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Objectives of chapter 4:

• Understand the notion of economic cost• The short-run production relationship• The short-run production costs• The long-run production costs

Chapter 4: The Costs of Production

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Introduction

– Businesses produce goods and services. To produce, those firms need economic resources

– To use the resource, we need to make monetary payment to resource owners (such as salary for workers).

– To use the resource we already own, there is an opportunity cost.

– The monetary payment and the opportunity cost constitutes the cost of production in any given firms.

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Economic costs

• Explicit costs: monetary payments or cash expenditure a firm makes to those who supply labor services, materials, fuel, transportation services, etc.

• Implicit costs: the opportunity costs of using its self-owned, self-employed resources. – To a firm, implicit costs are the money payments that

self-employed resources could have earned in their best alternative use.

• Normal profit of a firm is considered as an economic cost. The normal profit is the profit required to attract and retain resources in a specific line of production.

• Economic profit: pure profit after deducting the economic cost, which include the normal profit.

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Economic profit

Economic profit

Implicit costs (including a normal profit)

Explicit costs

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Short-run and long-run

• Short-run: Fixed plant– A period too brief for a firm to alter its plant capacity.– The firm’s plant capacity is fixed in the short-run.– However, the firm can vary its output by applying larger or

smaller amounts of labor, materials, and other resources to that plant.

• Long-run: Variable plant– A period long enough for a firm to adjust the quantities of all

the resources that it employs, including plant capacity. – The long-run also includes enough time for existing firm to

dissolve and leave the industry or for new firms to be created and enter the industry.

• The short-run and the long-run are conceptual periods rather than calendar time periods.

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Short-run production relationships

• Total product (TP): The total quantity, or total output, of a particular good produced.

• Marginal product (MP): The extra output or added product associated with adding a unit of a variable resource, normally labor.

MP = ∆ TP / ∆ units of labor

• Average product (AP): also called labor productivity. AP is the output per unit of labor input.

AP= TP / Units of labor

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Law of diminishing returns (a)

• Law of diminishing returns = law of diminishing marginal product

• The law of diminishing returns: states that as successive units of a variable resource (labor) are added to a fixed resource (capital), the marginal product (extra product), that can be attributed to each additional unit of the variable resource, will decline.

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Law of diminishing returns (b)

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Law of diminishing returns (c)

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Short-run production costs (a)

• A firm’s total cost (TC) is the cost of all resources used.

• Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output.

• Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output.

• Total cost equals total fixed cost plus total variable cost. That is:

TC = TFC + TVC

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Short-run production costs (b)

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Short-run production costs (c)

• Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product.

• Average fixed cost (AFC) is total fixed cost per unit of output.

• Average variable cost (AVC) is total variable cost per unit of output.

• Average total cost (ATC) is total cost per unit of output.

ATC = AFC + AVC

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Short-run production costs (d)

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Long-run production costs (a)

• In the long run, all inputs are variable and all costs are variable.

• Diminishing Marginal Product of Capital– The marginal product of capital is the increase in output

resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labor employed.

• For each plant, diminishing marginal product of labor creates a set of short run, U-shaped costs curves for MC, AVC, and ATC.

• The larger the plant, the greater is the output at which ATC is at a minimum.

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Long-run production costs (b)

• Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases.

• Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases.

• Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases.