ECON101 Study Guide

Unit 5: The Producer

5a. Analyze the behavior of the producer

Define and explain the difference between accounting profit and economic profit.
Define opportunity costs and explain how they affect a company's production decisions?

In this unit, we analyze how businesses or producers make decisions. For example, businesses decide how much they should produce of the item they are selling, the price they should charge customers, and the number of hours they should operate. Costs and revenues are important considerations for companies that aim to maximize profit.

It is important to distinguish between accounting profit and economic profit. Companies make decisions based on their goal to maximize economic, not accounting, profit. For example, a company may be able to earn a positive accounting profit, but determine it is best to close its operations if economic profit remains negative.

Economic profits offer businesses a useful tool for making decisions. For example, consider an individual who quits their corporate job (earning $60,000 a year) to start a small business that earns $40,000 a year in accounting profits. The positive accounting profit indicates the business is able to cover its costs and earn positive profits. However, when the business owner considers an economic profit of -$20,000 (calculated as accounting profit minus the opportunity cost of the foregone salary) they determine it may be best to close the business and return to earning their previous corporate salary.

Review the decision making process companies face in:

5b. Compare the costs of production in the short run to costs of production in the long run

Define a short-run cost, long-run cost, and respective cost.
Define and name some examples of fixed costs, variable costs, and total costs.
Define average total cost and explain how to compute it.
Define marginal cost and explain how to compute it.
How do costs change when we increase or decrease output?

Economics defines profits as the total revenues minus the total costs (which include opportunity costs). While revenues largely depend on demand and consumer behavior, businesses have direct control over their costs.

In this section, we analyze a company's cost structure and its effect on profitability and production decisions. Review how to distinguish between short-run and long-run costs, since they affect outcomes in different ways.

Short-Run Costs

The short-run describes a time period when many variables are fixed. In the long run, all variables are flexible.

Consider an ice cream shop that leases an ice cream machine and has contracted two employees to work on an hourly basis (at $10 per hour). The cost to rent the storefront and the cost to lease the ice cream machine is fixed: the ice cream shop must pay these fixed costs regardless of how many ice cream cones it produces or sells. How do fixed costs behave when we increase the number of ice cream cones produced?

Since the business manager has contracted its employees to work on an hourly basis, the number of work hours will vary with the level of production (number of ice cream cones produced and sold). This cost is variable not fixed. We can see in the table that larger quantities of production are associated with more hours worked.

Ice Cream Shop Costs

Ice Cream Cones	Fixed Cost	Variable Cost	Total Cost	Average Total Cost	Marginal Cost
0	$1,000	$0	$1,000	-	-
1	$1,000	$10	$1,010	$1,010	$10
5	$1,000	$10	$1,010	$202	$0
10	$1,000	$30	$1,030	$103	$20
15	$1,000	$60	$1,060	$71	$30
20	$1,000	$100	$1,100	$55	$40

Review the theory of costs and some visual examples in Production Choices and Costs: The Short Run from Principles of Microeconomics.

Long-Run Costs

How can we interpret the region of the long-run average cost (LRAC) where costs are falling (points A and B)?
How can we interpret the region of the long-run average cost (LRAC) where costs are rising (point D)?
What is the meaning of the lowest point on the long-run average cost (LRAC) curve (point C)?

The long-run describes a time period in which all costs are variable. For example, a production facility or factory may be a fixed variable in the short run, but with sufficient time in the long run, the business owner could build a new facility in a new location, close an existing operation, expand or reduce its production capacity. The factory itself becomes a variable resource in the long run.

For example, consider Figure 8.9, which illustrates the long-run cost curve of a company producing CDs. Note that the long-run average total cost curve envelopes its short-run cost average total cost curves.

Relationship between Short-Run and Long-Run Average Total Costs

We derive the long-run average cost (LRAC) by taking the lowest average total cost curve at each level of output. The graph displays the average total cost curves for 20, 30, 40, and 50 units of capital (the four smaller yellow curves).

When the CD company produces 10,000 CDs per week, it can minimize the cost per CD by producing with 20 units of capital (point A).
When the CD company produces 20,000 CDs per week, with an expansion in plant size, it can minimize the cost per CD by producing with 30 units of capital (point B).
The CD company achieves the lowest cost per unit when it produces 30,000 CDs per week using 40 units of capital (point C).
If the CD company decides to produce 40,000 CDs per week, it will do so most cheaply with 50 units of capital (point D).

Review long-run costs in:

5c. Identify the production function in the short run as well as the long run

The Production Function

What are the goals of the company when choosing a specific combination of inputs and a production function?
What could cause an increase in labor productivity? Think about specialization and trade.
What could cause a decrease in labor productivity? Think about the effect of crowding out a small space with too many employees.
Define the law of diminishing marginal returns.

A production function is the relationship between a company's factors of production and its output. For example, the ice cream shop from the previous section uses inputs: fixed resources (the shop and the ice cream machine) and variable resources (employees, sugar, cream, cones) to produce output: ice cream cones.

As we examine the company's production choices, we consider factors that contribute to its profitability, such as the productivity of its resources.

This figure gives an example of a company that produces jackets. The table above the graph indicates output levels per day for Acme Clothing Company at various quantities of labor per day, assuming the company's capital is fixed.

Acme Clothing's Total Product Curve

We plot these values on the graph as a total product curve. As we move from points A, B, C to D, the slope of the production function rises, indicating increased worker productivity.

However, as we continue adding more employees past point D, labor productivity declines (diminishing marginal product) until it reaches point H. After point H, further additions of labor will actually lead to negative returns in production.

This type of outcome in production is so common, that economists define it as the law of diminishing marginal returns, which holds that the marginal product of any variable factor of production will eventually decline, assuming the quantities of other factors of production are unchanged.

Review the production function in:

The Company Shut-Down Decision

Define the company shut down decision.
How does its average total cost and average variable cost influence this decision in the short and long runs?

Have you been to a store or restaurant when you were the only customer? You may have wondered why the owner chose to keep the restaurant open at this time of the day or week. However, this decision to remain open during low customer traffic times may be a profit-maximizing (or loss-minimizing) choice.

The shutdown rule refers to the times when a company chooses to remain open during times of low activity, provided it can cover its variable costs with any revenue it generates. The company weighs whether it is better to incur a certain loss by staying open or incur an even bigger loss by closing during these times. Remember, it must pay its fixed costs regardless of whether it stays open or closes.

Review the shut-down rule in Understanding the Short-Run Shutdown.

5d. Compute the relationship between different cost functions

What specific calculations define each type of cost?
What does a graph of the respective cost curve look like?
How does the slope of each graph change in response to changes in output?
Why is the average fixed cost a downward sloping function?
Why are the marginal cost, average variable cost, and average total cost U-shaped?
Why does the marginal cost curve cross the average total cost and the average variable cost curve exactly at their minimum points?

Make sure you can define each of the following cost functions, describe how each variable affects production choices, draw each cost curve on a graph, and analyze their shapes and interactions.

Fixed costs
Variable costs
Total costs
Marginal costs
Average fixed costs
Average variable costs
Average total costs

For our ice cream shop example, consider how fixed costs and average fixed costs behave as the shop produces more ice cream cones. Remember that fixed costs will remain the same regardless of how many ice cream cones are produced. Therefore, the average fixed cost must decline with each additional unit produced. The shop will lower per unit costs of production by raising output.

With respect to variable costs, note that average variable costs increase as production increases. What will that look like on a graph? Consider the effect on worker productivity, as you add additional employees in a crowded space and as you ask employees to work extra long hours.

How do you calculate marginal cost from total cost and what is the interpretation of an increasing marginal cost? Again, consider the effect on worker productivity, as you add additional employees in a crowded space and as you ask employees to work extra long hours.

Ice Cream Shop Costs

Ice Cream Cones	Fixed Cost	Average Fixed Cost	Variable Cost	Average Variable Cost	Total Cost	Average Total Cost	Marginal Cost
0	$1,000	-	$0	-	$1,000	-	-
1	$1,000	$200	$10	$10	$1,010	$1,010	$10
5	$1,000	$200	$10	$2	$1,010	$202	$0
10	$1,000	$100	$30	$3	$1,030	$103	$20
15	$1,000	$67	$60	$4	$1,060	$71	$30
20	$1,000	$50	$100	$5	$1,100	$55	$40

Once you master the definitions, you can put these costs together on the same graph and examine their interactions and dependencies.

Key Takeaways from Production Choices and Costs: The Short Run

In Panel (a), the total product curve for a variable factor in the short run shows that the firm experiences increasing marginal returns from zero to Fa units of the variable factor (zero to Qa units of output), diminishing marginal returns from Fa to Fb (Qa to Qb units of output), and negative marginal returns beyond Fb units of the variable factor.

Panel (b) shows that marginal product rises over the range of increasing marginal returns, falls over the range of diminishing marginal returns, and becomes negative over the range of negative marginal returns. Average product rises when marginal product is above it and falls when marginal product is below it.

In Panel (c), total cost rises at a decreasing rate over the range of output from zero to Qa. This was the range of output that was shown in Panel (a) to exhibit increasing marginal returns. Beyond Qa, the range of diminishing marginal returns, total cost rises at an increasing rate. The total cost at zero units of output (shown as the intercept on the vertical axis) is total fixed cost.

Panel (d) shows that marginal cost falls over the range of increasing marginal returns, then rises over the range of diminishing marginal returns. The marginal cost curve intersects the average total cost and average variable cost curves at their lowest points. Average fixed cost falls as output increases. Note that average total cost equals average variable cost plus average fixed cost.

Review this material in:

Unit 5 Vocabulary

Accounting profit
Average fixed costs
Average product
Average total costs
Average variable costs
Company shutdown rule
Cost function
Constant returns to scale
Diminishing marginal product
Diseconomies of scale
Economic profit
Economies of scale
Fixed costs
Labor productivity
Law of diminishing marginal returns
Long-run cost
Long-run average cost
Marginal cost
Marginal product
Marginal product of labor
Opportunity cost
Production function
Respective cost
Short-run cost
Short-run average cost
Total costs
Variable costs