized and highly efficient machinery
LRAC Curve in the Case of Constant Returns to Scale

AC

Constant returns to scale

LRAC

0 Qm Q
Relationship between Long Run and Short Run Average Costs

AC

SRATC

LRAC

0 Qm Q
The SRATC curves are tangent to the LRAC curve. But, at values other than Qm, the
tangency point is NOT at the minimum of the SRATC.

AC

LRAC

SRATC

0 Qm Q
We can try to show this using a proof by contradiction: i.e, we suppose the contrary.
Suppose that the SRATC curve were linked to the LRAC curve at the minimum of the
SRATC curve (as shown in the next figure).

Suppose that the level of output produced is Q1, at the minimum average cost possible
in the short run. If the firm decides to reduce production, from Q1 to Q2, then it will
incur an increase in the per-unit cost. The Short-Run average cost of producing Q2 is
given by AC SR. However, from the figure, we can see that the Long-Run average cost
of producing Q2 is AC LR, which is higher  than AC

SR. This cannot be true because,

by definition, the long-run average cost AC LR of producing the amount Q2 is the

minimum achievable cost. Any lower value is not attainable given current technologies
and input prices. Hence, the way we drew the SRATC curve is not correct.

The only exception occurs when producing at the point of minimum efficient scale (Qm)
 AC
N O T C orrect!!!

LR A C

A C LR S R A TC

A C SR

0 Q2 Q1 Qm Q