Businesses and the Costs of Production

10

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Costs

• The payment that must be made to obtain and retain the services of a resource

• Explicit Costs

• Monetary payments

• Implicit Costs

• Value of next best use

• Self-owned resources

• Includes normal profitLO1

Accounting Profit and Normal Profit

• Accounting profit

= Revenue – Explicit Costs

• Economic profit

= Accounting Profit – Implicit Costs

• Economic profit (to summarize)

=Total Revenue – Economic Costs

=Total Revenue – Explicit Costs – Implicit Costs

LO1

Economic Profit

LO1

Explicitcosts

Accounting costs (explicit

costs only)

Implicit costs (including a

normal profit)

Economicprofit Accounting

profit

Eco

no

mic

(Op

po

rtu

nit

y)C

ost

s

To

tal

Rev

enu

e

Short Run and Long Run

• Short Run

• Some variable inputs

• Fixed plant

• Long Run

• All inputs are variable

• Variable plant

• Firms enter and exit

LO1

Short-Run Production Relationships

• Total Product (TP)

• Marginal Product (MP)

• Average Product (AP)

LO2

Marginal ProductChange in Total Product

Change in Labor Input=

Average Product Total Product

Units of Labor=

The Law of Diminishing Returns

LO2

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

1 2 3 4 5 6 7 8 90

10

20

30

To

tal P

rod

uct

, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

gin

al P

rod

uct

, MP

Short-Run Production Costs

• Fixed Costs (TFC)

• Costs do not vary with output

• Variable Costs (TVC)

• Costs vary with output

• Total Costs (TC)

• Sum of TFC and TVC

• TC = TFC + TVC

LO3

Short-Run Production Costs

LO3

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

100

200

300

400

500

600

700

800

900

1000

$1100

TFC

TC

TVC

TotalCost

VariableCost

FixedCost

Per-Unit, or Average, Costs

• Average Fixed Costs AFC = TFC/Q

• Average Variable Costs AVC = TVC/Q

• Average Total Costs ATC = TC/Q

• Marginal Costs MC = ΔTC/ΔQ

LO3

Per-Unit, or Average, Costs

LO3

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

ATCAVC

AVC

AFC

Marginal Cost

LO3

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

MC and Marginal Product

LO3

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves

Long-Run Production Costs

• The firm can change all input amounts, including plant size.

• All costs are variable in the long run.

• Long run ATC

• Different short run ATCs

LO4

The Long-Run Cost Curve

LO4

Long-RunATC

Ave

rag

e T

ota

l C

ost

s

ATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

Economies and Diseconomies of Scale

• Economies of scale

• Labor specialization

• Managerial specialization

• Efficient capital

• Other factors

• Constant returns to scale

LO4

Economies and Diseconomies of Scale

• Diseconomies of scale

• Control and coordination problems

• Communication problems

• Worker alienation

• Shirking

LO4

MES and Industry Structure

• Minimum Efficient Scale (MES):

• Lowest level of output where long- run average costs are minimized

• Can determine the structure of the industry

LO4

MES and Industry Structure

LO4

Output

Av

era

ge

To

tal C

ost

s

Long-RunATC

EconomiesOf Scale

Constant ReturnsTo Scale

DiseconomiesOf Scale

q1 q2

Don’t Cry Over Sunk Costs

• Sunk costs

• Costs have already been incurred and thus are irrecoverable

• Rule: Do not engage in any activity where MB<MC

• Rule: Ignore sunk costs

• They are irrecoverable