Production and Costs Topic PRODUCTION & COSTS Production & Costs concepts Short run Costs Long Run Costs Some cost concepts Opportunity Cost  Opportunity cost: The benefit foregone, or opportunity lost, by not using resources in their best alternative use  Real Opportunity cost:   Maximum quantity of output forgone Money Opportunity cost  Maximum value of output forgone Some cost concepts Explicit Vs Implicit Cost  Explicit costs   what we actually pay for use of resources in business Implicit costs  opportunity costs of resources used but not actually paid for by the firm (eg proprietor's labour) Profit concepts  Accounting profit =Total revenue – Total Explicit costs  Economic profit = Total revenue – (Total Explicit costs + Total Implicit costs) = Total revenue – Opportunity costs of all resources used  Normal profit = Zero Economic profit or breaking even = The minimum cost payment just sufficient to keep the firm in business Exercise Bill runs a computer shop as a sole proprietorship The following data are about his financial matters in his first year of business Calculate Bill's accounting profit and economic profit for his first year of business $ 190,000 Total revenue 65,000 Salary that Bill could have earned if he had worked for another firm 90,000 Loan from a bank 9,000 Interest paid to the bank 70,000 Purchase of durable assets with his own money 4,200 Dividend that he could have earned by investing his $70,000 in shares 14,000 Depreciation of the durable assets 30,000 Salary for an assistant 67,000 Raw materials used Short- Run Vs Long-Run  Short run the time frame in which at least one input factor is fixed   Long run the time frame in which all input factors are variable  There is no fixed calendar definition of long or short run– it depends! Short Run Production   Assume all factors fixed, except labour Average Product of labour (APL) is the total product output per unit of labour where: Q is the total product output L is no of labour units Short Run Production  Marginal product of labour (MPL) is the additional product output resulting from an extra unit of labour ∆Q is the change in product output ∆L is no of units of labour  TP = Q = Total product or Total output Wheat production per year from a particular farm (tonnes) Copyright 2001 Pearson Education LONG-RUN THEORY OF PRODUCTION  In the long run All factors of production are variable LONG-RUN THEORY OF PRODUCTION Economies of scale:  As firm increases its scale of output => LRAC decreases Reasons  Specialisation & division of labour  Managerial Specialization  Efficient Capital  Bulk Buying  Greater efficiency of large machines  Supporting Facilities Costs ($) Economies of Scale LRAC O Output (a) Economies of scale fig Copyright 2001 Pearson Education LONG-RUN THEORY OF PRODUCTION  Diseconomies of scale As firm increases its scale of output, LRAC increases  Reasons:     Over specialization of labor Managerial Problems- Bureaucracy Access to Materials Access to skilled labours Diseconomies of Scale Costs LRAC O Output (b) Diseconomies of scale fig Copyright 2001 Pearson Education Costs Constant Return to scales O LRAC Output (c) Constant costs fig Copyright 2001 Pearson Education Costs A typical long-run average cost curve O Economies of scale Constant Return to scale q1 Diseconomies of scale q2 fig LRAC Output Copyright 2001 Pearson Education Minimum Efficient Scale (MES) Definition:  MES is the smallest level of output at which a firm can minimize its LR average costs  MES occurs at q1 unit of output Costs A typical long-run average cost curve Economies of scale Constant Return to scale Diseconomies of scale LRAC MES O q1 q2 fig Output Copyright 2001 Pearson Education Constructing long-run average cost curves: factories of fixed size Costs SRAC1 factory O Output fig Copyright 2001 Pearson Education Constructing long-run average cost curves: factories of fixed size SRAC1 Costs SRAC2 factories O Output fig Copyright 2001 Pearson Education Constructing long-run average cost curves: factories of fixed size SRAC1 Costs SRAC2 SRAC3 factories O Output fig Copyright 2001 Pearson Education Constructing long-run average cost curves: factories of fixed size SRAC1 Costs SRAC2 SRAC3 SRAC5 SRAC4 factories factories O Output fig Copyright 2001 Pearson Education Constructing long-run average cost curves: factories of fixed size SRAC1 SRAC2 SRAC3 SRAC5 SRAC4 Costs LRAC O Output fig Copyright 2001 Pearson Education Assuming a virtually unlimited number of plant sizes, LRAC curve takes on a smoother shape Costs LRAC O Output fig Copyright 2001 Pearson Education .. .PRODUCTION & COSTS Production & Costs concepts Short run Costs Long Run Costs Some cost concepts Opportunity Cost  Opportunity cost:... profit =Total revenue – Total Explicit costs  Economic profit = Total revenue – (Total Explicit costs + Total Implicit costs) = Total revenue – Opportunity costs of all resources used  Normal... Scale Costs LRAC O Output (b) Diseconomies of scale fig Copyright 2001 Pearson Education Costs Constant Return to scales O LRAC Output (c) Constant costs fig Copyright 2001 Pearson Education Costs