Lecture Business economics - Lecture 7: The costs of production - I

In this chapter you will examine how taxes reduce consumer and producer surplus, learn the meaning and causes of the deadweight loss of a tax, consider why some taxes have larger deadweight losses than others, examine how tax revenue and deadweight loss vary with the size of a tax.

Review of the previous lecture

• The consumer optimizes by choosing the point on his budget constraint that lies on the highest indifference curve

• When the price of a good falls, the impact on the consumer’s choices can

be broken down into an income effect and a substitution effect

• The income effect is the change in consumption that arises because a lower price makes the consumer better off

• The income effect is reflected by the movement from a lower to a higher indifference curve

Review of the previous lecture

• The substitution effect is the change in consumption that arises because a price change encourages greater consumption of the good that has become relatively cheaper

• The substitution effect is reflected by a movement along an indifference

curve to a point with a different slope

• The theory of consumer choice can explain:

– Why demand curves can potentially slope upward

– How wages affect labor supply

– How interest rates affect household saving

Lecture 7

The Costs of Production- I

Instructor: Prof.Dr.Qaisar Abbas

Course code: ECO 400

Lecture Outline

1 What Are Costs?

2 Costs as Opportunity Costs

3 Production and Costs

Costs

•A firm’s cost of production includes all the opportunity costs of making its

output of goods and services

Explicit and Implicit Costs

• A firm’s cost of production include explicit costs and implicit costs

• Explicit costs are input costs that require a direct outlay of money

by the firm

• Implicit costs are input costs that do not require an outlay of

money by the firm

Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

Economic Profit versus Accounting Profit

•Economists measure a firm’s economic profit as total revenue minus total

cost, including both explicit and implicit costs

•Accountants measure the accounting profit as the firm’s total revenue minus

only the firm’s explicit costs

•When total revenue exceeds both explicit and implicit costs, the firm earns

economic profit.

•Economic profit is smaller than accounting profit

Economic versus Accountants

Production and Costs The Production Function

• The production function shows the relationship between quantity of

inputs used to make a good and the quantity of output of that good

•Production Function

Q = F(K,L)

Q is quantity of output produced

K is capital input

L is labor input

• F is a functional form relating the inputs to output

• The maximum amount of output that can be produced with K units of capital and L units of labor

•Short-Run vs Long-Run Decisions

•Fixed vs Variable Inputs

Production and Costs

• Linear production function: inputs are perfect substitutes.

• Leontief production function: inputs are used in fixed proportions.

• Cobb-Douglas production function: inputs have a degree of substitutability

bL aK

L K F

cL bK

L K F

b

aL K L

K F

Productivity Measures: Total Product

• Total Product (TP): maximum output produced with given amounts of inputs.

• Example: Cobb-Douglas Production Function:

Q = F(K,L) = K.5 L.5

– K is fixed at 16 units

– Short run Cobb-Douglass production function:

Q = (16).5 L.5 = 4 L.5

– Total Product when 100 units of labor are used?

Q = 4 (100).5 = 4(10) = 40 units

Productivity Measures: Average Product of an Input

• Average Product of an Input: measure of output

produced per unit of input.

– Average Product of Labor: AP L = Q/L.

• Measures the output of an “average” worker

• Example: Q = F(K,L) = K.5 L.5

– If the inputs are K = 16 and L = 16, then the average product of labor is

– Average Product of Capital: AP K = Q/K.

• Measures the output of an “average” unit of capital

• Example: Q = F(K,L) = K.5 L.5

– If the inputs are K = 16 and L = 16, then the average product of capital

Productivity Measures: Marginal Product of an Input

• Marginal Product on an Input: change in total output attributable to the last unit of an input

– Marginal Product of Labor: MP L = DQ/DL

• Measures the output produced by the last worker

• Slope of the short-run production function (with respect to labor)

– Marginal Product of Capital: MP K = DQ/DK

• Measures the output produced by the last unit of capital

• When capital is allowed to vary in the short run, MPK is the slope of the production function (with respect to capital)

Increasing, Diminishing and Negative Marginal Returns

Production and Costs From the Production Function to the Total-Cost Curve

•The relationship between the quantity a firm can produce and its costs determines pricing decisions

•The total-cost curve shows this relationship graphically

Production and Costs

A Production Function and Total Cost: Cookie factory

Production and Costs Cookie factory Production Function Total-Cost Curve: Cookie factory

Summary

• The goal of firms is to maximize profit, which equals total revenue minus total cost

• When analyzing a firm’s behavior, it is important to include all the

opportunity costs of production

• Some opportunity costs are explicit while other opportunity costs are

implicit

• A firm’s costs reflect its production process.

• Linear production function: inputs are perfect substitutes

• Leontief production function: inputs are used in fixed proportions

• Cobb-Douglas production function: inputs have a degree of substitutability.

• A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product