Chapter 5
COSTS AND PRODUCTIVITY
1. Opportunity Costs




The correct measure of the costs of any action is
what has been given up by taking that action instead
of another. (Why accounting and law professors are paid more)
The opportunity cost of any action—
consumption, production, leisure, government
spending—is the value of the next-best alternative
lost.
Opportunity cost is precisely defined not by any
alternative but by the next-best alternative.
The opportunity cost of any resource—land,
labor capital, materials—is the payment that that
resource would receive in its next-best alternative
use.
1.1 Explicit and Implicit
Costs




When a firm requires resource it makes payments for
the resources; the skilled mechanic gets a weekly
paycheck; etc.
An explicit cost (also called an accounting cost) is
incurred when an actual payment is made for a
resource.
Firms also incur implicit costs in acquiring and using
resources; no actual payments are made; no money
changes hands, but these are real costs to the firm.
An implicit cost is incurred when an alternative is
sacrificed by the firm using a resource that it owns.
1.2 Economic Profits


Economic profit equals the firm’s
revenues minus its total opportunity
costs (explicit plus implicit costs).
A normal profit is earned when total
revenues equal total opportunity costs.
An economic profit is earned when total
revenues exceed total opportunity
costs.
2. The Short Run and
Long Run


The optimal (profit-maximizing) level of
output depends on how opportunity costs
change with the level of output.
Business firms expand their volume of output
by hiring or using additional resources.




As more resources are employed, the opportunity costs
of production increase.
The opportunity cost of the resources used to produce
output depend on their prices and their productivity.
The higher the resource prices, the higher the
opportunity costs of production.
The lower the productivity of resources, the higher the
opportunity costs of production.
2. The Short Run and
Long Run – cont.




Time plays a role in determining resource
cost; some resources can be increased or
reduced more rapidly than others.
Variable inputs increase with output.
Fixed inputs cannot be changed in the
relevant time frame.
Economists distinguish between the short run
and long run when considering the time
necessary to change input levels.
2. The Short Run and
Long Run – cont.




The short run is a period of time too short
for plant or equipment to be varied.
Additional output can be produced only by
increasing the variable outputs, usually labor
and material.
The long run is a period of time long enough
to vary all inputs and for firms to enter and
leave the industry.
The long run is not a predetermined amount
of calendar time; a new assembly line may be
installed in a few weeks.
3. Diminishing Returns

Ricardo, an English economist (1500’s), noted
that agricultural land was in fixed supply even
though other factors of production like labor,
could be increased, there were limits to the
growth of agricultural output.


As more variable inputs were added to the fixed amount
of input, land, eventually these variable inputs would
yield smaller and smaller additions to output. Why?
As the fixed input became overcrowded with variable
inputs, as more farmhands were added to already
overcrowded farmland, their extra contribution to output
would become smaller and smaller.
3. Diminishing Returns
– cont.

The marginal product (MP) of labor—or
of any variable factor—is the increase in
output that results from increasing the input
by one unit.
(Labor, output and Marginal product example)

The law of diminishing returns states that
as ever larger inputs of a variable factor are
combined with fixed inputs, eventually its MP
will decline.
(Why wine is produced almost everywhere)
4. Short-Run Costs

The behavior of costs in the short run
reflects the law of diminishing returns.
4.1 Fixed and Variable
Costs


In the short run, some factors (such as plant
and equipment) are fixed in supply; even if
the firm wanted to increase them, it would
not be possible in the short run; the cost of
these fixed factors are fixed costs.
Fixed costs (FC) do not vary with output:
variable costs (VC) do. Total costs (TC)
are fixed costs plus variable costs: TC = FC +
VC.
4.1 Fixed and Variable
Costs – cont.



In the long run, all costs are variable and
fixed costs are zero. In the short run, some
costs are fixed.
There is no way to change fixed costs; fixed
resources have no alternative use; they are
fixed and cannot be used elsewhere.
Output can be expanded only by an increase
in variable inputs and thus in variable costs.
4.2 Marginal and Average
Costs

Productivity and costs are inversely
related.


The higher productivity, the lower costs;
The lower productivity, the higher costs.
4.2.1 Marginal costs



TC = FC + VC
Since fixed costs are constant, as output
increases both total costs and variable cost
increase by the same amount.
Marginal costs (MC) is the change in total
cost (or, equivalently, in variable cost) divided
by the increase in output—or, alternatively,
the increase in costs per unit increase and
output (Q): MC = TC/Q = VC/Q.
4.2.2 Average cost




While marginal costs look at the change in costs per
unit change in output, average costs spread total,
variable, or fixed costs over the entire quantity of
output.
Average variable cost (AVC) is variable cost
divided by output.
Average fixed cost (AFC) is fixed cost divided by
output.
Average total cost (ATC) is total cost divided by
output, which also equals the sum of average
variable cost and average fixed cost.
4.3 The Cost Curves





FC + VC = TC (Panel A, Panel B example)
FC/Q + VC/Q = TC/Q
AFC + AVC = ATC
The law of diminishing returns dictates
that marginal costs must eventually rise
as output expands.
Marginal cost equals ATC and AVC at
their minimum values.
5. Long Run Costs



In the long run, enterprises do not have any fixed
costs; all costs are available; the business is free to
choose any combination of inputs to produce output.
Once long run decisions are executed (the company
completes a new plant), the enterprise again has
fixed factors and fixed costs.
In the long run, enterprises are free to select the
cost-minimizing level of capital, labor, and land
inputs; their decisions are based on the prices the
firm must pay for land, labor, and capital.
5.1 Shift in Cost Curves

See Acme Steel example
5.2 The Long-Run Cost
Curve



In the long run, all costs are variable; therefore,
there is no distinction between long-run variable
costs and long-run total costs—there is only long-run
average costs.
Long-run average cost (LRAC) is the average cost
for each level of output when all factor inputs are
variable.
In the long-run, the enterprise is free to select the
most effective combination of factor inputs because
none of the inputs are fixed; the long-run cost curve
envelops the short-run cost curves, forming a longrun curve that touches each short-run cost curve at
only one point.
5.3 Economics and
Diseconomies of Scale



In the short run, the fact that some factors of
production are fixed causes the short-run average
total cost curve to be U-shaped.
The law of diminishing returns does not apply to the
long run because all inputs are variable.
Why would long-run average costs (LRAC) first
decline as output expands and then later increase as
output expands even further? Firms experience first
economies of scale, then constant returns to scale,
and finally diseconomies of scale as output expands.
5.3.1 Economies of Scale



The declining portion of the LRAC curve is
due to economics of scale.
Economies of scale are present when an
increase in output causes average costs to
fall.
Workers are able to specialize in various
activities; increase their productivity or
dexterity through experience, and save time
in moving from one task to another.
5.3.1 Economies of Scale
– cont.


Economics of scale occur because of the
greater productivity of specialization in any of
a variety of areas, including technological
equipment, marketing, research and
development, and management.
As the output of an enterprise increases with
all inputs variable; average costs will decline
because of the economies of scale associated
with increased specialization of labor,
management, plant, and equipment.
5.3.2 Constant Returns to
Scale


Economies of scale will become
exhausted at some point when
expanding output no longer increases
productivity.
Constant returns to scale are present
when an increase in output does not
change average costs of production.
5.3.3 Diseconomies of
Scale



As the enterprise continues to expand its
output, eventually all the economies of largescale production will be exploited and longrun average costs will begin to rise.
The rise in long-run average costs as output
of the enterprise expands is the result of
diseconomies of scale.
Diseconomies of scale are present when an
increase in output causes average costs to
increase.
5.3.3 Diseconomies of
Scale – cont.

Diseconomies of scale can be caused by various
factors:



As the firm continues to expand, managers must assume
additional responsibility, and managerial talents are spread
so thin that the efficiency of management declines.
The problem of maintaining communications within a large
firm grows, and additional rules, regulations, and paperwork
requirements become commonplace.
As the output of an enterprise continues to increase,
average cost will eventually rise because of the
diseconomies of scale associated with the growing
problems of managerial control and coordination.
5.4 Minimum Efficient
Scale




Firms and industries differ in their patterns of LRAC;
they have different minimum efficient scales.
The minimum efficient scale is the lowest level of
output at which long-run average costs are
minimized.
Minimum efficient scale is an important determinant
of industrial structure.
In industries such as restaurants, commercial
printing, etc., where firms reach their minimum
efficient scale at low levels of output, the industry is
populated by a large number of small firms.
5.4 Minimum Efficient
Scale – cont.


In industries such as automobiles and
electricity generation, where minimum
efficiency scale is not reached until there are
very high volumes of output, the industry is
populated by a small number of large firms.
Minimum efficiency scale, therefore, plays an
important role in determining the amount of
competition in the industry.
(Airbus versus Boeing example)