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07

Businesses and the Costs of


Production

McGraw-Hill/Irwin

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

Economic Costs

The payment that must be made to

LO1

obtain and retain the services of a


resource
Explicit Costs
Monetary payments
Implicit Costs
Value of next best use
Self-owned resources
Includes normal profit
7-2

Accounting Profit and Normal Profit

Accounting profit

LO1

= Revenue Explicit Costs


Economic profit
= Accounting Profit Implicit Costs
Economic profit (to summarize)
=Total Revenue Economic Costs
=Total Revenue Explicit Costs
Implicit Costs
7-3

Economic Profit

LO1

Implicit costs
(including a
normal profit)
Explicit
costs

Total Revenue

Economic
(Opportunity)
Costs

Economic
profit

Accounting
profit

Accounting
costs (explicit
costs only)

7-4

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

7-5

Short-Run Production Relationships

Total Product (TP)


Marginal Product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input

Average Product (AP)


Average Product

LO2

Total Product
Units of Labor

7-6

Total Product, TP

The Law of Diminishing Returns


30

TP

20
10
0

Marginal Product, MP

LO2

20

Increasing
Marginal
Returns

Negative
Marginal
Returns

Diminishing
Marginal
Returns

10

AP
1

8 9
MP
7-7

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

7-8

Short-Run Production Costs


$1100

TC

1000
900

TVC

800

Costs

700
600

Fixed
Cost

500
400

Total
Cost

300

Variable
Cost

200
100

TFC
0

LO3

10

7-9

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 = TC/Q

LO3

7-10

Per-Unit, or Average, Costs


$200

Costs

150

ATC
AVC

100

AFC
50

AVC
AFC
0

LO3

10

7-11

Marginal Cost
$200

MC

Costs

150

ATC
AVC

100

AFC
50

AVC
AFC
0
LO3

10

Q
7-12

Average Product and


Marginal Product

MC and Marginal Product


Production Curves

AP
MP
Quantity of Labor

MC
Cost (Dollars)

AVC

Cost Curves
Quantity of Output
LO3

7-13

Long-Run Production Costs

The firm can change all input

LO4

amounts, including plant size.


All costs are variable in the long run.
Long run ATC
Different short run ATCs

7-14

Average Total Costs

The Long-Run Cost Curve

ATC-1

ATC-5
ATC-2

ATC-3

ATC-4

Long-Run
ATC

Output

LO4

7-15

Economies and Diseconomies of Scale

Economies of scale
Labor specialization
Managerial specialization
Efficient capital
Other factors
Constant returns to scale

LO4

7-16

Economies and Diseconomies of Scale

Diseconomies of scale
Control and coordination problems
Communication problems
Worker alienation
Shirking

LO4

7-17

MES and Industry Structure

Minimum Efficient Scale (MES):


Lowest level of output where longrun average costs are minimized
Can determine the structure of the
industry

LO4

7-18

Average Total Costs

MES and Industry Structure

Constant Returns
To Scale

Economies
Of Scale

Diseconomies
Of Scale

Long-Run
ATC

q1

q2

Output

LO4

7-19

Dont 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

7-20