Tuesday, November 3, 2015

Output & Costs (Costs)

Output & Costs
This section has quite a few moving parts and therefore is best studied in sections. Lets start with costs.

Costs exist because resources are scarce and have alternative uses.
(This makes sense in that owners of resources are competing with other owners to sell their goods (labor) to the highest bidder) Employers and producers are competing with each other to buy the cheaper goods or hire labor at a lower price. Often the fallacious idea is that employers and employees are in competion with one another. This is false, employers are in competition with other employers and employees are in competition with other employees. The employee who pays more wins, (how does this translate to competition between employer and employee?) Don't think me daft, I do understand that employees would like to be paid more and employers would like to pay less but I would like to pay less for the potatoes at the grocery store and yet I don't feel I'm in competition with the grocer.

OK, so Economic Costs are the payments (for goods) or incomes it must offer (for people), to attract the resources from alternative production opportunities. 
(Simple yes, to get someone to work for you you must be willing to pay them and they must accept)

We can separate (for the AP) two broad categories of costs.

Explicit Costs - (Accounting costs) – Money actually paid for inputs for production. (Wages, electricity, input costs, transportation, etc) 

Implicit Costs – Think, opportunity cost – money that could have been earned by the entrepreneur with the next best alternative. Economists always take into account the implicit costs in evaluating choices.

Total Costs - Fixed Costs - Variable Costs

Total Fixed Costs – Costs that don’t vary with output. (Ex. Rent, interest on loans, insurance premiums) These costs must be paid even if output is zero. Even if the firm goes out of business these costs must be paid.

Total Variable Costs – Costs that change with the level of output. (Ex. Labor, materials, electricity, transportation) (For the AP when you see variable costs, think labor)
Total Costs – The sum of variable and fixed costs. (TC = FC + VC) or (TC = ATC x quantity of output)

Marginal Costs – The additional cost of producing one more unit of output. 

Understand: the vertical distance between the TC & TVC curve is TFC.
Understand: the mathematical relationship between the cost curves.
TC = TVC + TFC     (5 = 3 + 2)
TVC = TC – TFC      (3 = 5 - 2)
TFC = TC – TVC         (2 = 5 - 3)

Be able to draw the Total Cost Graph - Understand: the vertical distance between the TC & TVC curve is TFC. (Obviously, if TC is TFC + TVC), then everything under the TVC is Total Variable Costs, while the difference between TVC and TC must be TFC

Think of the combination of the costs like this graph.
The area under the TVC curve is variable costs. (Labor, almost always the biggest part of a business)
and then the difference between TC and TVC is fixed costs.

Short-Run (Fixed & Variable Costs)Time Period

Short-Run – A time period in which a producer (a firm) is able to change the quantities of some, but not all of the inputs, factors of production or resources they employ.
(Resources that can be adjusted are labor, and purchase of raw materials)
(The short-run has some resources that are fixed, (Factory/Plant))
(Firms cannot enter or exit the industry in the short-run)

Long –Run (All Costs are Variable (Changeable))

Long Run – a time period in which producers can change all of the resources they employ.
(In the long-run firms can enter and exit the industry)
(In the long-run there is no fixed costs as all costs are changeable, thus variable)

Short-run Production Analysis (AFC, ATC, AVC)

Average Total Costs – A firms total costs divided by output. (TC/Q) or (AFC + AVC = ATC)
Understand: As production increases, initially there is a decrease in ATC at small levels of   production. As production increases with larger quantities of production ATC increases to produce a U shaped curve.

Average Variable Costs – A firms total variable costs divided by output. (TVC/Q) or (ATC – AFC = AVC)
Understand: As production increases, initially there is a decrease in AVC at small levels of   production. As production increases with larger quantities of production AVC increases to produce a U shaped curve.

Average Fixed Costs – A firms total fixed costs divided by output. (TFC/Q) or (ATC – AVC = AFC)
                                      Understand:  average fixed costs decease as production increases.
Total Fixed costs are (fixed) and therefore don’t change when production increases but average fixed costs decrease                 
Fixed costs per unit (average fixed costs) will change as the production/output changes.

U shaped Cost Curves (WHY?)

Diminishing Returns & the U Shape of the Curves – The Law of Diminishing Returns states that as additional inputs are added to fixed capital, returns will eventually decrease.

Initially the cost curves are decreasing as more input is added reflecting efficiency, but as more inputs are added costs increase as inputs become increasingly inefficient. Thus the rising cost curves with more output.

(Ex. If you have a coffee cart out in front of the school and it is only big enough for two people. Hiring one person will lower your average costs as you can actually produce a good that will be sold. Hiring two people will allow a division of labor that will increase your output. Hiring a third person will slow down the production process as the coffee cart (fixed capital) isn’t big enough for three people to operate effectively in the short run.)

Relationship between Marginal Costs and Average Total Costs
·       Marginal Cost curve cuts the ATC & AVC curves at their minimum
·       When the MC curve is less than the ATC/AVC, ATC & AVC curves are decreasing
·       When the MC curve is greater than the ATC/AVC curves, the ATC/AVC are increasing
·       Marginal Cost curve eventually rise with increased output
·       The ATC/AVC curves are U shaped due to the Law of Diminishing Returns

1995 AP Micro Exam

#6 Answer - C
The question asks for average total costs,
so, AFC + AVC = ATC
       50   +    45  = 95

#7 Answer - D
Profit Max  (MR = MC)
at output/quantity 5 the MC's are 80.00
if you produced 1 more unit, at a quantity of 6 you would be incurring a higher cost than the revenue brought in for that unit.

#8 Answer - A
An increase in wages (a variable cost) will shift the cost curves up. Understand that a shift implies at every level of output. A decrease in the price of energy would shift the curve down.