Costs of Production
1
COSTS (in Economics) that deal
with forgoing the opportunity to
produce alternative goods and
services.
The OPPORTUNITY COST of
producing a good is its value or
worth in its best alternative use.
2
Explicit costs are those payments a
firm must make, or incomes it must
provide to resource suppliers to
attract these resources away from
alternative production
opportunities.
3
Examples:
payments to hired
labor
payments to vendors
payments for rent or
mortgage
payments for trucks,
etc.
4
IMPLICIT COSTS
Costs of self-owned,
self-employed
resources
Money payments the
self-employed
resources could have
earned in their next
best alterative
employments.
5
Examples:
 value lost by investing
in business instead of
alternative investment
 value lost in working
for someone else
 value lost by not using
entrepreneurial skill in
another way
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NORMAL PROFIT
Amount remaining from
revenue less those costs to
attract and retain resources
in a given line of production.
Minimum return needed by
entrepreneur to stay in
business
If not realized,
entrepreneur will reallocate
resources to more attractive
pursuits.
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ECONOMIC PROFITS
Total Revenue minus all Costs
Costs will include both
explicit and implicit
costs
Implicit costs will
include the normal profit
8
ECONOMIC PROFITS
Economic profits =
Total revenue —opportunity costs of all
inputs
Economic profit is not a cost!
… it is a return in excess of the normal profit
required to retain the entrepreneur
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ECONOMIC
PROFITS
E
C
O
N
O
M
I C
C O
S
T
S
Implicit Costs
including
Normal Profit
Explicit Costs
T
O
T
A
L
ACCOUNTING
PROFITS
R
E
V
E
N
U
E
ACCOUNTING
COSTS
explicit costs
only
10
Gomez runs a small firm which makes pottery. He hires
one helper at $12,000 per year, pays annual rent of
$5,000 and materials cost $20,000 per year.
Gomez has $40,000 of his own funds
invested in equipment which could earn
$4,000.
Gomez has been offered $15,000 to work as a
potter for a competitor. He estimates his
entrepreneurial skills are worth $3,000 per
year.
Explicit Costs?
Implicit Costs?
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Explicit costs:
$12,000 + $5,000 +
$20,000 = $37,000
Implicit Costs:
$4,000 + $15,000+
$3,000 = $22,000
12
• If Total Revenue is $72,000
Accounting Profits
Explicit costs:
$37,000
$72,000— $37,000 = $35,000
Economic Profits
Explicit
costs:$37,000
Implicit
costs:$22,000
$72,000— $37,000—$22,000 = $13,000
13
What is a Fixed Cost?
Cost to a firm that does
not vary with the quantity
of goods produced
14
What are examples of
Fixed Costs?
• rent or mortgage
• loan payments
• certain salaries
• a part of utilities
• property taxes
15
What are some other
names for Fixed Cost?
Sunk and Historical
16
What is a
Variable
Cost?
Cost that varies with the
quantity of goods produced
17
What are examples of
Variable Costs?
• worker’s wages
• raw materials
• some utilities
18
Short Run Costs of
Production
Total costs =
Total Fixed costs +
Total Variable costs
TC = TFC + TVC
19
Total Fixed cost curve
P/C
TFC
Q
20
Total Variable Cost Curve
P/C
TVC
0
Q
21
Total Costs, Sum of Variable
and Fixed Cost
TC
P/C
TVC
TFC
Q
0
22
What is
Average Fixed Cost?
Total fixed cost divided
by the quantity of goods
produced
AFC = TFC/Q
23
What is
Average Variable Cost?
Total variable cost
divided by the
quantity of goods
produced
AVC = TVC/Q
24
What is
Average Total Cost?
Total cost divided by
the quantity of goods
produced
ATC = TC/Q
25
P/C
ATC
AVC
AFC
Q
26
P/C
Ave. Fixed Costs
ATC
AVC
Q
27
What is
Marginal Cost?
The change in total cost
generated by a change in
the quantity of a good
produced
28
So…
MC =
TC
Q
=
TVC
Q
29
P/
C
MC
Ave. Fixed Costs
ATC
AVC
Q
30
Why does MC = ATC at
minimum ATC?
• If the margin is above the
average, the average
increases
• If the margin is below the
average, the average decrease
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