Module 5: Production and costs
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
Module 5: Production and costs 5.2.1: Demonstration - production of tennis balls ● Production of anything is essentially a threestep process: ○ Inputs are combined ○ Production process ○ Output is produced ● Activity in “live” class introduces concept of production ○ Tennis balls “produced” when a student grabs one from the bucket and passes it along the “production line” to another bucket. To be counted, the ball must be touched by all “workers” and cannot be dropped. ■ Start with 2 workers → 8 balls “produced” ■ With 4 workers → 11 balls ■ With 6 → 11 balls ■ With 8 → 13 balls ■ With 10 → 13 balls, but 2 are “broken” (dropped) ■ With 12 → 15 balls (several dropped) ○ The question: Are we better off with 2 workers or with 12?
5.2.2: Production process at a glance ● Let’s look at how the previous example fits into the production process. Our inputs are: ○ workers we changed the number each time, so these are a variable input . ○ buckets these didn’t change, so they are a fixed input ○ (We’re leaving out the tennis balls here, since they’re also outputs) ● Inputs at the Black Dog: ○ Electric bill fixed ○ Building/kitchen space fixed ■ Mike could open a second store, or expand space but both would cost time, money and other resources ○ Staff variable ■ Goal is 20% of costs, but can run a little high because building setup doesn’t allow for full efficiency ■ Labor fluctuates with number of sandwiches sold. ■ Started with 2 cooks; at some point, realized 3rd would move food (and tables) faster. Can’t go any higher because there’s not room. ● Whether an input is fixed or variable can depend on the time frame. ○ Long run time in which some inputs are fixed ○ Short run time in which all inputs are variable ○ Kitchen could become variable input if he has time to change it in the long run, essentially, all inputs are variable and there are no fixed inputs ○ Terms economists tend to use: ■ labor in reference to variable inputs (often associated with staffing)
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
■ capital in reference to fixed inputs (often associated with plant, place, machinery, etc. things that take longer to purchase)
5.2.3: A numerical example - cooks in the kitchen ● Mike, owner of the Black Dog: ○ As we got busier, determined we’d need 3 servers all the time (and sometimes 4) adding more would make it too crowded. Each server gets 45 tables. ○ Started with 2 cooks, later added a 3rd, but not space for any more ○ Added folks in the back to do prep work so people on the line can work faster ○ Big consideration is balancing the number of workers against the limited space. ● As you increase the number of workers and have a fixed input, you run into that fixed input’s limitations, which affects productivity. ● Let’s look at one scenario for the Black Dog: ○ The total product curve at the right reflects the schedule of cooks/sandwiches gained that I couldn’t get to play nicely with the chart ■ After a point (cook #2), the gains from adding additional cooks become smaller. ■ The Y axis is the marginal product of labor , or MP . L ■ If we followed this chart a little farther, adding more cooks (labor), we’d see productivity start to decrease forming an inverted U shape ○ Now let’s add in the marginal product how many more sandwiches we add with each cook. ○ MP = Δ Q L Δ L ○ We see a diminishing margin of product for the variable output at some point, you have too many cooks .
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
5.3.1: Fixed, variable and total costs ● Let’s assume Mike has two inputs ○ cooks = $80/day per worker (variable input) ○ grill = $100/day (fixed input loan must be paid even if no sandwiches produced or restaurant is closed) ● Variable costs = # workers x $80; fixed cost = $100 ● Total costs = fixed cost + variable cost (TC = FC + VC) ○ So our table looks like this: # cooks
# sandwiches
Marginal product
Fixed costs
Variable costs
Total costs
0
0
0
$100
$0
$100
1
40
40
$100
$80
$180
2
90
50
$100
$160
$260
3
120
30
$100
$240
$340
4
135
15
$100
$320
$420
5
140
5*
$100
$400
$500
6
142
2*
$100
$480
$580
*Videos list these as 0, possibly for simplification purposes
○ This will produce a chart that looks something like the one at right. This is the total cost curve . ■ Increases slightly at beginning, but shoots up a lot as you go further out. ● This is because your costs increase steadily, but the gains in number of sandwiches produced are getting smaller. ■ It’s a mirror image of the total product curve we flipped the axes. ■ The slope of this curve is called the marginal cost of production tells you how much the cost of production goes up with each additional cook.
5.3.2: Marginal costs ● Marginal costs the additional costs required to produce one more of an item. ○ MC = Δ TC Δ Q
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
# cooks
# sandwiches
Marginal product
Fixed costs
Variable costs
Total costs
Marginal costs
0
0
0
$100
$0
$100
1
40
40
$100
$80
$180
$2
2
90
50
$100
$160
$260
$1.60
3
120
30
$100
$240
$340
$2.70
4
135
15
$100
$320
$420
$5.30
5
140
5*
$100
$400
$500
$16
6
142
2*
$100
$480
$580
$40
*Videos list these as 0, presumably for simplification purposes
● As the marginal product of labor decreases, the marginal costs increase.
5.3.3: Cost curves # cooks
# sandwiches
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
0
0
1
40
$2.50
$2
$4.50
$2
2
90
$1.11
$1.78
$2.89
$1.60
3
120
$0.83
$2
$2.83
$2.70
4
135
$0.74
$2.37
$3.11
$5.30
5
140
$0.71
$2.86
$3.57
$16
6
142
$0.70
$3.38
$4.08
$40
● Calculating perunit basis for fixed costs ( average fixed cost ) ○ Average fixed costs = fixed costs/output (AFC = FC/Q) ○ Higher at the beginning, but goes down as output increases ● Calculating average variable cost ○ Average variable cost = variable cost/output (AVC = VC/Q) ○ Will go up at some point because more workers are being paid the same money, regardless of how productive they are ● Average total cost per unit (ATC) = AVC + AFC ○ Same as TC/Q
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
○ Note that average total cost goes down for the first three cooks, then starts to rise again. ○ The lowest point on the average total cost curve ($2.83) is the minimumcost output the lowest cost per sandwich we can achieve. ■ This is the most efficient use of resources the best possible way of doing this. ■ The marginal cost curve crosses the average total cost curve at this point. This isn’t coincidence, but a mathematical property. ● When the marginal is higher than the average, your average will go up. ● When the marginal’s lower than the average, your average will go down.
Module 6: Competitive output 6.2.1: The maximizing profit assumption ● Probably best explained in the “greed … is good” speech from Wall Street ○ Greed is what drives the economy, what drives people to innovate ultimately means more jobs, food on the table, etc. ● For our purposes, we’ll assume any company, manager, etc. is driven by greed that their only goal is to get the highest possible profit (though in reality, there are lots of other reasons one might start a company). ○ Profit = Revenue Cost (or π = R TC) ○ We use π for profit because P = price, and TC = total cost
6.2.2: The profit equation ● Let’s say you own a BBQ sandwich joint, and at current production levels, your economic profits are zero. Which of the following should you do? ○ Continue to operate your business ○ Get out of the business ○ Expand operations ○ Reduce operations ● Economic theory says you should keep doing what you’re doing if your economic profits are zero, you’re actually doing pretty well . ○ This differs from most people’s kneejerk response, which is to reduce operations or to cut and run. ● To understand why, you must understand the difference between economic profits and accounting profits.
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
○ Mike at the Black Dog: Worked 15 years as bartender at the Esquire Lounge; was talking about business idea with one of the club’s three owners, who became my business partner. ■ Spent a year looking for a location; he taught me a lot along the way about the process. Found this place and knew the owner, who was looking to get out, and bought the building. ■ Had quit job just before that twin sons were born had no income until a while after business opened. Living daytoday the most expensive part; wife works, which helps, but she wasn’t working much at that point, having just given birth. ■ Today, it seems like a nobrainer; not that obvious the first few months, but quickly caught on. ○ Economic profits take into consideration opportunity cost money a person must forgo in undertaking a business decision. ■ Mike had to quit his job to put in enough time for the new business for it to be a successful venture for him, it had to give him as much money as he was making as a bartender. ■ Hypothetical numbers: Say Mike made $100/day as a bartender, and that his sandwich place brings in $200/day in revenue and has operating costs of $100/day. What are Mike’s profits? Depends on how they’re calculated: ● Accounting profits → $200 (R) $100 (TC) = $100 ○ Does not consider opportunity cost. ● Economic profits → $200 (R) $100 (TC) $100 (OC) = 0 ○ If his economic profits are zero, that means Mike isn’t just paying himself a salary he’s paying himself as much as he would have made working somewhere else. ○ For purposes of this course, when we say profits, we are referring to economic profits this becomes really important in some of the equations we do later.
6.2.3: The profit-maximizing rule ● Now, we’re trying to find a rule to help us answer the following question: How much output should be produced to maximize profits? ○ Say at your current level of production, your average total cost is $4.08. If you charge $8 for each BBQ sandwich and want to increase profits, should you: ■ Produce more sandwiches ■ Produce fewer sandwiches ■ Produce the same number of sandwiches ■ We can’t answer ○ From the information given, we can’t tell though we can calculate that our profit (π = RTC) is $3.92 per sandwich. ■ We can also calculate total profits = (P ATC) * Q ● example: 1 cook/40 sandwiches → (8 4.50) * 40 = $140
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
○ Let’s go back to our table from last week, with profits added:
# cooks
# sandwiches
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
Profits ( π)
0
0
1
40
$2.50
$2
$4.50
$2
$140
2
90
$1.11
$1.78
$2.89
$1.60
$460
3
120
$0.83
$2
$2.83
$2.70
$620
4
135
$0.74
$2.37
$3.11
$5.30
$660
5
140
$0.71
$2.86
$3.57
$16
$620
6
142
$0.70
$3.38
$4.08
$40
$556
●
● ● ●
○ With the table in front of us, it’s clear that reducing output from 142 to 140 would let you get rid of a cook, raising profits from $556 to $620. Knowing that, our answer to the first question is that we should reduce output . ■ We could not answer that question without knowing the marginal cost change . The chart also indicates that the best output for maximizing profits is 135 sandwiches ($660 profits). ○ What happens if we produce a different output? Say you have 4 cooks (for maximum profits) and decide to add a 5th anyway. ■ change in Q = 5 ■ ATC = ($3.57 $3.11) = $0.46 ■ Hiring another worker increases cost for each of those 5 extra sandwiches from $5.30 to $16 while you’re getting just $8 in revenue per sandwich. ○ What if you’re using 3 cooks and making 120 sandwiches, and are looking to go to 4 cooks/135 sandwiches? ■ change in Q = +15 ■ Marginal cost of those sandwiches rises from $2.70 to $5.30, which is still lower than the revenue being brought in per sandwich. ■ π = RC → 8 5.30 = $2.70 in profits Profits will rise as long as revenue rises more than costs. ○ If MR > MC of last unit → you should produce more If costs rise more than revenue, profits will go down. ○ If MR
Module 5: Production and costs 5.2.1: Demonstration - production of tennis balls ● Production of anything is essentially a threestep process: ○ Inputs are combined ○ Production process ○ Output is produced ● Activity in “live” class introduces concept of production ○ Tennis balls “produced” when a student grabs one from the bucket and passes it along the “production line” to another bucket. To be counted, the ball must be touched by all “workers” and cannot be dropped. ■ Start with 2 workers → 8 balls “produced” ■ With 4 workers → 11 balls ■ With 6 → 11 balls ■ With 8 → 13 balls ■ With 10 → 13 balls, but 2 are “broken” (dropped) ■ With 12 → 15 balls (several dropped) ○ The question: Are we better off with 2 workers or with 12?
5.2.2: Production process at a glance ● Let’s look at how the previous example fits into the production process. Our inputs are: ○ workers we changed the number each time, so these are a variable input . ○ buckets these didn’t change, so they are a fixed input ○ (We’re leaving out the tennis balls here, since they’re also outputs) ● Inputs at the Black Dog: ○ Electric bill fixed ○ Building/kitchen space fixed ■ Mike could open a second store, or expand space but both would cost time, money and other resources ○ Staff variable ■ Goal is 20% of costs, but can run a little high because building setup doesn’t allow for full efficiency ■ Labor fluctuates with number of sandwiches sold. ■ Started with 2 cooks; at some point, realized 3rd would move food (and tables) faster. Can’t go any higher because there’s not room. ● Whether an input is fixed or variable can depend on the time frame. ○ Long run time in which some inputs are fixed ○ Short run time in which all inputs are variable ○ Kitchen could become variable input if he has time to change it in the long run, essentially, all inputs are variable and there are no fixed inputs ○ Terms economists tend to use: ■ labor in reference to variable inputs (often associated with staffing)
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
■ capital in reference to fixed inputs (often associated with plant, place, machinery, etc. things that take longer to purchase)
5.2.3: A numerical example - cooks in the kitchen ● Mike, owner of the Black Dog: ○ As we got busier, determined we’d need 3 servers all the time (and sometimes 4) adding more would make it too crowded. Each server gets 45 tables. ○ Started with 2 cooks, later added a 3rd, but not space for any more ○ Added folks in the back to do prep work so people on the line can work faster ○ Big consideration is balancing the number of workers against the limited space. ● As you increase the number of workers and have a fixed input, you run into that fixed input’s limitations, which affects productivity. ● Let’s look at one scenario for the Black Dog: ○ The total product curve at the right reflects the schedule of cooks/sandwiches gained that I couldn’t get to play nicely with the chart ■ After a point (cook #2), the gains from adding additional cooks become smaller. ■ The Y axis is the marginal product of labor , or MP . L ■ If we followed this chart a little farther, adding more cooks (labor), we’d see productivity start to decrease forming an inverted U shape ○ Now let’s add in the marginal product how many more sandwiches we add with each cook. ○ MP = Δ Q L Δ L ○ We see a diminishing margin of product for the variable output at some point, you have too many cooks .
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
5.3.1: Fixed, variable and total costs ● Let’s assume Mike has two inputs ○ cooks = $80/day per worker (variable input) ○ grill = $100/day (fixed input loan must be paid even if no sandwiches produced or restaurant is closed) ● Variable costs = # workers x $80; fixed cost = $100 ● Total costs = fixed cost + variable cost (TC = FC + VC) ○ So our table looks like this: # cooks
# sandwiches
Marginal product
Fixed costs
Variable costs
Total costs
0
0
0
$100
$0
$100
1
40
40
$100
$80
$180
2
90
50
$100
$160
$260
3
120
30
$100
$240
$340
4
135
15
$100
$320
$420
5
140
5*
$100
$400
$500
6
142
2*
$100
$480
$580
*Videos list these as 0, possibly for simplification purposes
○ This will produce a chart that looks something like the one at right. This is the total cost curve . ■ Increases slightly at beginning, but shoots up a lot as you go further out. ● This is because your costs increase steadily, but the gains in number of sandwiches produced are getting smaller. ■ It’s a mirror image of the total product curve we flipped the axes. ■ The slope of this curve is called the marginal cost of production tells you how much the cost of production goes up with each additional cook.
5.3.2: Marginal costs ● Marginal costs the additional costs required to produce one more of an item. ○ MC = Δ TC Δ Q
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
# cooks
# sandwiches
Marginal product
Fixed costs
Variable costs
Total costs
Marginal costs
0
0
0
$100
$0
$100
1
40
40
$100
$80
$180
$2
2
90
50
$100
$160
$260
$1.60
3
120
30
$100
$240
$340
$2.70
4
135
15
$100
$320
$420
$5.30
5
140
5*
$100
$400
$500
$16
6
142
2*
$100
$480
$580
$40
*Videos list these as 0, presumably for simplification purposes
● As the marginal product of labor decreases, the marginal costs increase.
5.3.3: Cost curves # cooks
# sandwiches
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
0
0
1
40
$2.50
$2
$4.50
$2
2
90
$1.11
$1.78
$2.89
$1.60
3
120
$0.83
$2
$2.83
$2.70
4
135
$0.74
$2.37
$3.11
$5.30
5
140
$0.71
$2.86
$3.57
$16
6
142
$0.70
$3.38
$4.08
$40
● Calculating perunit basis for fixed costs ( average fixed cost ) ○ Average fixed costs = fixed costs/output (AFC = FC/Q) ○ Higher at the beginning, but goes down as output increases ● Calculating average variable cost ○ Average variable cost = variable cost/output (AVC = VC/Q) ○ Will go up at some point because more workers are being paid the same money, regardless of how productive they are ● Average total cost per unit (ATC) = AVC + AFC ○ Same as TC/Q
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
○ Note that average total cost goes down for the first three cooks, then starts to rise again. ○ The lowest point on the average total cost curve ($2.83) is the minimumcost output the lowest cost per sandwich we can achieve. ■ This is the most efficient use of resources the best possible way of doing this. ■ The marginal cost curve crosses the average total cost curve at this point. This isn’t coincidence, but a mathematical property. ● When the marginal is higher than the average, your average will go up. ● When the marginal’s lower than the average, your average will go down.
Module 6: Competitive output 6.2.1: The maximizing profit assumption ● Probably best explained in the “greed … is good” speech from Wall Street ○ Greed is what drives the economy, what drives people to innovate ultimately means more jobs, food on the table, etc. ● For our purposes, we’ll assume any company, manager, etc. is driven by greed that their only goal is to get the highest possible profit (though in reality, there are lots of other reasons one might start a company). ○ Profit = Revenue Cost (or π = R TC) ○ We use π for profit because P = price, and TC = total cost
6.2.2: The profit equation ● Let’s say you own a BBQ sandwich joint, and at current production levels, your economic profits are zero. Which of the following should you do? ○ Continue to operate your business ○ Get out of the business ○ Expand operations ○ Reduce operations ● Economic theory says you should keep doing what you’re doing if your economic profits are zero, you’re actually doing pretty well . ○ This differs from most people’s kneejerk response, which is to reduce operations or to cut and run. ● To understand why, you must understand the difference between economic profits and accounting profits.
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
○ Mike at the Black Dog: Worked 15 years as bartender at the Esquire Lounge; was talking about business idea with one of the club’s three owners, who became my business partner. ■ Spent a year looking for a location; he taught me a lot along the way about the process. Found this place and knew the owner, who was looking to get out, and bought the building. ■ Had quit job just before that twin sons were born had no income until a while after business opened. Living daytoday the most expensive part; wife works, which helps, but she wasn’t working much at that point, having just given birth. ■ Today, it seems like a nobrainer; not that obvious the first few months, but quickly caught on. ○ Economic profits take into consideration opportunity cost money a person must forgo in undertaking a business decision. ■ Mike had to quit his job to put in enough time for the new business for it to be a successful venture for him, it had to give him as much money as he was making as a bartender. ■ Hypothetical numbers: Say Mike made $100/day as a bartender, and that his sandwich place brings in $200/day in revenue and has operating costs of $100/day. What are Mike’s profits? Depends on how they’re calculated: ● Accounting profits → $200 (R) $100 (TC) = $100 ○ Does not consider opportunity cost. ● Economic profits → $200 (R) $100 (TC) $100 (OC) = 0 ○ If his economic profits are zero, that means Mike isn’t just paying himself a salary he’s paying himself as much as he would have made working somewhere else. ○ For purposes of this course, when we say profits, we are referring to economic profits this becomes really important in some of the equations we do later.
6.2.3: The profit-maximizing rule ● Now, we’re trying to find a rule to help us answer the following question: How much output should be produced to maximize profits? ○ Say at your current level of production, your average total cost is $4.08. If you charge $8 for each BBQ sandwich and want to increase profits, should you: ■ Produce more sandwiches ■ Produce fewer sandwiches ■ Produce the same number of sandwiches ■ We can’t answer ○ From the information given, we can’t tell though we can calculate that our profit (π = RTC) is $3.92 per sandwich. ■ We can also calculate total profits = (P ATC) * Q ● example: 1 cook/40 sandwiches → (8 4.50) * 40 = $140
Lauren Phillips Microeconomics Principles, Winter 2014 Dr. José J. VázquezCognet, University of Illinois at UrbanaChampaign
○ Let’s go back to our table from last week, with profits added:
# cooks
# sandwiches
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
Profits ( π)
0
0
1
40
$2.50
$2
$4.50
$2
$140
2
90
$1.11
$1.78
$2.89
$1.60
$460
3
120
$0.83
$2
$2.83
$2.70
$620
4
135
$0.74
$2.37
$3.11
$5.30
$660
5
140
$0.71
$2.86
$3.57
$16
$620
6
142
$0.70
$3.38
$4.08
$40
$556
●
● ● ●
○ With the table in front of us, it’s clear that reducing output from 142 to 140 would let you get rid of a cook, raising profits from $556 to $620. Knowing that, our answer to the first question is that we should reduce output . ■ We could not answer that question without knowing the marginal cost change . The chart also indicates that the best output for maximizing profits is 135 sandwiches ($660 profits). ○ What happens if we produce a different output? Say you have 4 cooks (for maximum profits) and decide to add a 5th anyway. ■ change in Q = 5 ■ ATC = ($3.57 $3.11) = $0.46 ■ Hiring another worker increases cost for each of those 5 extra sandwiches from $5.30 to $16 while you’re getting just $8 in revenue per sandwich. ○ What if you’re using 3 cooks and making 120 sandwiches, and are looking to go to 4 cooks/135 sandwiches? ■ change in Q = +15 ■ Marginal cost of those sandwiches rises from $2.70 to $5.30, which is still lower than the revenue being brought in per sandwich. ■ π = RC → 8 5.30 = $2.70 in profits Profits will rise as long as revenue rises more than costs. ○ If MR > MC of last unit → you should produce more If costs rise more than revenue, profits will go down. ○ If MR
