Do Now 1)What is the difference between supply and quantity supplied? 2)Are hotel rooms elastic or inelastic? Why? 3)What do producers have to consider.

Do Now

1) What is the difference between supply and quantity supplied?

2) Are hotel rooms elastic or inelastic? Why?

3) What do producers have to consider when determining the cost of their product?

5.2 Costs of Production

Labor and Output• Number of workers hired will affect total

production

• Marginal product of labor: change in output from hiring one more worker

Why would the marginal product of

labor decrease

eventually?

Labor (# of workers)

Output (beanbags per hour)

Marginal product of labor

0 0 -

1 4 4

2 10 6

3 17 7

4 23 6

5 28 5

6 31 3

Labor and Output

• Increasing marginal returns: a level of production in which the marginal product of labor increases as the number of workers increases

• More workers = more specialization = increased output per worker

Labor and Output

• Diminishing marginal returns: a level of production in which the marginal product of labor decreases as the number of workers increases

• Once a firm hires enough workers for each task, the benefits of specialization end.– Can still increase total output, but at a decreasing

rate• Limited amount of capital = diminishing returns• Negative marginal returns: total output decreases

– Workers get in each other’s way and disrupt production process

What is the marginal

product of labor when the

factory currently

employs 4 workers?

Production Costs

• Fixed costs: a cost that does not change, no matter how much of a good is produced.– Ex. rent, machinery repairs, property taxes,

salaries of workers that keep business running even when production pauses

• Variable costs: costs that rise or fall depending on the quantity produced.– Ex. raw materials, some labor, electricity, heating– If production slows, a company may lay off

workers

Production Costs

• Total cost: fixed costs + variable costs• Marginal cost: the cost of producing one more unit

of a good– Rising marginal cost shows diminishing returns to

labor

Beanbags (per hour)

Fixed cost

Variable cost

Total cost

Marginal cost

Marginal revenue (market price)

Total revenue

Profit

0 $36 $0 $36 ---------- $24 $0 $-36

1 36 8 44 $8 24 24 -20

2 36 12 48 4 24 48 0

3 36 15 51 3 24 72 21

4 36 20 56 5 24 96 40

5 36 27 63 7 24 120 57

6 36 36 72 9 24 144 72

Why is the marginal revenue always equal to $24?

Setting Output

• Basic goal: maximize profits• Profit: total revenue – total cost• Total revenue: the money the firm gets by selling the

product; equal to price of each good x number sold• To find level of output with highest profit, look for

biggest gap between total revenue and total cost

Beanbags (per hour)

Fixed cost

Variable cost

Total cost

Marginal cost

Marginal revenue (market price)

Total revenue

Profit

0 $36 $0 $36 ---------- $24 $0 $-36

1 36 8 44 $8 24 24 -20

2 36 12 48 4 24 48 0

3 36 15 51 3 24 72 21

4 36 20 56 5 24 96 40

5 36 27 63 7 24 120 57

6 36 36 72 9 24 144 72

What number of beanbags produces the

highest profit?

Setting Output

• Marginal revenue: the additional income from selling one more unit of a good; sometimes equal to price (when firm has no control over market price)

• Can also find the best level of output when the marginal revenue = marginal cost

• If marginal cost is greater than price, company loses money

• If marginal cost is increasing and price stays constant, the losses get worse at higher levels of output

If a firm chooses to

produce below the best level of output, is it

making as much money

as it can?

Setting Output

• Responding to price changes– If the price of a beanbag rose from $24 to $37, we would

predict the company would increase production so that marginal cost is equal to the new price

– Raising production to match a new price allows the company to make a higher profit.

What law does this

demonstrate?

The Shutdown Decision

• A company can be producing at the most profitable level of profit and still be losing money.

• If the market price is too low, the total revenue can be less than total cost = losing money

• Should the company shut down?• Stay open when total revenue is > cost of keeping it

open• Operating cost: the cost of operating a facility

– Includes variable costs, but not fixed costs.

Beanbags (per hour)

Fixed cost

Variable cost

Total cost

Marginal cost

Marginal revenue (market price)

Total revenue

Profit

0 $36 $0 $36 ---------- $24 $0 $-36

1 36 8 44 $8 24 24 -20

2 36 12 48 4 24 48 0

3 36 15 51 3 24 72 21

4 36 20 56 5 24 96 40

5 36 27 63 7 24 120 57

6 36 36 72 9 24 144 72

Price drops to $7. Max level? Benefit? Shut down? Total cost? Shut down or stay open?

Output Fixed Cost Variable Cost

1 $5 $10

2 5 27

3 5 55

4 5 91

5 5 145

1) What is the total cost when output is 2?

2) What is the marginal cost of the third unit?

3) How much should this firm produce if the market price is $24?