Cost of Production Chapter 5 Section 2 Objectives

Cost of Production Chapter 5 Section 2

Objectives � Explain how firms decide how much labor to hire to produce a certain level of output. � Analyze the production costs of a firm. � Understand how a firm chooses to set output. � Explain how a firm decides to shut down and unprofitable business. � Key Terms ◦ Marginal product of labor ◦ Increasing marginal returns ◦ Diminishing marginal returns ◦ Fixed cost ◦ Variable cost ◦ Total cost ◦ Marginal revenue ◦ Operating cost

Labor and Output

Labor and Output � Marginal Labor Product of ◦ The change in output from hiring one more worker ◦ Measures the change in output at the margin; increase in output added by the last unit of labor � Increasing Returns Marginal ◦ Output goes up when a worker is added for production ◦ Workers can specialize, therefore production increases ◦ A. K. A. rising marginal product of labor

Labor and Output � Diminishing Marginal Returns ◦ When adding more workers increases total output, but at a decreasing rate ◦ Less and less output from each additional unit of labor � Negative Returns Marginal ◦ The stage where output decreases due to the added labor; workers get in each others’ way and disrupt the production process

Paper Chain Gang Labor (# of Workers) Output (Paper links per Marginal Product of minute) Labor

Production Costs

Production Costs � Fixed Costs ◦ A cost that does not change no matter how much of a good is produced ◦ Examples: facilities, rent, machinery repairs, property taxes, salaries ◦ What are fixed costs for a high school? � Variable Costs ◦ Costs that rise or fall depending on the quantity produced ◦ Examples: raw materials, some labor (since it changes with the # of workers), heat, electricity ◦ What are some variable costs for a high school?

Production Costs � Total Cost ◦ Fixed Costs plus the variable costs � Marginal Cost ◦ The cost of producing one more unit of a good

Setting Output �A company’s goal is to make profit. � Profit= Total Revenue-Total Cost � Revenue= Price X Quantity � Total Cost= Fixed costs + Variable costs ***To find the level of output with the highest profit, look for the biggest gap between total revenue and total cost. ***

Setting Output Marginal Revenue and Marginal Cost � Marginal Revenue ◦ Additional income from selling one more unit ◦ Is the market price for the good ◦ When marginal revenue =marginal cost, then pure profit results (ideal) ◦ Profit results when the company receives more for the last product than it cost to produce Responding to Price Changes � This is where the law of supply goes into ACTION! � If the market price increases, then marginal revenue increases, thus increasing production so that the firm can capture profits. ◦ See figure 5. 11 pg 113

The Shutdown Decision ØWhen the market price is so low that the factory’s total revenue is less than the total cost, the firm looses money! ØA factory owner must determine if the profit-maximizing level is sufficient to cover the operating costs (cost of running the facility) ØOperating costs include variable costs to keep the factory running, but do not include fixed costs that will need to be paid regardless of production. ØWhen might a factory decide to stop production? What could a factory do to pay it’s fixed costs if it closes?