Chapter 5
Costs and Productivity
After reading Chapter 5, COSTS AND PRODUCTIVITY, you should be able to:
• Define and explain Opportunity Cost.
• Explain the difference between an Explicit Cost and an Implicit Cost and the difference between
Economic Profit and a Normal Profit.
• Distinguish between the Short Run and the Long Run and how both relate to Fixed Costs and
Variable Costs.
• Explain the Law of Diminishing Returns.
• Define, calculate, and illustrate Marginal Costs, Average Variable Costs, and Average Total Cost.
Explain how these costs are influenced by the law of diminishing returns.
• Discuss and illustrate Long-Run Average Costs.
• Define Economies of Scale, Constant Returns to Scale, Diseconomies of Scale, and Minimum
Efficient Scale, and how they relate to long run average costs.
T Outline
I.
Opportunity Costs, Economic Profit and Normal Profit
A) The Opportunity Cost of any action is the value of the next-best alternative. The opportunity
cost of any resource is the payment that the resource would receive in its next highest best
alternative use.
B) An Explicit Costs, such as wage payments made to workers, is incurred when an actual
payment is made for a resource.
C) An Implicit Costs, such as the worth of the time the owner of a firm spends running the
business, is incurred when an alternative is sacrificed by the firm using a resource that it owns.
D) Economic Profit equals the firm’s total revenues minus its total opportunity costs, where total
opportunity costs include both explicit and implicit costs.
E) A Normal Profit is earned when total revenues equal total opportunity costs. A normal profit is
the amount of profit that is necessary to induce the company’s owner to continue operating the
business.
II.
The Short Run and Long Run
A) Variable Inputs are inputs that increase with output. Fixed Inputs are inputs that cannot be
changed in the relevant time frame.
46
Gregory • Essentials of Economics, Sixth Edition
B) The Short Run is a period of time too short for plant and equipment to be varied. The Long
Run is the period of time long enough so that a firm can vary all the inputs used in production
and for firms to enter and leave the industry. In the short run at least one input is fixed. In the
long run all inputs are variable.
III. Diminishing Returns
A) The Margnal Product of Labor or any variable factor is the increase in output that results from
increasing the input by one unit.
B) The Law of Diminishing Returns states that as ever larger inputs of a variable factor are
combined with fixed inputs, eventually its marginal product will decline.
IV.
Short Run Costs
A) Total Costs can be divided into fixed costs and variable costs.
1. Fixed Costs (FC) are the costs of the fixed inputs and do not vary with output.
2. Variable Costs (VC) are the costs of the variable inputs and vary with output.
3. Total Costs (TC) are equal to the sum of fixed costs and variable costs: TC = FC + VC.
4. In the short run at least some costs are fixed. In the long run all costs are variable and fixed
costs are equal to zero.
B) Marginal Cost (MC) is the increase in cost per unit increase in output. It can be calculated as
the change in total cost (or variable costs) divided by the change in output.
1. Fixed costs do not affect the marginal cost because fixed costs do not change when output
changes.
2. Variable costs influence the marginal cost because variable costs change when output
changes.
3. Extra output can be produced only by hiring extra variable inputs. Since the law of
diminishing returns states that the extra output produced by the additional factors eventually
falls, the marginal cost of producing an extra unit of output ultimately rises.
C) Average Costs
1. Average Variable Cost (AVC) is equal to variable cost divided by output: AVC = VC/Q
2. Average Fixed Cost (AFC) is fixed cost divided by output: AFC = FC/Q
3. Average Total Costs (ATC) equal total costs divided by total output: ATC = TC/Q. ATC is
also equal to the sum of average fixed costs plus average variable costs.
D) The figure below illustrates the relevant cost curves.
Chapter 5
Costs and Productivity
47
1. Because of diminishing returns the marginal cost curve will eventually rise.
2. The marginal cost curve intersects the minimum points of the average total and average
variable cost curves.
3. As output increases, average fixed costs get smaller and smaller, and the average total and
average variable costs curves get closer together.
IV.
Long-Run Costs
A) The Long-Run Average Cost (LRAC) is the average cost for each level of output when all
factors are variable. It curve shows the minimum average cost of producing all possible levels of
output. The LRAC curve is U-shaped.
1. Economies of Scale are present when an increase in output causes long-run average costs.
The LRAC curve is falling. Economies of scale arise due to increased specialization of labor,
management, plant and equipment.
2. Constant Returns to Scale are present when an increase in output does not change long-run
average costs of production. The LRAC is curve is horizontal.
3. Diseconomies of Scale are present when an increase in output causes long-run average costs
to increase. The LRAC curve is rising. Diseconomies of scale arise due to problems of
managerial control and coordination.
B) Minimum Efficient Scale is the lowest level of output at which long-run average costs are
minimized. Minimum efficient scale is a factor that determines the amount of competition in an
industry. All else equal, industries in which the minimum efficient scale output is relatively low
will have a relatively large number of firms.
T Review Questions
True/False
If the statement is correct, write true in the space provided; if it is wrong, write false. Below the question
give a short statement that supports your answer.
_____
1.
Explicit costs always exceed implicit costs.
_____
2.
Opportunity cost equals the loss of all the alternatives foregone when an action is undertaken.
_____
3.
Only explicit costs are counted when calculating a firm’s economic profits.
_____
4.
A normal profit is just enough to cause a firm to commit capital to a business enterprise.
_____
5.
In the short run, additional output can be produced by increasing the amount of fixed inputs
employed.
_____
6.
The long run equals one year.
_____
7.
In the long run, all costs are variable costs.
_____
8.
A firm’s total costs equals its fixed costs plus its marginal cost.
48
Gregory • Essentials of Economics, Sixth Edition
_____
9.
Marginal cost is the change in costs incurred when output is increased by one unit.
_____
10. The law of diminishing returns states that a firm’s profits always fall as it produces more
output.
_____
11. The law of diminishing returns is the reason why the marginal cost curve eventually rises.
_____
12. The long-run average cost curve shows the minimum average cost of producing each level of
output when all factors are variable.
_____
13. Constant returns to scale occur when the LRAC curve is horizontal.
_____
14. The minimum efficient scale of a firm is where the marginal costs are lowest.
Multiple Choice Questions
Circle the letter corresponding to the correct answer.
1.
Which of the following is an implicit rather than explicit cost to a firm?
(a) The cost of hiring an outside consultant
(b) The electricity used by the firm
(c) The time on the weekend the owner devotes to the firm’s business
(d) The paycheck paid to the owner
(e) The interest paid on a bank loan
2.
Total opportunity costs equals ____.
(a) the firm’s explicit costs
(b) the firm’s implicit costs
(c) the firm’s marginal cost
(d). the firm’s fixed cost
(e) the sum of the firm’s implicit and explicit costs
3.
A normal profit is earned when total revenues
(a) equal total accounting costs.
(b) equal total opportunity costs.
(c) are less than total accounting costs.
(d) are less than total opportunity costs.
(e) are greater than total opportunity costs.
4.
Which of the following statements about the short run is false?
(a) Not all inputs can be altered in the short run.
(b) Fixed inputs cannot be changed in the short run.
(c) Additional output can be produced only by altering the amount of variable inputs employed.
(d) The firm pays no fixed costs in the short run.
(e) None of the above.
Chapter 5
Costs and Productivity
49
5.
Which cost does not change in the short run as output increases?
(a) Marginal costs
(b) Variable costs
(c) Fixed costs
(d) Opportunity costs
(e) Explicit plus implicit costs
6.
The fact that the marginal cost curve eventually slopes up as output expands reflects
(a) the point that fixed costs eventually increase as output expands.
(b) the negative slope of the average total cost curve.
(c) the law of diminishing returns.
(d) the increasing marginal product of labor.
(e) None of the above.
7.
Marginal cost is
(a) a cost of an input that is not necessary (that is, it is marginal) to the firm’s operations.
(b) the extra cost incurred when one more unit of output is produced.
(c) the change in fixed costs whenever they change.
(d) equal to the difference between total fixed costs and total variable costs.
(e) total cost divided by total output.
8.
If the long run average cost curve first falls, next is constant, and finally rises, the firm encounters
(a) first economies of scale, next constant returns to scale, then diseconomies of scale.
(b) first constant returns to scale, next economies of scale, then diseconomies of scale.
(c) first diseconomies of scale, then economies of scale, but no section of constant returns to scale.
(d) the firm always encounters diseconomies of scale.
(e) It is impossible to say with the information given in the question.
9.
The marginal product of labor
(a) is always constant.
(b) is part of the variable costs of the firm.
(c) equals marginal cost.
(d) is the increase in output gained by hiring one more unit of labor.
(e) is total costs divided by the total amount of labor.
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Gregory • Essentials of Economics, Sixth Edition
Essay Questions
Write a short essay or otherwise answer each question.
1.
Complete the following table:
Quantity
0
1
2
3
4
5
6
Fixed Cost
$5000
—
—
$5000
$5000
—
$5000
Variable Cost
—
$2000
$3000
—
$7000
$15,000
—
Total Cost
—
$7000
—
—
$12,000
—
$30,000
Average Total Cost
XXX
—
$4000
$3000
—
—
$5000
2.
Suppose Pat’s Taco and Chow Mein Shoppe had revenues of $300,000 and total explicit costs of
$250,000. Say that Pat worked 1000 hours in the shop without pay. If Pat could earn $10 per hour
managing another fast-food stand, what is Pat’s economic profit? Finally, assume that in addition to
managing the stand, Pat invested $400,000 in the business. If the $400,000 could have earned a return
of 15 percent in another investment, what is Pat’s economic profit now?
3.
Identify the curves in the figure.
For the next two problems, use the following table.
Quantity
0
1
2
3
4
5
4.
Total Costs
$30,000
$45,000
$65,000
$95,000
$130,000
$180,000
What is the marginal cost of producing one rather than zero units of output? Two rather than one?
Three rather than two? Four rather than three? Five rather than four?
Chapter 5
Costs and Productivity
51
5.
What is the amount of the firm’s fixed costs? What is the total variable cost of producing one unit of
output? Of producing four units of output?
6.
Explain why a firm’s long-run average cost curve is U-shaped.
7.
Explain the difference between the law of diminishing returns and diseconomies of scale.
T Answers to Review Questions
True/False
1.
False. There is no necessary relationship between implicit and explicit costs. For some companies,
explicit costs may be larger, while for others, implicit costs may be greater.
2.
False. The opportunity cost equals the value of only the best action sacrificed.
3.
False. All opportunity costs, including implicit costs, are included in order to calculate a firm’s
economic profit.
4.
True. While a firm would like to earn more than a normal profit, the opportunity to earn a normal
profit is the minimum profit necessary to entice a firm into investing in a business.
5.
False. In the short run, a firm cannot increase the amount of the fixed inputs it employs. For example,
a firm cannot increase the number of assembly lines it operates. It can, however, hire an extra shift of
workers to work on the assembly line; that is, it can increase its variable inputs.
6.
False. The long run is the amount of time necessary for a firm to be able to change the employment of
all of its inputs. This is different for companies in different industries.
7.
True. In the long run a firm can change the employment of all factors, so all factors are variable.
8.
False. Total costs equal total fixed costs plus total variable costs.
9.
True. Marginal costs are the extra costs necessary to produce an extra unit of output.
10. False. The law of diminishing returns states that as more of one input is employed while the amounts
of the other factors are not changed, the marginal product of the factor being increased eventually
falls.
11. True. When the marginal product of a variable factor is falling, hiring an additional unit creates less
output than before. But the cost of hiring the extra factor does not change, so the per-unit cost (the
marginal cost) of the extra output rises.
12. True. This is the definition of the long-run average cost curve.
13. True. Constant returns to scale mean that the average costs of extra output (that is, an increase in the
scale of the firm’s operations) do not change (that is, are constant).
14. False. The minimum efficient scale of a firm is where the long-run average costs are lowest.
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Gregory • Essentials of Economics, Sixth Edition
Multiple Choice Questions
1.
(c) This is an opportunity cost of running the firm, since the owner could have spent that time doing
something else.
2.
(e) Total opportunity costs measures the firm’s entire costs, so it includes both implicit as well as
explicit costs.
3.
(b) This is the definition of a normal profit.
4.
(d) In the short run, the firm has some fixed inputs. Payments to these inputs are fixed costs, and so
the firm will have fixed costs in the short run.
5.
(c) Fixed costs remain constant no matter what the level of production.
6.
(c) The law of diminishing returns states that the additional output produced by hiring an extra
input—say another worker—eventually declines. When this happens, the marginal cost of
producing another unit of output increases because the added cost of hiring the worker remains
constant, but the worker produces fewer added units of output.
7.
(b) Marginal cost equals the change in total costs that results from changing output a unit.
8.
(a) This is the standard sort of U-shaped long-run average cost curves possessed by most companies.
9.
(d) The key word marginal refers to changes; in this case, the marginal product of labor is the
change in output resulting from hiring one additional unit of labor. Indeed, in economics, the
word marginal always refers to a change!
Essay Questions
1.
The correct table is:
Quantity
0
1
2
3
4
5
6
Fixed Cost
$5000
$5000
$5000
$5000
$5000
$5000
$5000
Variable Cost
$0
$2000
$3000
$4000
$7000
$15,000
$25,000
Total Cost
$5000
$7000
$8000
$9000
$12,000
$20,000
$30,000
Average Total Cost
XXX
$7000
$4000
$3000
$3000
$4000
$5000
To see how these answers are obtained, take first the second row, where the quantity equals 1. To
begin, by definition fixed cost always equals $5000, without regard for the level of production. Then
average total cost equals total cost divided by the level of output, or in this case, $7000/1 = $7000.
Now look at the row where the quantity equals 3. Here we first calculate the total cost. Recalling that
total cost divided by output equals average total cost, that is (TC)/(q) = ATC, it makes sense that
average total cost times output equals total cost, that is, (ATC) × (q) = TC. Thus, in the case at hand,
we have that total cost equals ($3000) × (3), so that total cost equals $9000. Finally, to compute
variable cost, make use of the fact that total cost equals the sum of fixed cost plus variable cost, or, in
terms of a formula, TC = FC + VC. Since we know that fixed cost equals $5000 and just calculated
that total cost is $9000, we see immediately that variable cost must equal $4000. The rest of the
answers are computed similarly.
Chapter 5
Costs and Productivity
53
2.
When Pat works 100 hours, there is an implicit opportunity cost of $10 × 1,000 hours, or $10,000.
Thus total opportunity costs are the $250,000 of explicit costs plus the $10,000 of implicit costs,
which equals $260,000. Hence, economic profits are revenue, $300,000, minus total opportunity
costs, $260,000, or total economic profit of $40,000. Once we take account of the $400,000 Pat has
invested in the business, the implicit opportunity cost of Pat’s funds is 15 percent × $400,000 =
$60,000. Total economic costs become $320,000 so Pat’s economic profits are an economic loss
of –$20,000.
3.
The figure appears here, with labeled curves. This is an important diagram that will recur throughout
the next several chapters, so be sure you can draw it and identify the curves.
4.
The marginal cost is the change in total cost divided by the change in output. Thus, the marginal cost
of producing 1 rather than 0 is $15,000; 2 rather than 1 is $20,000; 3 rather than 2 is $30,000; 4 rather
than 3 is $35,000; 5 rather than 4 is $50,000.
5.
When a firm produces 0, it hires no variable inputs. Thus, when production is 0 all the costs are fixed
costs, so the table shows that the firm’s fixed costs are $30,000. Since the firm’s fixed costs do not
change with output, when the firm produces 1 unit its fixed costs remain $30,000. Therefore, the total
variable costs equal the total costs minus the fixed costs, or $15,000. When the production level is 4,
total variable costs are $100,000.
6.
A firm’s long-run average cost curve is typically U-shaped because the firm enjoys economies of
scale from an increased ability to specialize when output is first expanded. For example, if one person
runs the company, that person must produce, sell, collect past due bills, and so on. As more labor is
added and output expands, workers are able to specialize, so that some sell, others keep the books,
and so forth. Specialized machines also may be purchased. These gains from specialization mean that
the company experiences economies of scale and output expands more rapidly than costs. Over this
range of output, the LRAC is falling as output expands. Eventually, the gains from specialization
become more meager while the costs of an increasing bureaucracy become larger. At this point, costs
of expanding output rise more rapidly than output and the firm experiences diseconomies of scale.
When this occurs, LRAC is rising as output expands. Thus, the firm’s LRAC curve is U-shaped
because it first encounters economies of scale and then diseconomies of scale.
7.
Diminishing returns implies that the marginal product of an input will eventually fall as more of the
input is employed, while the employment of all other inputs is not changed. So, only one input is
varied. Diseconomies of scale take place along the long-run average cost curve whenever a change in
output results in higher average costs. In this case, more than one input may be changed. The key
distinction between the two concepts is in the number of inputs changed.
54
Gregory • Essentials of Economics, Sixth Edition
T Additional Questions
1.
Suppose that last year Jill decided to quit her job as an economic consultant to open a coffee shop. In
the first year her revenue was $250,000 and she paid explicit costs of $180,000.
(a) If Jill earned $60,000 per year at her old job, what is her economic profit?
(b) Jill’s coffee shop is also located in a building that she owns. She could rent the building for
$2,000 per month. What is her economic profit now?
2.
The table below shows how much output can be produced as more labor is used. Complete the table
and explain at what point diminishing returns start.
Labor
0
1
2
3
4
5
3.
Marginal Product
A firm produces widgets using labor and machinery as its only inputs. The firm has two machines but
can vary the amount of labor it hires. Complete the table below assuming the wage of a worker is
$100 and the cost of a machine is $500.
Labor
0
1
2
3
4
5
4.
Output
0
25
75
175
225
250
Output
Fixed
Cost
Variable
Cost
Total
Cost
Average
Total Cost
Average
Variable Cost
Marginal
Cost
0
20
50
70
80
85
True or False. When a firm is operating at the point where there are diminishing returns the firm is
also operating where there are diseconomies of scale. Explain your answer.
Answers
1.
(a) Her economic profit is $10,000: the $250,000 in revenue minus the $180,000 in total costs minus
the $60,000 for the opportunity cost of Jill’s time.
(b) Jill now has an economic loss of $14,000: $250,000 – $180,000 – $60,000 – 12 × $2,000 (for the
foregone rent).
Chapter 5
Costs and Productivity
55
2.
Labor
0
1
2
3
4
5
Output
0
25
75
175
225
250
Marginal Product
25
50
100
50
25
Diminishing returns begins with the fourth worker since the marginal product begins to fall.
3.
4.
Labor
Output
0
1
2
3
4
5
0
20
50
70
80
85
Fixed
Cost
1000
1000
1000
1000
1000
1000
Variable
Cost
0
100
200
300
400
500
Total
Cost
1000
1100
1200
1300
1400
1500
Average
Total Cost
Average
Variable Cost
55.00
24.00
18.57
17.50
17.65
5.00
4.00
4.29
5.00
5.88
Marginal
Cost
5.00
3.33
5.00
10.00
20.00
This statement is false. Diminishing returns occur in the short run when at least one input is fixed.
Diseconomies of scale occur in the long run when all inputs are variable.