EXPLICIT COSTS
A firm’s actual cash payments for its inputs
IMPLICIT COSTS
• Opportunity costs of non-purchased inputs such as the
entrepreneur’s time and money.
– opportunity cost of something is what you sacrifice to
get it.
• Opportunity cost of the entrepreneur’s time:
Time given up to operate a firm;
• Opportunity cost of funds:
Money given up to set up and run a business.
Economic Cost
• The sum of explicit and
implicit costs.
• The economic cost is higher
because the economist
includes implicit costs but
the accountant does not.
Accounting versus Economic Cost
Accounting
Approach
Explicit Cost
(Purchased Inputs)
$60,000
Implicit Cost
(Opportunity cost of
entrepreneur)
(Opportunity cost of
funds)
Total Cost
Economic
Approach
$60,000
$30,000
$10,000
------------$60,000
------------$100,000
TIME PERIODS
• SHORT RUN
A period of time over which at least one input to
production is fixed. For most firms, the fixed
input is capital: firm cannot modify production
facility or build a new facility.
• LONG RUN
A period of time over which a firm is perfectly
flexible in its choice of inputs.
In the long run, a firm can build a new production
facility (factory,store, office or restaurant) or
modify an existing facility, hire a workforce, and
buy raw materials.
Time Period Decisions
• Short Run
How much output to produce;
• Long Run
What type of production facility
to build;
Principle of Diminishing
Returns
• Suppose an output is produced with
two or more inputs, and we increase
one input while holding the other
inputs fixed. Beyond some point -called the point of diminishing returns
-- output will increase at a decreasing
rate.
Computer Chip Manufacturing
• As firm packs more and more
workers into factory, total output
increases, but at a decreasing rate.
------------flipping this around------------• As the firm steadily increases its
output, the firm requires more and
more workers to increase its output
by a single chip.
Diminishing Returns and Increasing Marginal Cost
For One More Chip
Quantity of Additional Additional Additional
Marginal Chips
Labor Time Labor Cost Material
Cost
Cost
Small: 100
Medium: 300
Large: 400
2 hours
6 hours
10hours
$16
$48
$80
$10
$10
$10
$26
$58
$90
Short-Run Marginal Cost
The change in total cost
resulting from a one-unit
increase in the output of
an existing production
facility.
Short-Run Marginal and Average Cost Curves
short-run average
total cost curve (SATC)
Marginal
or
Average 90
Cost
$$$
t
e
f
68
58
26
short-run marginal
cost curve (SMC)
QUANTITY SMC SATC
m
100
300
400
s
100
300
400
Quantity of Chips produced per hour
26
58
90
90
58
68
Short-Run Average Total Cost
(SATC)
• Equals the total cost divided
by the quantity of output, or
the cost per unit output.
• Total cost is the sum of the
fixed cost per chip, the labor
cost per chip, and the
material cost per chip.
• U-shaped.
Short-Run Average Total Cost
QUANTITY OF CHIPS
SMALL
Number of Chips
Fixed Cost / Chip($)
Labor Hours
Labor Cost ($)
Labor Cost / Chip ($)
Material Cost / Chip ($)
Total Cost / Chip ($)
100
72
100
800
8
10
90
MEDIUM
LARGE
300
24
900
7,200
24
10
58
400
18
2,000
16,000
40
10
68
Short-Run Average Total Cost
Number of Chips
Fixed Cost ($)
Fixed Cost / Chip($)
Labor Hours
Labor Cost ($)
Labor Cost / Chip ($)
Material Cost ($)
Material Cost / Chip ($)
Total Cost ($)
Total Cost / Chip ($)
QUANTITY OF CHIPS
SMALL MEDIUM LARGE
100
300
400
7,200 7,200
7,200
72
24
18
100
900
2,000
800
7,200
16,000
8
24
40
1,000 3,000
4,000
10
10
10
9,000 17,400 27,200
90
58
68
Average Costs
• As production increases:
Fixed cost per chip decreases from
$72 to $24 to $18;
Labor cost per chip increases from
$8 to $24 to $40;
Material cost per chip doesn’t change
$10.
• Cost is lowest ($58) at the medium level of
production.
Marginal & Average-Total Cost
Relationship
• Short-run average total cost is at its
minimum value where average total
cost and marginal cost are equal.
Average total cost slope = 0.
• If marginal cost is less than average
total cost, average total cost is
decreasing -- has a negative slope.
• If marginal cost is greater than average
total cost, average total cost is
increasing -- has a positive slope.
SHORT-RUN AVERAGE COST CURVES
Average
cost per
chip ($)
90
72
68
58
50
Short-run
average
total cost
(SATC)
t
f
u
m
g
n
34
24
18
Short-run
average
variable cost
(SAVC)
v
100
p
h
Quantity SATC SAVC AFC
100
90
18 72
300
58
34 24
400
68
50 18
Average Fixed
Cost
300
400
Quantity of Chips per Hour
SATC = SAVC + AFC
LONG-RUN AVERAGE COST
• Total cost divided by the
quantity of output when the
firm can choose a production
facility of any size
• The long-run average cost
curve is L-shaped, initially the
result of economies of scale.
Economies of Scale
Cost saving associated with scaling up -adding more capital, labor and materials to
produce more output may be caused by
either of two effects:
• Indivisible inputs;
• Specialization
LONG-RUN AVERAGE COST CURVE
FOR ALUMINUM PRODUCTION
Average cost
$ per pound
2.80
Long-run average cost curve
f
e
2.10
d
c
b
1.60
1.00
0.50 1.00 1.50 2.00 2.50
Millions of Pounds of Aluminum per year
Indivisible Inputs
Inputs which cannot be scaled down to
produce a small quantity of output.
Examples:
• Railroad track between two cities cannot be
scaled from two to one track.
• An industrial mold must be complete to
produce many copies or a single copy.
Specialization
• In a small operation with just a few workers,
each performs a wide variety of tasks.
• In a large operation with many workers,
each worker specializes in one or two tasks,
and is more productive because:
• Repetition increases productivity;
• Workers spend less time switching
from task to task.
Minimum Efficient Scale
The output at which the longrun average cost curve
becomes horizontal.
INDUSTRIES EXPERIENCING MINIMUM
EFFICIENT SCALE
INDUSTRY
MINIMUM EFFICIENT SCALE
British Sulfuric Acid
1 million tons
British Steel
9 million tons
U.S. Automobiles
Large U.S. Breweries
200,000 to 400,000 per year
4.5 million barrels
DISECONOMIES OF SCALE
• Increase in output leads to increases
in the average cost of production:
higher costs accompany scaling up.
• Diseconomies may occur for two
reasons:
• Coordination problems;
• Increasing input costs.
Coordination Problems
• Large organizations require several
layers of management (a
bureaucracy) to coordinate the
activities of the different parts of the
organization. This leads to a
positively sloped average-cost
curve.
Increasing Input Costs
• As a firm increases its output, it will
demand more of each of its inputs,
which may lead to higher prices for
some inputs.
• Higher prices increases the average
cost of production, resulting in a
positively sloped average-cost curve.
FOUR TYPES OF MARKETS
• Perfect Competition --A market with a very large number of
firms, each of which produces the
same standardized product and
takes the market price as given.
A price-taking firm.
FOUR TYPES OF MARKETS
• Perfect Competition
EXAMPLES
• The wheat farmer,
• The average stock investor
FOUR TYPES OF MARKETS
• Monopolistic Competition --There are many firms, each sells a
differentiated product. Because products
sold by different firms are not perfect
substitutes, each firm has some control
over price. There are no barriers to
entering the market.
FOUR TYPES OF MARKETS
• Monopolistic competition --EXAMPLES
• restaurants,
• retail stores,
• gas stations,
• clothing
FOUR TYPES OF MARKETS
• Oligopoly --- There are just a few
firms in the market, a result of two
sorts of barriers to entry:
• economies of scale,
• government may limit number
of firms in the market
FOUR TYPES OF MARKETS
• Oligopoly
EXAMPLES
• automobiles,
• airline travel,
• breakfast cereals
FOUR TYPES OF MARKETS
• Monopoly --A single firm serves the entire market.
A monopoly occurs when the
barriers to entry are very strong,
which could result from very large
economies of scale or a government
limit on the number of firms.
FOUR TYPES OF MARKETS
• Monopoly ---
EXAMPLES
large scale economies:
• local phone service,
• electric power generation,
established by government policy:
• drugs covered by patents,
• concessions in National Parks
Characteristics of Different Types of Markets
Number
Perfect
Monopolistic
Oligopoly Monopoly
very large
many
few
of firms
Type of
standardized differentiated
product
Control
none
slight
over price
Entry
no barriers
conditions
Examples wheat
soybeans
no barriers
restaurants
retail stores
clothing
Competition
std or diff.
Competition
one
unique
considerable considerable
if not
regulated
large
large
barriers
barriers
automobiles local phone
air travel
and electric
breakfast
patented
cereal
drugs
TOTAL REVENUE
• The money the firm gets from selling its
product and is equal to price times quantity
sold:
Total Revenue = price
*
quantity
ECONOMIC PROFIT
Total revenue - total economic cost
Total economic cost
= explicit costs
( firm’s actual cash payments for inputs )
+ implicit costs
( opportunity costs of non-purchased inputs,
entrepreneur’s time or money )
such as