Ch07.docx

1、Ch07CHAPTER 7THE COST OF PRODUCTIONTEACHING NOTES The key topics in this chapter are accounting versus economic costs of production, definitions of total, average, and marginal cost in the short run and long run, a graphical representation of total, average, and marginal cost, and cost minimization,

2、 graphically in the chapter, and mathematically in the appendix. It is important to distinguish between accounting and economic costs so that students will understand that zero (economic) profit is a feasible long run equilibrium. It is important to spend time on the cost curve definitions and graph

3、 because they form the foundation for what will be covered in chapter 8 (firm supply). The cost minimization problem is useful for explaining which inputs the firm should use to produce a given quantity of output, and this discussion draws on the discussion of isoquants from chapter 6. It is also po

4、ssible at this point to discuss the basic concept of hiring inputs until the wage is equal to the marginal revenue product of the input (chapter 14). The chapter also contains three sections that can be covered as special topics (production with two outputs, dynamic changes in costs, and estimating

5、cost), or can be skipped altogether. Opportunity cost forms the conceptual base of this chapter. While most students think of costs in accounting terms, they must develop an understanding of the distinction between accounting, economic, and opportunity costs. One source of confusion is the opportuni

6、ty cost of capital, i.e., why the rental rate on capital must be considered explicitly by economists. It is important, for example, to distinguish between the purchase price of capital equipment and the opportunity cost of using the equipment. The opportunity cost of a persons time also leads to som

7、e confusion for students. Following the discussion of opportunity cost, the chapter diverges in two directions: one path introduces types of cost and cost curves, and the other focuses on cost minimization. Both directions converge with the discussion of long-run average cost. While the definitions

8、of total cost, fixed cost, average cost, and marginal cost and the graphical relationships between them can seem tedious and/or uninteresting to the student, both are important in terms of understanding the derivation of the firms supply curve in chapter 8. Doing algebraic or numerical examples in t

9、able form is helpful for some students in terms of seeing the relationships between the different costs. Explain that each firm has a unique set of cost curves based on its own particular production function and resulting total cost function. Discuss the importance of returns to scale and diminishin

10、g returns in explaining the shapes of the cost curves. Point out the clear rules that average cost tends to be u-shaped in the short run and marginal cost will hit average cost and average variable cost at their respective minimum points. Once you have successfully developed the cost curve graph, yo

11、u can then take it and address the questions of finding the profit maximizing level of output and deriving the firm, and hence industry, supply curve. The cost minimization problem is useful for addressing a different type of question, namely what quantity of the inputs should the firm use to produc

12、e a given level of output. Point out to students that the necessary condition for cost minimization, where the ratio of the marginal products is equal to the ratio of the input costs, is very similar to the necessary condition for profit maximization. A clear understanding of short-run cost and cost

13、 minimization is necessary for the derivation of long-run average cost. With long-run costs, stress that firms are operating on short-run cost curves at each level of the fixed factor and that long-run costs do not exist separately from short-run costs. Exercise (6) illustrates the relationship betw

14、een long-run cost and cost minimization, with an emphasis on the importance of the expansion path. Stress the connection between the shape of a long-run cost curve and returns to scale.QUESTIONS FOR REVIEW1. A firm pays its accountant an annual retainer of $10,000. Is this an economic cost?Explicit

15、costs are actual outlays. They include all costs that involve a monetary transaction. An implicit cost is an economic cost that does not necessarily involve a monetary transaction, but still involves the use of resources. When a firm pays an annual retainer of $10,000, there is a monetary transactio

16、n. The accountant trades his or her time in return for money. Therefore, an annual retainer is an explicit cost.2. The owner of a small retail store does her own accounting work. How would you measure the opportunity cost of her work?Opportunity costs are measured by comparing the use of a resource

17、with its alternative uses. The opportunity cost of doing accounting work is the time not spent in other ways, i.e., time such as running a small business or participating in leisure activity. The economic, or opportunity, cost of doing accounting work is measured by computing the monetary amount tha

18、t the owners time would be worth in its next best use.3. Please explain whether the following statements are true or false.a. If the owner of a business pays himself no salary, then the accounting cost is zero, but the economic cost is positive.True. Since there is no monetary transaction, there is

19、no accounting, or explicit, cost. However, since the owner of the business could be employed elsewhere, there is an economic cost. The economic cost is positive, reflecting the opportunity cost of the owners time. The economic cost is the value of the next best alternative, or the amount that the ow

20、ner would earn if he took the next best job. b. A firm that has positive accounting profit does not necessarily have positive economic profit.True. Accounting profit considers only the explicit, monetary costs. Since there may be some opportunity costs that were not fully realized as explicit moneta

21、ry costs, it is possible that when the opportunity costs are added in, economic profit will become negative. This indicates that the firms resources are not being put to their best use. c. If a firm hires a currently unemployed worker, the opportunity cost of utilizing the workers services is zero.F

22、alse. The opportunity cost measures the value of the workers time, which is unlikely to be zero. Though the worker was temporarily unemployed, the worker still possesses skills, which have a value and make the opportunity cost of hiring the worker greater than zero. In addition, since opportunity co

23、st is the equivalent of the workers next best option, it is possible that the worker might have been able to get a better job that utilizes his skills more efficiently. Alternatively, the worker could have been doing unpaid work, such as care of a child or elderly person at home, which would have ha

24、d a value to those receiving the service.4. Suppose that labor is the only variable input to the production process. If the marginal cost of production is diminishing as more units of output are produced, what can you say about the marginal product of labor ?The marginal product of labor must be inc

25、reasing. The marginal cost of production measures the extra cost of producing one more unit of output. If this cost is diminishing, then it must be taking fewer units of labor to produce the extra unit of output, since the extra cost refers to the extra cost of the labor. If fewer units of labor are

26、 required to produce a unit of output, then the marginal product (extra output produced by an extra unit of labor) must be increasing. Note also, that MC=w/MPL, so that if MC is diminishing then MPL must be increasing for any given w.5. Suppose a chair manufacturer finds that the marginal rate of te

27、chnical substitution of capital for labor in his production process is substantially greater than the ratio of the rental rate on machinery to the wage rate for assembly-line labor. How should he alter his use of capital and labor to minimize the cost of production?To minimize cost, the manufacturer

28、 should use a combination of capital and labor so the rate at which he can trade capital for labor in his production process is the same as the rate at which he can trade capital for labor in external markets. The manufacturer would be better off if he increased his use of capital and decreased his

29、use of labor, decreasing the marginal rate of technical substitution, MRTS. He should continue this substitution until his MRTS equals the ratio of the rental rate to the wage rate. The MRTS in this case is equal to MPK/MPL. As the manufacturer uses more K and less L, the MPK will diminish and the M

30、PL will increase, both of which will decrease the MRTS until it is equal to the ratio of the input prices (rental rate on capital divided by wage rate). 6. Why are isocost lines straight lines?The isocost line represents all possible combinations of labor and capital that may be purchased for a give

31、n total cost. The slope of the isocost line is the ratio of the input prices of labor and capital. If input prices are fixed, then the ratio of these prices is clearly fixed and the isocost line is straight. Only when the ratio or factor prices change as the quantities of inputs change is the isocos

32、t line not straight.7. Assume the marginal cost of production is increasing. Can you determine whether the average variable cost is increasing or decreasing? Explain.Marginal cost can be increasing while average variable cost is either increasing or decreasing. If marginal cost is less (greater) tha

33、n average variable cost, then each additional unit is adding less (more) to total cost than previous units added to the total cost, which implies that the AVC declines (increases). Therefore, we need to know whether marginal cost is greater than average variable cost to determine whether the AVC is increasing or de