Micro: Unit 3.2 -- Production Costs

Summary

TLDRIn this video, Mr. Willis explains key economic concepts related to production costs, including the difference between explicit and implicit costs, and how firms calculate accounting and economic profits. He explores fixed and variable costs, total production costs, and how these influence a firm’s decision-making process. The video also introduces per-unit production costs such as average fixed cost, average variable cost, and marginal cost, while highlighting the impact of diminishing marginal returns. Through practical examples, viewers gain a better understanding of how firms manage costs to maximize profits.

Takeaways

💼 Economics distinguishes between explicit costs (out-of-pocket payments) and implicit costs (opportunity costs) of production.
🔢 Accountants consider only explicit costs, while economists include both explicit and implicit costs in their calculations.
💹 A firm earns accounting profits if revenue exceeds explicit costs, but economic profits require revenue to exceed both explicit and implicit costs.
🏭 Fixed costs are constant and include expenses like rent, insurance, and business licenses, which do not change with output level.
🔄 Variable costs change with production levels and include wages, electricity, and raw materials.
📈 Total cost is calculated as the sum of fixed and variable costs, increasing with output.
📊 Average fixed cost per unit decreases as output increases because fixed costs are spread over more units.
📉 Average variable cost and average total cost initially decrease due to efficiency but can increase with the law of diminishing returns.
📋 Marginal cost is the additional cost of producing one more unit and is calculated by dividing the change in total cost by the change in output.
🍽️ The example of a small diner illustrates how to calculate fixed, variable, total, average, and marginal costs, emphasizing the importance of covering these costs through pricing.
📈 As production increases, the fixed cost per unit diminishes, but average variable and total costs may rise due to the law of diminishing marginal returns.

Q & A

What are economic costs in the context of production?
-Economic costs include both explicit costs, which are out-of-pocket payments for land, labor, and capital, and implicit costs, which are the opportunity costs of using resources.
How do economists and accountants differ in their view of production costs?
-Accountants only consider explicit costs (out-of-pocket expenses), while economists include both explicit and implicit costs (opportunity costs).
What is the significance of opportunity costs in economic decision-making?
-Opportunity costs represent the value of the next best alternative that is foregone when resources are used in a particular way, which is crucial for economists in analyzing trade-offs.
How do accounting profits differ from economic profits?
-Accounting profits are the difference between revenue and explicit costs, while economic profits subtract both explicit and implicit costs from revenue.
What happens if a firm's revenue exceeds its explicit costs but not its economic costs?
-The firm is earning accounting profits but incurring economic losses, as it cannot cover the total of both explicit and implicit costs.
What are fixed costs in the production process?
-Fixed costs are expenses that do not change with the level of production, such as rents, interest payments, insurance, and business licenses.
How do variable costs change with production levels?
-Variable costs increase with higher production as more resources like labor and equipment are required, and decrease when production levels drop.
How is total cost calculated in the production process?
-Total cost is the sum of fixed costs and variable costs. As production increases, variable costs increase, and so does the total cost.
What is marginal cost, and how is it calculated?
-Marginal cost is the cost of producing an additional unit of output. It is calculated by dividing the change in total cost by the change in total product (output).
Why do average fixed costs decrease as output increases?
-Average fixed costs decrease because fixed costs are spread over a larger number of units as production increases, reducing the cost per unit.

Outlines

00:00

💼 Economics of Production Costs

This paragraph introduces the concept of economic costs during the production process, differentiating between explicit costs (out-of-pocket payments for resources like land, labor, and capital) and implicit costs (opportunity costs of using resources). It explains that while accountants only consider explicit costs, economists include both explicit and implicit costs due to the importance of opportunity costs and scarcity. The paragraph also discusses how these costs affect a firm's profits, distinguishing between accounting profits (revenue exceeding explicit costs) and economic profits (revenue exceeding both explicit and implicit costs). It concludes with an introduction to fixed costs, variable costs, and total costs, using the example of starting a small diner to illustrate these concepts.

05:00

📈 Calculating Production Costs for a Small Diner

The second paragraph delves into the specifics of calculating production costs for a small diner, starting with fixed costs that remain constant regardless of output level. It explains how variable costs change with output and are calculated by adding the wages and rents of variable resources. The paragraph outlines how to calculate total costs by summing variable and fixed costs. It then introduces the concept of per-unit production costs, including average fixed cost, average variable cost, average total cost, and marginal cost. Each of these costs is calculated using the example of the diner, showing how costs change as output increases. The paragraph emphasizes the importance of understanding these costs for a firm to maximize profits.

10:00

📊 Pricing Strategy Based on Production Costs

The final paragraph focuses on how the diner must price its meals to cover production costs. It discusses the relationship between average fixed cost, average variable cost, and average total cost with the quantity of meals produced. The paragraph explains that as production increases, the fixed cost per unit decreases due to the law of diminishing returns. It also highlights how average variable cost and average total cost initially decrease and then increase with production due to the same law. The paragraph uses a hypothetical scenario with workers to illustrate how diminishing returns affect average variable cost. It concludes by encouraging viewers to subscribe to the channel for more economic insights.

Mindmap

Keywords

💡Economic Costs

Economic costs encompass both explicit and implicit costs associated with the production process. Explicit costs are actual monetary payments made, such as wages or rents. Implicit costs, on the other hand, represent the opportunity cost of using resources, which might include the value of the owner's time or the potential earnings from an alternative use of capital. In the video, economic costs are central to understanding how firms calculate profitability, as they must consider both types of costs to determine if they are truly making a profit or incurring a loss.

💡Accounting Profits

Accounting profits refer to the financial gains a firm makes when its revenue exceeds its explicit costs. The script uses the example of a firm selling goods in the product market, where if the price per unit collected is greater than the out-of-pocket payments for resources, the firm is said to be earning accounting profits. However, this does not take into account the opportunity costs, which are considered in economic profits.

💡Economic Profits

Economic profits occur when a firm's revenue is greater than the sum of both its explicit and implicit costs. The video explains that for a firm to be earning economic profits, it must be covering all its opportunity costs in addition to its out-of-pocket expenses. This is a crucial concept in economics as it reflects the true profitability of a firm's operations, considering all costs, not just the financial ones.

💡Fixed Costs

Fixed costs are expenses that a firm must pay regardless of the level of production. These include costs such as rent, insurance, and business licenses. The video uses the example of a small diner that must pay a fixed cost of $100 for these overhead costs before it can even begin to produce any meals. Fixed costs are important for firms to consider when planning production levels and pricing strategies.

💡Variable Costs

Variable costs change with the level of output produced. They include wages for workers and costs for raw materials that are directly tied to the production process. In the script, the variable cost for the diner includes the wages for labor and the cost of renting equipment, which increase as more meals are produced. Understanding variable costs helps firms manage their production levels and control costs effectively.

💡Total Cost

Total cost is the sum of both fixed and variable costs incurred by a firm in the production process. The video illustrates this by adding the fixed cost of $100 to the variable cost at each output level to calculate the total cost for the diner. This concept is essential for firms to determine their break-even point and to maximize profits.

💡Average Fixed Cost

Average fixed cost is calculated by dividing the total fixed costs by the quantity of output produced. The video explains that as the diner produces more meals, the average fixed cost per meal decreases because the fixed costs are spread over a larger number of units. This concept helps firms understand how to minimize costs per unit by increasing production.

💡Average Variable Cost

Average variable cost is determined by dividing the total variable costs by the quantity of output. The script uses the example of the diner where, as more workers are hired and production increases, the average variable cost per meal can initially decrease due to economies of scale but may increase again if the law of diminishing returns sets in.

💡Average Total Cost

Average total cost represents the total cost of production per unit of output. It is calculated by dividing the total cost by the quantity of output. The video explains that average total cost can also be found by adding average fixed cost per unit to average variable cost per unit. This metric is crucial for firms to price their products competitively and to ensure profitability.

💡Marginal Cost

Marginal cost is the additional cost incurred from producing one more unit of output. The video describes how to calculate marginal cost by dividing the change in total cost by the change in output. For the diner, as more meals are produced, the marginal cost can provide insights into the most efficient production levels and help in making decisions about expanding or reducing output.

💡Law of Diminishing Marginal Returns

The law of diminishing marginal returns states that as more units of a variable input are used to produce a good, the additional output (marginal product) from each additional unit of input will eventually decrease. The video uses the example of the diner hiring more workers, where the average variable cost decreases initially as more efficient workers are hired, but then increases as the least productive worker is added due to the law of diminishing returns. This concept is important for understanding the optimal level of input usage in production.

Highlights

Economic costs include both explicit and implicit costs, whereas accountants only consider explicit costs.

Explicit costs are out-of-pocket payments for acquiring resources like land, labor, and capital.

Implicit costs represent the opportunity costs of using resources during the production process.

Accounting profits are earned when revenue exceeds explicit costs, but economic profits require revenue to exceed both explicit and implicit costs.

Firms can earn accounting profits while incurring economic losses if their revenue does not cover both explicit and implicit costs.

Fixed costs are constant and include overhead costs like rent and insurance, regardless of production level.

Variable costs change with output and include wages for labor and rents for equipment.

Total cost is the sum of fixed and variable costs, and it increases with output due to rising variable costs.

Average fixed cost decreases as output increases because fixed costs are spread over more units.

Average variable cost and average total cost initially decrease due to increasing productivity but eventually increase due to the law of diminishing marginal returns.

Marginal cost is the cost of producing one additional unit and is calculated by dividing the change in total cost by the change in output.

Firms need to cover per unit production costs to avoid losses, which includes setting prices that reflect these costs.

The small diner example illustrates the calculation of fixed costs, variable costs, total costs, and per unit costs in a practical scenario.

Average fixed cost per unit is calculated by dividing total fixed costs by the quantity of output.

Average variable cost per unit is found by dividing total variable costs by the quantity of output.

Average total cost per unit is calculated by dividing total costs by the quantity of output or by summing average fixed and variable costs per unit.

Marginal cost helps firms decide the optimal level of production by showing the additional cost of producing one more unit.

The video provides a comprehensive overview of production costs, including fixed, variable, total, and per unit costs, and their implications for pricing and profitability.