Ch07.docx
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Ch07.docx
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Ch07
CHAPTER7
THECOSTOFPRODUCTION
TEACHINGNOTES
Thekeytopicsinthischapterare
∙accountingversuseconomiccostsofproduction,
∙definitionsoftotal,average,andmarginalcostintheshortrunandlongrun,
∙agraphicalrepresentationoftotal,average,andmarginalcost,and
∙costminimization,graphicallyinthechapter,andmathematicallyintheappendix.
Itisimportanttodistinguishbetweenaccountingandeconomiccostssothatstudentswillunderstandthatzero(economic)profitisafeasiblelongrunequilibrium.Itisimportanttospendtimeonthecostcurvedefinitionsandgraphbecausetheyformthefoundationforwhatwillbecoveredinchapter8(firmsupply).Thecostminimizationproblemisusefulforexplainingwhichinputsthefirmshouldusetoproduceagivenquantityofoutput,andthisdiscussiondrawsonthediscussionofisoquantsfromchapter6.Itisalsopossibleatthispointtodiscussthebasicconceptofhiringinputsuntilthewageisequaltothemarginalrevenueproductoftheinput(chapter14).Thechapteralsocontainsthreesectionsthatcanbecoveredasspecialtopics(productionwithtwooutputs,dynamicchangesincosts,andestimatingcost),orcanbeskippedaltogether.
Opportunitycostformstheconceptualbaseofthischapter.Whilemoststudentsthinkofcostsinaccountingterms,theymustdevelopanunderstandingofthedistinctionbetweenaccounting,economic,andopportunitycosts.Onesourceofconfusionistheopportunitycostofcapital,i.e.,whytherentalrateoncapitalmustbeconsideredexplicitlybyeconomists.Itisimportant,forexample,todistinguishbetweenthepurchasepriceofcapitalequipmentandtheopportunitycostofusingtheequipment.Theopportunitycostofaperson’stimealsoleadstosomeconfusionforstudents.
Followingthediscussionofopportunitycost,thechapterdivergesintwodirections:
onepathintroducestypesofcostandcostcurves,andtheotherfocusesoncostminimization.Bothdirectionsconvergewiththediscussionoflong-runaveragecost.
Whilethedefinitionsoftotalcost,fixedcost,averagecost,andmarginalcostandthegraphicalrelationshipsbetweenthemcanseemtediousand/oruninterestingtothestudent,bothareimportantintermsofunderstandingthederivationofthefirm’ssupplycurveinchapter8.Doingalgebraicornumericalexamplesintableformishelpfulforsomestudentsintermsofseeingtherelationshipsbetweenthedifferentcosts.Explainthateachfirmhasauniquesetofcostcurvesbasedonitsownparticularproductionfunctionandresultingtotalcostfunction.Discusstheimportanceofreturnstoscaleanddiminishingreturnsinexplainingtheshapesofthecostcurves.Pointouttheclearrulesthataveragecosttendstobeu-shapedintheshortrunandmarginalcostwillhitaveragecostandaveragevariablecostattheirrespectiveminimumpoints.Onceyouhavesuccessfullydevelopedthecostcurvegraph,youcanthentakeitandaddressthequestionsoffindingtheprofitmaximizinglevelofoutputandderivingthefirm,andhenceindustry,supplycurve.
Thecostminimizationproblemisusefulforaddressingadifferenttypeofquestion,namelywhatquantityoftheinputsshouldthefirmusetoproduceagivenlevelofoutput.Pointouttostudentsthatthenecessaryconditionforcostminimization,wheretheratioofthemarginalproductsisequaltotheratiooftheinputcosts,isverysimilartothenecessaryconditionforprofitmaximization.
Aclearunderstandingofshort-runcostandcostminimizationisnecessaryforthederivationoflong-runaveragecost.Withlong-runcosts,stressthatfirmsareoperatingonshort-runcostcurvesateachlevelofthefixedfactorandthatlong-runcostsdonotexistseparatelyfromshort-runcosts.Exercise(6)illustratestherelationshipbetweenlong-runcostandcostminimization,withanemphasisontheimportanceoftheexpansionpath.Stresstheconnectionbetweentheshapeofalong-runcostcurveandreturnstoscale.
QUESTIONSFORREVIEW
1.Afirmpaysitsaccountantanannualretainerof$10,000.Isthisaneconomiccost?
Explicitcostsareactualoutlays.Theyincludeallcoststhatinvolveamonetarytransaction.Animplicitcostisaneconomiccostthatdoesnotnecessarilyinvolveamonetarytransaction,butstillinvolvestheuseofresources.Whenafirmpaysanannualretainerof$10,000,thereisamonetarytransaction.Theaccountanttradeshisorhertimeinreturnformoney.Therefore,anannualretainerisanexplicitcost.
2.Theownerofasmallretailstoredoesherownaccountingwork.Howwouldyoumeasuretheopportunitycostofherwork?
Opportunitycostsaremeasuredbycomparingtheuseofaresourcewithitsalternativeuses.Theopportunitycostofdoingaccountingworkisthetimenotspentinotherways,i.e.,timesuchasrunningasmallbusinessorparticipatinginleisureactivity.Theeconomic,oropportunity,costofdoingaccountingworkismeasuredbycomputingthemonetaryamountthattheowner’stimewouldbeworthinitsnextbestuse.
3.Pleaseexplainwhetherthefollowingstatementsaretrueorfalse.
a.Iftheownerofabusinesspayshimselfnosalary,thentheaccountingcostiszero,buttheeconomiccostispositive.
True.Sincethereisnomonetarytransaction,thereisnoaccounting,orexplicit,cost.However,sincetheownerofthebusinesscouldbeemployedelsewhere,thereisaneconomiccost.Theeconomiccostispositive,reflectingtheopportunitycostoftheowner’stime.Theeconomiccostisthevalueofthenextbestalternative,ortheamountthattheownerwouldearnifhetookthenextbestjob.
b.Afirmthathaspositiveaccountingprofitdoesnotnecessarilyhavepositiveeconomicprofit.
True.Accountingprofitconsidersonlytheexplicit,monetarycosts.Sincetheremaybesomeopportunitycoststhatwerenotfullyrealizedasexplicitmonetarycosts,itispossiblethatwhentheopportunitycostsareaddedin,economicprofitwillbecomenegative.Thisindicatesthatthefirm’sresourcesarenotbeingputtotheirbestuse.
c.Ifafirmhiresacurrentlyunemployedworker,theopportunitycostofutilizingtheworker’sservicesiszero.
False.Theopportunitycostmeasuresthevalueoftheworker’stime,whichisunlikelytobezero.Thoughtheworkerwastemporarilyunemployed,theworkerstillpossessesskills,whichhaveavalueandmaketheopportunitycostofhiringtheworkergreaterthanzero.Inaddition,sinceopportunitycostistheequivalentoftheworker’snextbestoption,itispossiblethattheworkermighthavebeenabletogetabetterjobthatutilizeshisskillsmoreefficiently.Alternatively,theworkercouldhavebeendoingunpaidwork,suchascareofachildorelderlypersonathome,whichwouldhavehadavaluetothosereceivingtheservice.
4.Supposethatlaboristheonlyvariableinputtotheproductionprocess.Ifthemarginalcostofproductionisdiminishingasmoreunitsofoutputareproduced,whatcanyousayaboutthemarginalproductoflabor?
Themarginalproductoflabormustbeincreasing.Themarginalcostofproductionmeasurestheextracostofproducingonemoreunitofoutput.Ifthiscostisdiminishing,thenitmustbetakingfewerunitsoflabortoproducetheextraunitofoutput,sincetheextracostreferstotheextracostofthelabor.Iffewerunitsoflaborarerequiredtoproduceaunitofoutput,thenthemarginalproduct(extraoutputproducedbyanextraunitoflabor)mustbeincreasing.Notealso,thatMC=w/MPL,sothatifMCisdiminishingthenMPLmustbeincreasingforanygivenw.
5.Supposeachairmanufacturerfindsthatthemarginalrateoftechnicalsubstitutionofcapitalforlaborinhisproductionprocessissubstantiallygreaterthantheratiooftherentalrateonmachinerytothewagerateforassembly-linelabor.Howshouldhealterhisuseofcapitalandlabortominimizethecostofproduction?
Tominimizecost,themanufacturershoulduseacombinationofcapitalandlaborsotherateatwhichhecantradecapitalforlaborinhisproductionprocessisthesameastherateatwhichhecantradecapitalforlaborinexternalmarkets.Themanufacturerwouldbebetteroffifheincreasedhisuseofcapitalanddecreasedhisuseoflabor,decreasingthemarginalrateoftechnicalsubstitution,MRTS.HeshouldcontinuethissubstitutionuntilhisMRTSequalstheratiooftherentalratetothewagerate.TheMRTSinthiscaseisequaltoMPK/MPL.AsthemanufacturerusesmoreKandlessL,theMPKwilldiminishandtheMPLwillincrease,bothofwhichwilldecreasetheMRTSuntilitisequaltotheratiooftheinputprices(rentalrateoncapitaldividedbywagerate).
6.Whyareisocostlinesstraightlines?
Theisocostlinerepresentsallpossiblecombinationsoflaborandcapitalthatmaybepurchasedforagiventotalcost.Theslopeoftheisocostlineistheratiooftheinputpricesoflaborandcapital.Ifinputpricesarefixed,thentheratioofthesepricesisclearlyfixedandtheisocostlineisstraight.Onlywhentheratioorfactorpriceschangeasthequantitiesofinputschangeistheisocostlinenotstraight.
7.Assumethemarginalcostofproductionisincreasing.Canyoudeterminewhethertheaveragevariablecostisincreasingordecreasing?
Explain.
Marginalcostcanbeincreasingwhileaveragevariablecostiseitherincreasingordecreasing.Ifmarginalcostisless(greater)thanaveragevariablecost,theneachadditionalunitisaddingless(more)tototalcostthanpreviousunitsaddedtothetotalcost,whichimpliesthattheAVCdeclines(increases).Therefore,weneedtoknowwhethermarginalcostisgreaterthanaveragevariablecosttodeterminewhethertheAVCisincreasingorde
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