10

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
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
LO1
 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

Economic
profit
Accounting
Implicit costs
profit

Total Revenue
(including a
normal profit)
(Opportunity)
Economic

Costs

Accounting
Explicit
costs (explicit
costs
costs only)

LO1
 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)
Change in Total Product
Marginal Product =
Change in Labor Input

• Average Product (AP)

Total Product
Average Product = Units of Labor

LO2
 Law of Diminishing Returns

• Resources are of equal quality

• Technology fixed
• Variable resources are added to fixed
resources
• At some point, marginal product will
fall
• Rationale

LO2
 The Law of Diminishing Returns
Total, Marginal, and Average Product: The Law of Diminishing Returns

(1) (3)
(4)
Units of the (2) Marginal
Average Product
Variable Total Product Product (MP)
(AP),
Resource (TP) Change in (2)/
(2)/(1)
(Labor) Change in (1)
0 0 -
1 10 10 Increasing 10.00
2 25 15 marginal 12.50
returns
3 45 20 15.00
4 60 15 15.00
5 70 10 Diminishing 14.00
marginal
6 75 5 returns 12.50
7 75 0 10.71
8 70 -5 Negative 8.75
marginal
returns
LO2
 The Law of Diminishing Returns

Total Product, TP
30
TP

20

10

0
1 2 3 4 5 6 7 8 9
Marginal Product, MP

Increasing Diminishing Negative

Marginal Marginal Marginal
20 Returns Returns Returns

10 AP

1 2 3 4 5 6 7 8 9
MP

LO2
 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
$1100
1000 TC
900
TVC
800
700

600
Costs

Fixed
500 Cost
400
300 Total Variable
Cost Cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3
 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
 Short-Run Production Costs
Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run

Marginal
Total Cost Data Average Cost Data Cost
(6)
(3) (5) Average (7) (8)
(1) (2) Total (4) Average Variable Average Marginal
Total Total Fixed Variable Total Cost Fixed Cost Cost Total Cost Cost
Product Cost Cost (TC) (AFC) (AVC) (ATC) (MC)
(Q) (TFC) (TVC) TC=TFC+TVC AFC = TFC/Q AVC=TVC/Q ATC = TC/Q MC =ΔTC/ΔQ

0 $100 $0 $100
1 100 90 190 $100.00 $90.00 $190.00 $90
2 100 170 270 50.00 85.00 135.00 80
3 100 240 340 33.33 80.00 113.33 70
4 100 300 400 25.00 75.00 100.00 60
5 100 370 470 20.00 74.00 94.00 70
6 100 450 550 16.67 75.00 91.67 80
7 100 540 640 14.29 77.14 91.43 90
8 100 650 750 12.50 81.25 93.75 110
9 100 780 880 11.11 86.67 97.78 130
10 100 930 1030 10.00 93.00 103.00 150

LO3
 Per-Unit, or Average, Costs
$200

150

ATC
Costs

100
AVC
AFC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3
 Marginal Cost

$200

MC
150

ATC
Costs

100
AVC
AFC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3
 MC and Marginal Product
Production Curves

AP
MP
Quantity of Labor

MC
AVC

Cost Curves
Quantity of Output
LO3
 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
 Firm Size and Costs
Average Total Costs

ATC-1
ATC-5
ATC-2
ATC-3 ATC-4

Output

LO4
 The Long-Run Cost Curve
Average Total Costs

ATC-1
ATC-5
ATC-2
ATC-3 ATC-4 Long-run
ATC

Output

LO4
 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

Economies Constant Returns Diseconomies

Average Total Costs

Of Scale To Scale Of Scale

Long-run
ATC

q1 q2
Output

LO4
 MES and Industry Structure

Economies Diseconomies
Average Total Costs

Of Scale
Of Scale

Long-run
ATC

Output

LO4
 MES and Industry Structure

Economies Diseconomies
Average Total Costs Of Scale Of Scale
Long-run
ATC

Output

LO4
 Applications and Illustrations

• Rising gasoline prices

• Successful start-up firms
• Verson stamping machine
• The daily newspaper
• Aircraft and concrete plants

LO3
 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