07
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
•
•
LO1
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
7-2
Accounting Profit and Normal Profit
• Accounting profit
•
•
LO1
= Revenue – Explicit Costs
Economic profit
= Accounting Profit – Implicit Costs
Economic profit (to summarize)
=Total Revenue – Economic Costs
=Total Revenue – Explicit Costs –
Implicit Costs
7-3
Economic Profit
LO1
Implicit costs
(including a
normal profit)
Explicit
costs
Total Revenue
Economic
(Opportunity)
Costs
Economic
profit
Accounting
profit
Accounting
costs (explicit
costs only)
7-4
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
7-5
Short-Run Production Relationships
• Total Product (TP)
• Marginal Product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input
• Average Product (AP)
Average Product
LO2
=
Total Product
Units of Labor
7-6
Law of Diminishing Returns
• Resources are of equal quality
• Technology fixed
• Variable resources are added to fixed
•
•
LO2
resources
At some point, marginal product will
fall
Rationale
7-7
The Law of Diminishing Returns
Total, Marginal, and Average Product: The Law of Diminishing Returns
LO2
(1)
Units of the
Variable
Resource
(Labor)
(3)
Marginal
Product (MP)
Change in (2)/
Change in (1)
(2)
Total Product
(TP)
0
0
1
10
10
2
25
15
3
45
20
4
60
15
5
70
10
6
75
5
7
75
0
8
70
-5
(4)
Average
Product (AP),
(2)/(1)
Increasing
marginal
returns
10.00
12.50
15.00
15.00
Diminishing
marginal
returns
14.00
12.50
10.71
Negative
marginal
returns
8.75
7-8
Total Product, TP
The Law of Diminishing Returns
30
TP
20
10
0
Marginal Product, MP
1
LO2
20
2
3
Increasing
Marginal
Returns
4
5
6
7
8
9
Negative
Marginal
Returns
Diminishing
Marginal
Returns
10
AP
1
2
3
4
5
6
7
8 9
MP
7-9
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
7-10
Short-Run Production Costs
$1100
TC
1000
900
TVC
800
Costs
700
600
Fixed
Cost
500
400
Total
Cost
300
Variable
Cost
200
100
TFC
0
LO3
1
2
3
4
5
6
7
8
9
10
Q
7-11
Per-Unit, or Average, Costs
• Average Fixed Costs
• Average Variable Costs
• Average Total Costs
• Marginal Costs
LO3
AFC = TFC/Q
AVC = TVC/Q
ATC = TC/Q
MC = ΔTC/ΔQ
7-12
Short-Run Production Costs
Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run
Total Cost Data
Average Cost Data
Marginal
Cost
(6)
Average
Variable
Cost
(AVC)
(7)
Average
Total Cost
(ATC)
(8)
Marginal
Cost
(MC)
(1)
Total
Product
(Q)
(2)
Total Fixed
Cost
(TFC)
(3)
Total
Variable
Cost
(TVC)
(4)
Total Cost
(TC)
(5)
Average
Fixed Cost
(AFC)
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
7-13
Per-Unit, or Average, Costs
$200
Costs
150
ATC
AVC
100
AFC
50
AVC
AFC
0
LO3
1
2
3
4
5
6
7
8
9
10
Q
7-14
Marginal Cost
$200
MC
Costs
150
ATC
AVC
100
AFC
50
AVC
AFC
0
LO3
1
2
3
4
5
6
7
8
9
10
Q
7-15
MC and Marginal Product
Average Product and
Marginal Product
Production Curves
AP
MP
Quantity of Labor
MC
Cost (Dollars)
AVC
Cost Curves
Quantity of Output
LO3
7-16
Long-Run Production Costs
• The firm can change all input
•
•
LO4
amounts, including plant size.
All costs are variable in the long run.
Long run ATC
• Different short run ATCs
7-17
Average Total Costs
Firm Size and Costs
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Output
LO4
7-18
Average Total Costs
The Long-Run Cost Curve
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Long-run
ATC
Output
LO4
7-19
Economies and Diseconomies of Scale
• Economies of scale
• Labor specialization
• Managerial specialization
• Efficient capital
• Other factors
• Constant returns to scale
LO4
7-20
Economies and Diseconomies of Scale
• Diseconomies of scale
• Control and coordination problems
• Communication problems
• Worker Alienation
• Shirking
LO4
7-21
MES and Industry Structure
• Minimum Efficient Scale (MES):
• Lowest level of output where longrun average costs are minimized
• Can determine the structure of the
industry
LO4
7-22
Average Total Costs
MES and Industry Structure
Constant Returns
To Scale
Economies
Of Scale
Diseconomies
Of Scale
Long-run
ATC
q1
q2
Output
LO4
7-23
Average Total Costs
MES and Industry Structure
Economies
Of Scale
Diseconomies
Of Scale
Long-run
ATC
Output
LO4
7-24
Average Total Costs
MES and Industry Structure
Economies
Of Scale
Diseconomies
Of Scale
Long-run
ATC
Output
LO4
7-25
Applications and Illustrations
• Rising gasoline prices
• Successful start-up firms
• Verson stamping machine
• The daily newspaper
• Aircraft and concrete plants
LO3
7-26
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
7-27