The Costs of Production

00:01 Hello, and welcome back to your online presentation of Microeconomics.

00:04 My name is James DeNicco.

00:06 This presentation is gonna be about the Cost of Production.

00:09 We're gonna look at what the different costs of production are.

00:13 We're gonna find out the difference between economic and accounting profit.

00:18 We're gonna look at marginal cost and how they rise.

00:21 We're gonna look at average total cost curves. Why they're U shaped? We're gonna look at the relationship between marginal cost and average total cost curves.

00:30 So, let's get into it.

00:31 First, the cost of production here, alright? So, let's define profit. Our profit is gonna be our total revenue minus our total cost.

00:42 So, whenever you wanna increase your profits, you can either increase revenue or you can decrease costs.

00:49 Here, we're gonna be talking about the cost side. Okay? What are the different costs of production? Alright? So, our total cost, that's the market value of the inputs a firm uses in production.

01:00 Our total revenue, the amount of firm receives for the sale of its output.

01:04 So, now, our profit is gonna be our total revenue minus our total cost.

01:08 We have different types of cost. We have explicit costs and implicit costs.

01:13 As economists, we care about opportunity cost.

01:17 We care about both the explicit and the implicit.

01:20 They're both in our opportunity cost.

01:22 That's the distinction between accountants and an economist.

01:26 Economist care both about the implicit and the explicit costs in our analysis.

01:30 Accountants just look at explicit cost.

01:33 So, you have Caroline here and she wants to start a cookie business.

01:37 So, what are the opportunity costs? What is she giving up in order to start that cookie business? Well, she's gonna spend a thousand dollars on flour.

01:47 This is an explicit cost, alright? Part of her opportunity cost.

01:51 What is she giving up for the cookie business? A thousand dollars to buy flour. She also has implicit cost.

01:58 She has to spend a lot of time and energy setting up the cookie business.

02:03 That's time and energy she could be using elsewhere to earn wages.

02:07 She's missing out on those wages, setting up a cookie business.

02:11 Those are implicit costs. They both are part of opportunity cost.

02:15 They're both what she gives up in order to start her cookie business.

02:19 So, again, that brings up a distinction between economic analysis and accounting analysis.

02:24 We look at both the explicit and implicit cost. Accountants, they missed that implicit costs.

02:31 So, to drive it home a little bit more here, here we can see economic profit versus accounting profit.

02:37 So, both of them, the whole thing is revenue, alright? So, our economic profit, we take away implicit cost and explicit cost.

02:45 Accountants, they look and they just take account of the explicit cost, alright? So, revenue minus explicit cost equals accounting profit, revenue minus implicit and explicit costs, that's economic profit.

02:59 So, economic profit is always lower than the accounting profit if there's some implicit cost.

03:04 Alright, now, let's take a look at the production function, alright? So, here we're gonna have our example. Maybe it's our cookie business, alright? So, we're looking at the number of workers we have and how output changes.

03:16 So, here on the left column here, these are our number of workers, we see our output: zero, 50, 90, 120, 140, 150, 155. So, what's our marginal product of labor? That's the additional production we're gonna get from an additional worker here.

03:32 We can calculate that by just subtracting.

03:35 So, the first worker brings in 50, 50 minus zero is 50. The second worker, 90 minus 50 is 40.

03:41 The third worker, 120 minus 90 is 30. All the way down.

03:45 We see this diminishing marginal product of labor.

03:49 So, the extra production from hiring an extra worker diminishes.

03:54 So, there's always more production from hiring more people but the increases in production diminish.

03:59 And we'll talk more about that in some later slides.

04:02 The cost of our factory is gonna be constant. That's a fixed cost, alright? We buy the factory once, it's fixed, no matter how many cookies we produce, the cost of the factory doesn't change.

04:14 Now, we have our variable cost. It depends on how much we produce.

04:18 Our variable cost here is our labor. In order to produce more, we need to hire more workers.

04:24 So, what we're gonna see is we pay each one a wage of $10.

04:28 So, our first worker cost us $10. Our second worker, he cost us $10, total is 20.

04:33 Now, our total cost, that's our fixed cost plus our variable cost. So, 30 plus zero is 30.

04:40 Even without producing anything, we still have the cost of the factory that we have to pay for that $30.

04:45 Now, as we go along, we're just gonna be adding the variable cost to the fixed costs.

04:50 So, 30 plus 10, is 40; 30 plus 20 is 50, all the way down, 30 plus 60, is 90. Those are our total costs.

04:57 You'll see here a graph of our production function and a graph of our total cost curve.

05:03 So, now you see those diminishing marginal returns that I was talking about.

05:07 As you add more labor, production increases.

05:10 But the size of the increases gets smaller and smaller and smaller.

05:14 So, you can always reproduce more if you hire more people but the size of the increases, they get smaller.

05:20 So, what does that mean for the total cost curve? That means the total cost curve is gonna be getting steeper and steeper and steeper.

05:28 Because if you wanna produce the same amount, you need to hire more people for that production.

05:33 You need to hire more people to get the same size increases in production, as you did earlier.

05:39 So, you're gonna see a flattening out of the production curve and a steepening of the total cost curve.

05:45 So, again, we have two types of costs here. The first, we have the explicit and the implicit.

05:53 Now, there's two types of costs and a little bit of a different way.

05:55 There are fixed and variable costs that we're talking about.

05:58 So, fixed costs, they don't vary with the quantity of output.

06:01 Variable costs do. So, again, you go back to the factory.

06:05 You paid for the factory. It's $30 whether you produce zero cookies or a thousand cookies.

06:10 But now your variable costs they change. That's like your flour or your labor.

06:14 Labor is a big one. As you produce more, you have to hire more people. Those are variable costs.

06:20 Alright. Now, let's get some terms out of the way, alright? So, let's define our average total cost.

06:25 That's gonna be our total cost divided by our quantity of output, alright? We wanna understand what our average total cost is.

06:32 So, the average cost per unit that we make.

06:35 Our average fixed costs, that's just our fixed cost divided by the total quantity or the quantity of output.

06:42 We have our average variable costs.

06:44 So, those are our variable cost divided by the quantity of output.

06:47 And we have our marginal cost, which is our change in total cost divided by our change in quantity.

06:53 So, how much does it cost to produce one more unit? Alright? These are our terms: average total costs, average fixed cost, average variable cost, marginal cost.

07:02 You're gonna wanna keep those straight as we go through this.

07:05 So, let's have an example here, alright? Examples always help.

07:09 So, we're gonna have an example of a coffee house, alright? We're gonna look at the production function and the total cost curve.

07:15 And we're gonna look at how all of these cost curves relate to each other.

07:19 So here, we're gonna have the quantity of coffee produced, alright? That's our most leftward column here. We have our total costs, alright? Our total costs are made up of our fixed costs and our variable costs.

07:32 So, even when you produce nothing, our fixed cost is $3.

07:36 We can't get away from that. But our variable cost is zero when we produce zero.

07:40 Now, the cost, the fixed cost is gonna stay the same throughout.

07:44 We're gonna see the variable cost is gonna increase throughout, alright? So, the cost to produce one more unit is gonna go up.

07:52 We saw that total cost curve gets steeper. This was part of the reason, alright? Now, we have our average fixed cost. That's just our fixed costs divided by our quantity.

08:02 We're gonna see our average fixed cost goes down. It's the same no matter how much we produce.

08:09 So, the more we produce, the average decreases. You'll see our rising average variable costs.

08:15 That's the idea. That we have these diminishing returns in production.

08:19 So, to get the same size increase in production, you need to incur larger costs.

08:25 You need to hire more people to produce the same amount because of those diminishing returns.

08:31 Our average total cost, that's just our total cost divided by the quantity.

08:36 And now, you'll see our marginal cost, that's just gonna be the difference in our cost producing one more unit.

08:44 So, let's take a look at our total cost here. From $3.00 to $3.30, the marginal cost is $0.30.

08:50 So, from one to two, it goes from $3.30 to $3.80, the difference is $0.50.

08:57 So, it's just the difference in total cost divided by the change in quantity.

09:01 Here, the change in quantity is just one.

09:03 So, it's the additional cost we incur to produce an additional unit.

09:08 So, let's take a look at these cost curves, okay? We're gonna see our marginal cost rises with increased quantity that's due to our diminishing marginal returns of production.

09:18 We're gonna see our average total cost is U shaped.

09:21 Our average total costs is this green one right here decreases and then it bottoms out and then it starts to increase.

09:28 We're gonna see our average variable cost rises, alright? Again, that comes from our diminishing returns.

09:34 So, if we wanna increase the same quantity amount, we need to hire more people.

09:39 So, our costs are higher, because of that diminishing marginal product, alright? And we see our average fixed cost is always gonna be falling here because we pay for it one time, no matter how much we produce.

09:50 So, these are what our curves look like.

09:53 Now, let's get into a little bit why they have these shapes.

09:57 First are rising marginal cost. Now, why do we have these rising marginal costs? It comes from our diminishing product or diminishing returns on labor.

10:06 So, as you hire more people, you always have more production.

10:09 But the increases in production are smaller and smaller.

10:12 So, if you wanna get the same size increase in output, you need to hire more people.

10:17 So, why do we have these diminishing returns? Well, let's take a look at this coffee house example.

10:24 Why do you have diminishing returns? Well, say you have one coffee machine. Let's fix our capital here.

10:29 Because if you allow capital to move around, it will change the calculus.

10:33 But if you fix capital, you have one coffee machine.

10:36 The first person you hire, you have these very large increases in production, right? Before you hired anybody, you're producing zero. So, now you hire one person.

10:44 And the increases in production are huge, right? Now, you have somebody to make coffee and hand it out.

10:50 Sometimes, that coffee machine is not being used, right? It's sitting there while he's handing out the coffee.

10:56 So, if you hire another person, you're increasing for you -- you have any increase in production, production goes up.

11:02 But it won't go up as much as when you hire the first person.

11:06 The reason being is there's gonna be points in time, when somebody is using that coffee machine, the first worker is at that coffee machine using it.

11:14 And the second person is standing in line just waiting to use it.

11:17 He has idle time. The first person you hired, he had no idle time.

11:22 He was always working. So, the increases in production were huge.

11:26 You hire the second person, you have more production.

11:30 When the first person's out serving the coffee, you have a second person in there making coffee. So, production goes up.

11:36 But there's points in time where he's waiting to use the machine, so that he's idle.

11:41 So, the production increases aren't as much you hire a third person, it's the same.

11:45 Now, the coffee machines may be always being used, so production is up.

11:49 But now there's a lot more instances when the second or third worker are sitting there waiting to use the machine so there's more idle time.

11:57 So, that's the reason you have these rising marginal costs, because you have this diminishing marginal production or diminishing returns to production.

12:06 The production is always increasing but the size of the increases are smaller.

12:10 So, to get the same size increase in quantity, you need to hire more people which means you have higher increasing variable costs, you have higher marginal cost of production.

12:21 Now, our U-shaped average total cost curve. Why is it U-shaped? What's gonna come about, because you have your average fixed cost which is always decreasing, you have your average variable costs which is rising for the reasons we just talked about.

12:35 So, at first your average fixed cost is falling very fast, right? So, you pay $30 for the factory, no matter you're producing zero or producing one.

12:46 So, the first one you produce and then the second one you produce, the average fixed cost falls by half. It falls very fast at first.

12:54 The average total cost, it's the average fixed cost plus the average variable cost, right? So, the first the average fixed cost is falling faster than the average variable cost is rising.

13:07 When that's taking place, you're gonna have the average total cost curve going down.

13:12 At some point, the increases in the average variable cost are gonna become greater than the decreases in the average fixed cost.

13:22 When that takes place, you'll see that U-shaped start to happen in that average total cost curve, it'll start to come back up as the increases in the average variable costs are larger than the decreases in the average fixed cost.

13:36 Alright. Now, what's the relationship between our marginal cost and our average total cost curve? So, our marginal cost curve, our marginal cost is gonna cross our average cost that what we call the efficient scale.

13:48 So, that's gonna be the bottom of the U shape of our average total cost curve.

13:52 Okay. The average total cost, think of that as your GPA, alright? And your marginal cost is like the grade you get in your next course, right? So, that if your marginal cost is lower than your average total cost, it's gonna bring the average total cost down.

14:10 So, if your average grade is a 90 in your class, your next grade on a test is an 80, it's gonna bring the average total cost curve down. Now, if you have a 90 average in the class, you get 100 on your next test, that's gonna bring the average up.

14:27 So, the marginal cost curve has to intersect at the minimum point on that U-shaped average total cost curve.

14:35 Because when marginal cost is below average total cost, it's bringing it down, like giving a low score on an exam brings your average grade down.

14:44 When the marginal cost is above average total cost, it's gonna be bringing the average up, like you can get a really good grade in a class, it'll bring your class average up.

14:54 So, you're always gonna see that marginal curve is gonna intersect the average total cost curve at what we call the efficient scale or the bottom point, the minimum point on that U shape of your average total cost curve.

15:06 So, before we had some simple cost curves, now, this is more in line with what it actually looks like.

15:14 So, what you're gonna see is our marginal cost and our average variable costs are actually gonna go down a little bit before they come back up.

15:22 That's because of a teamwork effect.

15:24 So, you get one or two or three workers you build up.

15:26 At first, there's that teamwork effect where they get efficient working together.

15:30 And you can actually see gains, alright? But after a while, after a while, you're gonna run into these capacity problems, these logistical problems, where it's gonna become more difficult.

15:40 And then, you see you're at your rising marginal cost and your rising variable cost curves.

15:45 But in actuality, you might get some teamwork effect at first.

15:48 That lowers these costs as you hire people. So, the short run versus the long run.

15:53 There's differences between the short and the long run and it comes about because costs that are fixed in the short run can come variable in the long run.

16:02 So, you'll see this is our long run average total cost.

16:05 So, this is the average total cost. And this is the quantity.

16:08 So, when we have economies of scale, what's going on there is we can specialize once we hit our capacity, right? We hit our capacity constraints on one factory.

16:17 In the long run, we can buy another factory, alright? So, there's fixed cost become variable cost.

16:24 So, what we call economies of scale through specialization, when you purchase these other factories and we can get better and more efficient at what we do.

16:33 So, in the long run, you see this average total cost curve falling.

16:37 Now here, when we have these constant returns to scale, that's the property whereby long run average total costs, they don't change, okay? They don't change as we're increasing our quantity.

16:48 But at some point, even buying more factories doesn't alleviate the fact that you're gonna have these diseconomies of scale, that's when long run when the average total cost curve starts to rise.

16:59 That's because of coordination issues.

17:01 So, you can get some specialization with sharing knowledge and sharing resources between factories.

17:08 But even at some point, you're gonna have too many factories and it's gonna be just a job keeping up with it.

17:13 So, you're gonna run into coordination issues.

17:15 So, what you're gonna see here is the long run is just made up of these short runs.

17:19 But sometimes long run projections and long run strategies will be a little different than short run strategies because you can call, those fixed costs can become variable costs.

17:29 So, what did we learn here? We understand the different costs of production.

17:33 We know the difference between economic profit and accounting profit.

17:37 We understand why marginal costs rise.

17:39 We understand why average total cost curves are U shaped.

17:42 We understand the relationship between marginal cost curves and total cost curves.

17:46 So, that was your presentation on the Cost of Production. Thank you.