Economics
Combined Version
Edwin G. Dolan
Best Value Textbooks
4th edition
Chapter 8
Production and Cost
Morita’s Cost Curve (Sony Corp.)
Akio Morita, founder of Sony
Corporation, drew this cost
curve for transistor radios. He
saw that per-unit costs would
fall initially and then rise. He
turned down an order for
100,000 units because he
thought it would be risky to
increase production levels that
high. He asked “What if there
were no repeat order the next
year?”
Morita’s Cost Curve (Sony Corp.)
• Sony’s cost curve applied to a short term.
– Short term in Economics means a period when
some factors of production are fixed
• We’ll start with Short term costs and then look
at long term costs
Explicit and Implicit Costs
• Explicit costs take the form
of explicit payments to
suppliers of factors of
production
• Examples:
–
–
–
–
workers’ wages
managers’ salaries
salespeople’s commissions
interest payments to banks
and other creditors
– fees for legal advice and other
services
– payments for energy and raw
material
Explicit and Implicit Costs
• Implicit costs are
opportunity costs of using
resources contributed by
the firm or its owners
without explicit payments.
• Examples
– Labor of a small-business
owner
– Opportunity cost of smallbusiness owners’ own savings
invested in a business
– Opportunity cost of capital
invested by corporate
shareholders
Clicker: 2 Pts
Which of the following would be an implicit cost? (or, in
other words, a cost included by economic thinking
but NOT tracked by an accountant)
A. Repair and maintenance costs to keep the
equipment in working order
B. The cost of using a factory owned by the firm and
fully paid for
C. The licensing fee for software used in production
D. The salary paid to the manager
E. The utility charges for electricity to run the plant
Normal Profit
• Table shows the implicit and
explicit costs of the imaginary
firm Fieldcom, Inc.
• Total revenue minus explicit costs
equals accounting profit.
• Subtracting implicit costs from
this quantity yields pure
economic profit.
• The opportunity cost of capital
contributed by the owners can
also be called normal profit.
Total Revenue
$600,000
Less explicit costs:
Wages and salaries
300,000
Materials and other 100,000
_________
Equals accounting profit $200,000
Less implicit costs:
Owners’ forgone salary 160,000
80,000
Opportunity cost
of capital
20,000
_________
= pure economic profit
$ 20,000
Fixed and Variable Costs
• Variable costs: Costs of
inputs whose quantities can
be changed easily in the
short run
• Fixed costs: Costs of inputs
whose quantities can be
changed only in the long
run by increasing or
decreasing the size of the
firm’s plant
• Sunk costs: One-time costs
which, once made, cannot
be recovered if the firm
goes out of business
www.pdclipart.com
Marginal Physical Product
• Marginal physical product of labor is the amount by which total
output increases or decreases when the quantity of labor
increases by one unit
Law of Diminishing Returns
• According to the law of
diminishing returns, as
the amount of one
variable input is
increased while the
amounts of all other
inputs remain fixed, a
point will be reached
beyond which the
marginal physical product
of the input will decrease.
Range of
Diminishing
Returns
Marginal Costs
• Marginal cost (MC): the
change in cost caused by a
change in output.
• When marginal cost is
greater than average cost,
average cost rises -- ATC
curve slopes up.
• When marginal cost is
below ATC, then ATC falls -ATC curve slopes down.
changein totalcost
MC 
changein quantityof output
Average and Marginal Costs
Definition of Costs
• Total Costs (TC) -- the expenses a business has
in supplying goods and/or services.
• Total Fixed Costs (TFC) -- payments to
resources whose quantities can not be
changed during a fixed period of time – the
short run. (= total costs when Q=0)
• Total Variable Costs (TVC) -- payments for
additional resources used as output increases.
(=total costs – total fixed costs)
– These costs are relevant, but their curves will not be as important to us as the
next page.
Definition of Costs
• Average Fixed Cost -- the total fixed cost
divided by total output. (= total fixed costs/quantity)
• Average total Cost (SRATC): -- the total cost of
production divided by the total quantity of
output produced when at least one resource
is fixed (= total costs/quantity)
• Average Variable Cost -- total variable cost
divided by total output ( = total variable cost/quantity)
• Marginal Cost -- Additional cost associated
with producing one more unit ( = Δ Total Costs = Δ
Total Variable Costs)
Marginal and Average Costs
(1)
Total
Output
(Q)
(2)
Total
Fixed
Costs
(TFC)
(3)
Total
Variable
Costs
(TVC)
(4)
Total
Costs
(TC)
(5)
Average
Fixed
Costs
(AFC)
(6)
Average
Variable
Costs
(AVC)
(7)
Average
Total
Costs
(ATC)
(8)
Marginal
Costs
(MC)
0
$10
$0
$10
1
$10
$10
$20
$10
$10
$20
$10
2
$10
$18
$28
$5
$9
$14
$8
3
$10
$25
$35
$3.33
$8.33
$11.6
$7
4
$10
$30
$40
$2.5
$7.5
$10
$5
5
$10
$35
$45
$2
$7
$9
$5
6
$10
$42
$52
$1.66
$7
$8.66
$7
7
$10
$50.6
$60.6
$1.44
$7.2
$8.6
$8.6
8
$10
$60
$70
$1.25
$7.5
$8.75
$9.4
9
$10
$80
$90
$1.1
$8.8
$10
$20
A
B
Marginal-Average Rule
The marginal cost curve intersects the minimum points of the
average total cost and average variable cost curves
Marginal and Average Cost Curves
Short vs. Long Run
• The short run refers to any period of time during
which at least one resource can not be changed.
• In the long run, everything is variable – nothing is
fixed.
• The most important difference between the short
run and the long run is that the law of diminishing
marginal returns does not apply when all resources
are variable.
Economics of Scale
• Scale means size.
• Economies of scale: the decrease in per unit costs as
the quantity of production increases and all
resources are variable
• Diseconomies of scale: the increase in per unit costs
as the quantity of production increases and all
resources are variable
• Constant returns to scale: unit costs remain constant
as the quantity of production is increased and all
resources are variable
Economies of Scale
and Long-Run Cost Curves
• In the long run, a firm has many sizes to
choose from.
• The short run requires that scale be fixed—
only one or a few resources can be changed.
Long- and Short-Run Average Cost Curves
Each plant size can be represented by a U-shaped short-run average total cost
curve.
The firm’s long-run average cost curve is the “envelope” of these and other
possible short-run average total cost curves
– it is a smooth curve drawn so that it just touches the short-run curves without
intersecting any of them.
Short-Run and
Long-Run
Average-Cost
Curves
Long-Run Average Total Cost
• Long-run average total cost (LRATC): the
smooth curve drawn so that it just touches the
short-run curves without intersecting any of
them.
• The long-run average total cost curve gets its
shape from economies and diseconomies of
scale.
– NOT from diminishing marginal returns
Shape of LRATC
– If producing each unit of output becomes
less costly there are economies of scale.
– If producing each unit of output becomes
more costly there are diseconomies of
scale.
– If unit costs remain constant as output rises
there are constant returns to scale.
Long-Run Average Cost Curve
Long-Run and
Short-Run Cost Curves (1)
Long-Run and
Short-Run Cost Curves (2)
In some unusual cases Economies of Scale may prevail over the entire
range of an industry’s realistic market scale.
In this case, one very large firm would be the natural outcome and the
most efficient use of resources.
Long-Run and
Short-Run Cost Curves (3)
In some rare cases scale may not be relevant at all. Firms of various sizes
could compete with each other without any cost advantage from economies of
scale.
Minimum Efficient Scale
• Most industries experience both economies and
diseconomies of scale.
• The minimum efficient scale (MES) is the minimum point of
the long-run average-cost curve; the output level at which the
cost per unit of output is the lowest.
• The MES varies considerably across industries.
Morita’s Problem
and Minimum Efficient Scale