Unit 6: The Producer

6a. Analyze the behavior of the producer

  • Why do firms exist?
  • What is the difference between accounting profit and economic profit?
  • What are opportunity costs in the context of a company's production decisions?
  • What is the difference between the short and the long run in microeconomics?

Understanding producer behavior is a bit more complex than that of consumers. It helps to keep a simple guiding question in mind: once producers have decided what they want to produce and how they are going to produce it, how do they decide how many units to produce? What factors affect this decision? Whenever you feel a dark cloud of abstract concepts looming over you, go back to basic questions like this one.

When analyzing the producer's decision regarding how many units to produce, consider the timeframe. In microeconomics, the timeframe is straightforward: if the firm can only alter the number of workers employed during the production process, it is the short run. If the firm can adjust all of the factors of production, it is in the long run. This distinction frames Burger King's decision whether to hire another employee (short run) or open another restaurant (long run). 

Review the distinction between accounting profit (the difference between a firm's total revenue and its explicit costs like materials and labor)and economic profit (found by subtracting explicit and implicit costs from total revenue) because profit maximization guides producer behavior. For example, consider the economist who quits their corporate job (earning $60,000 a year) to start a small business that earns $40,000 a year in accounting profits. A positive accounting profit indicates that the business can cover its costs and earn positive profits. However, the –$20,000 economic profit (accounting profit minus the opportunity cost of the salary forgone) may convince the economist to close their new business and return to earning a corporate salary (if it is still available).

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6b. Compare the costs of production in the short run to the costs of production in the long run

  • What are fixed costs, variable costs, and total costs?
  • What are average total cost, marginal cost, and average variable cost? How are they computed and represented?
  • How do costs change when we increase or decrease output?
  • What is the long-run average total cost, and how is it represented graphically?
  • Can you identify economies of scale, diseconomies of scale and constant returns to scale in a diagram?

Short-Run Costs

Each firm's cost structure is unique due to its different production processes. However, all firms display certain common features. These features differ in the short and long run. Why? (hint: review the previous section). 

Here is a summary of the main properties of the short-run cost structure to help you review the relevant definitions and/or properties. Make sure you can explain the reasons behind each graphical representation (output is on the horizontal axis, and the relevant costs are on the vertical axis).

  1. Fixed costs do not change with the level of output. The fixed cost curve is a horizontal line.
  2. Variable costs change with the level of output. The variable cost curve is an upward-sloping curve. 
  3. Marginal cost represents the additional cost of producing one more unit of output. The marginal cost curve is U-shaped.
  4. Average fixed cost is the fixed cost per unit of output. The average fixed cost curve is a downward-sloping curve that shows how average fixed costs decrease as output increases.
  5. Average variable cost is the variable cost per unit of output. The average variable cost curve is U-shaped. It shows how average variable costs first decrease and then increase as output increases. Why?
  6. Average total cost is the total cost per unit of output. The average total cost curve is U-shaped. The explanation is the same as the one you just reviewed for the average variable cost curve.

Long-Run Costs

The long run is a time period where all costs are variable since the firm can adjust all its factors of production. It is specific to each firm. For example, Inditex might be able to open a new Zara store in Madrid more quickly than a local restaurant could open a new location in a nearby town.

The diagram below illustrates the long-run cost curve of a company producing CDs. Note that the long-run average total cost curve (LRAC) envelopes its short-run cost average total cost curves.


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

We derive the 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 firm produces 10,000 CDs per week, it can minimize the cost per CD by producing 20 units of capital (point A). What about when it produces 20,000 CDs per week?

Keep in mind that it takes time to move from one point to another along the LRAC. Each point represents the lowest average cost after all possible adjustments are made. With this long-run framework, the firm can determine the optimal scale of production and take advantage of economies of scale (the downward-sloping section of the LRAC in the diagram above). 

To review, see:

 

6c. Compute the relationship between different cost functions

  • What is the relationship between marginal cost and average total cost?
  • What is the relationship between the marginal cost curve and average variable cost?
  • What specific calculations define each type of cost?
  • What is the relationship between the production function and costs?

Consider an ice cream shop that rents 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 lease the ice cream machine is fixed: the business manager must pay these fixed costs regardless of how many ice cream cones he produces or sells. How do fixed costs behave when we increase the number of ice cream cones produced?

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

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

$1010

$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


How do we calculate marginal cost from total cost, and how do we interpret 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.

Review the relationship between the production functions and costs by revisiting the diagram below, where we measure the quantity produced on the vertical axis of the total product curve and on the horizontal axis of the total cost curve.


Key Takeaways from 8.1 Production Choices and Costs: The Short Run

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6d. Identify the production function in the short run as well as the long run

  • What is the short-run production function?
  • What is the Law of Diminishing Marginal Returns?
  • Why do diminishing marginal returns affect the short-run production function?
  • What optimization rule do companies follow to decide how many employees to hire?
  • What is the long-run production function?
  • What is the difference between diminishing marginal returns and negative returns?
  • What is the relationship between returns to scale and economies/diseconomies of scale?

A production function is the relationship between a company's factors of production and its output. 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 the output: ice cream cones. This is a short-run production function. Why?

This figure presents 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 short run. We plot these values on the graph as a total product curve.


Figure: Acme Clothing's Total Product Curve

As we move from points A, B, and C to D, the slope of the production function rises, indicating increased worker productivity. What could cause an increase in labor productivity? (Hint: we talked about workers' specialization in Unit 1).

However, as we continue adding more employees past point D, labor productivity declines (diminishing marginal product) until it reaches point H. After point H, additional labor will actually lead to negative returns in production. Do these negative returns make sense? Make sure you understand the difference between points H and I. 

What we see after point D is the Law of Diminishing Marginal Returns, which states that the marginal product of any variable factor of production eventually declines, assuming the quantities of other factors of production are unchanged. At this point, you should be able to explain why the marginal product will eventually decline. 

In the long run, when firms can freely adjust all factors of production, the constraint of fixed capital becomes irrelevant. We use the long-run production function to analyze this scenario. The long-run production function illustrates the maximum output that a firm can produce given its available resources and technology when all factors of production are variable. 

The long-run production function can show three different returns to scale:

  • Increasing returns to scale: Inputs increased by a certain percentage result in output increase by a larger percentage.
  • Decreasing returns to scale: Inputs increased by a certain percentage result in output increase by a smaller percentage.
  • Constant returns to scale: Inputs increased by a certain percentage result in a proportional increase in output.

You should now be able to match the different returns to scale with the economies and diseconomies of scale we reviewed previously. 

To review, see:

 

Unit 6 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • accounting profit
  • average fixed cost
  • average total cost
  • average variable cost
  • economic profit
  • fixed costs
  • Law of Diminishing Marginal Returns
  • long-run production function
  • long run
  • marginal cost
  • production function
  • short run
  • total cost curve
  • total product curve
  • variable costs