March 3 lecture notes
Definitions
Economic Costs (opportunity costs) -payments that must be made in order to obtain and retain the
services of a resource
Explicit costs – monetary payments that a firm must make to an outsider to obtain a resource
Implicit costs – monetary income foregone by using self-owned, self-employed resources in its own
production rather than selling them to other firms
Normal Profit – payment by a firm to obtain and retain entrepreneurial ability
Profit = revenue-costs
Suppose you earned $31,000/yr as a manager at a restaurant. Then you decided to open your own
restaurant and manage it yourself. This entrepreneurial ability is worth $10,000 per year.
You invest $40,000 in savings which could otherwise earn you $1,000/yr in interest
You own a restaurant space which you previously rented at $10,000/yr. You plan to use this space.
You hire a cook for $20,000/yr and a waitress for $15,000/yr. The cost of food is $30,000/yr.
Your utility bill is $7,000/yr
Suppose that in the first year your restaurant has total sales revenue of $240,000
What is your profit?
An accountant would tally your profit as follows:
Total Revenue:
Costs:
Food
Employees
Utilities
Total explicit costs
Accounting Profit:
240,000
30,000
35,000
7,000
72,000
168,000
But when economists calculate profit, they include implicit costs. By including implicit costs, such as
foregone wages, interest, etc., you do not ‘over state’ the success of your business.
Economists Calculation:
Total Revenue:
Costs:
Food
Employees
Utilities
Total explicit costs
Foregone interest
Foregone rent
Foregone wages
Foregone
entrepreneurial
income
Total implicit costs
Economic Profit:
240,000
30,000
35,000
7,000
72,000
1,000
10,000
31,000
10,000
52,000
116,000
So we have:
Accounting Profit = Total revenue – explicit costs
Economic Profit (pure profit) = Total revenue – explicit costs – implicit costs
Economic profit will always be smaller than accounting profit.
As we discussed, firms face different time periods in which they have different abilities to adjust to market
changes. In the immediate market period, firms cannot adjust at all, and hence cannot offer greater
quantities with greater prices. In the short term, firms cannot adjust their plant size, but they can change
some resources, such as the amount of labour they use. Hence, in the short run, firms can, and are willing
to offer slightly greater quantities as price increases. In the long run, firms can vary all resources input.
They can change both plant size and the amount of labour they use. Thus, in the long run, firms can and
are willing to offer greater quantities as price increases.
Note: short run and long run periods are conceptual rather than calendar periods. The long run must be
long enough for plant size to vary. In some industries (clothing manufacturers), plant size can be varied in
very short periods (weeks). In other industries (auto manufacturers, oil refiners), plant size may take
months or years to vary.
We can take a look at each period (short run and long run) and consider the types of costs that firms face.
Later we will use these cost definitions to show how firms make decisions on how much to produce in the
short run and long run.
Short Run Production – plant size is fixed, but we can use the plant more intensively by increasing
variable inputs such as labour
TERMS:
Total Product (TP) = total quantity or total output of a good produced by the firm
Marginal Product (MP) = the extra or added product associated with adding one unit of variable
resource (labour) to the production process.
MP = change in TP/change in Labour
Average Product (AP) = the output per unit of labour input (note: this is also called labour productivity)
AP= TP/Labour
Law of Diminishing Returns (Law of diminishing marginal product) – as successive units of a
variable resource (labour) are added to a fixed resource (plant), beyond some point, the extra (marginal)
product per resource unit will decline.
Consider a hamburger shop:
Units of Variable Resource (labour)
TP
MP (per extra labour)
AP
(units of
hamburgers
produced)
0
1
0
10
2
3
4
5
6
25
45
60
70
75
15
7
8
75
70
0
10
20
15
10
5
-5
n.a.
10
12.5
15
15
14
12.50
10.71
8.75
At 0 workers, no hamburgers are produced. At 1 worker, 10 are produced. This worker has to do all the
cooking, serving and cleaning up, and therefore cannot produce much alone. At 3 workers, each can
specialize in one task, and their average product is much higher (15). At 5 workers, however, the shop is
getting crowded and the workers aren’t working as efficiently. The marginal product of the last worker is
now only 10.
These costs can be graphed, and look as follows:
TP
75
2
6
Q Labour
MP, AP
20
AP
10
2
6
Q Labour
MP
Note: TP is maximized where MP=0. This is because when the MP falls below zero, each additional unit
of labour hired actually detracts from production, therefore, production falls. Also, notice that as soon as
MP starts to fall, TP increases at a decreasing rate, and AP starts to decrease. Why? If each added unit of
labour adds a smaller amount of production, then the increment in TP should be less than before. Also,
since AP is an average, if the extra unit added is smaller than the average, the average will fall. This is
why the MP intersects the AP at the maximum of the AP.
Short Run Costs
In the short run, a firm faces several kinds of costs:
Fixed costs (FC)– costs that, in total, do not change when the firm changes output (i.e. rent)
The sum of all fixed costs is total fixed costs, TFC
Variable costs (VC)– costs that change with the level of output (i.e. payments to labour)
The sum of all variable costs is total fixed costs, TVC
Total costs (TC)– the sum of all fixed and variable costs : TC=FC+VC
Average or per unit costs are simply the costs above, divided by the number of units produced:
Average Fixed Cost (AFC) = TFC/Q
Average Variable Cost (AVC) = TVC/Q
Average Total Cost (ATC) = TC/Q = (TFC+TVC)/Q = AVC + AFC
Marginal Cost(MC) – the extra or additional cost of producing one more unit of output
MC= (change in TC)/(change in Q) = (Change in TVC)/(change in Q) {because change in TFC=0}
also
MC=(change in ATC)/(change in Q) however our trick above does not work for change in AVC,
because AFC does change
You can think of TVC as the sum of all Marginal costs
An example of these costs in chart form is below:
TP=Q TFC TVC TC
AFC
AVC
ATC
MC
0
1
100
100
0
90
100
190
n.a.
100
n.a.
90
n.a.
190
90
2
3
4
5
100
100
100
100
170
240
300
370
270
340
400
470
50
33.33
25
20
85
80
75
74
135
113.33
100
94
80
70
60
70
6
7
8
100
100
100
450
540
650
550
640
750
16.67
14.29
12.50
75
77.14
81.25
91.67
91.43
93.75
80
90
110
Graphically:
TC
$
100
TVC
TFC
0
Quantity
$
MC
ATC
AVC
AFC
Quantity
Notice that the MC curve intersects both the AVC and ATC curves at their lowest points. It does this for
the same reasons as the MP curve.
Notice also that the MC curve exhibits diminishing returns past a certain point. That is, each added unit of
labour used in production results in fewer and fewer units produced per extra unit of labour.
What causes shifts in these cost curves?
1. Changes in resource prices. Ex. The cost of labour (wages) increases, will cause VC AVC TC and
ATC to rise.
2. Technological change. Ex. A technological improvement will cause VC AVC TC and AVC to fall
Long Run Production Costs
In the long run, a firm can expand it’s plant size. As such, in the long run, the firm faces several possible
short run ATCs:
Plant size 1=small plant = short run ATC1
Plant size 2=medium size plant = ATC2
Plant size 3=large plant = ATC3
Plant size 4=very large plant = ATC4
At each of these possible sizes, the firm faces a specific ATC for the short run. However, in the long run,
the firm could change it’s plant size, so as to produce with the least possible costs.
What would it’s long run cost curve look like then? It is drawn below.
ATC
ATC1
ATC2
ATC4
ATC3
LR ATC
Quantity
The long run is made up of the bottom most parts of the short run ATC curves
Note: we have assumed that increasing plant size leads to lower average unit costs up to a certain quantity,
after which, increasing plant size leads to higher costs. Why would we think this? It isn’t because of law
of diminishing returns, rather it is due to economies and diseconomies of scale.
Economies of scale: Long run costs decrease as firms grow. (increasing returns to scale)
Economies of scale are due to: managerial specialization, labour specialization, efficient capital,
design/R&D costs and advertising. The larger the plant is, up to a certain point, the more the firm is able
to utilize its managers to their fullest capabilities, improve labour productivity through specialization, etc.
See your book for more details.
Diseconomies of scale: Long run costs increase as firms grow. (decreasing returns to scale)
Diseconomies of scale are due to: difficulties in coordination of large plant size, and worker alienation.
The larger the firm, the more difficult it is to make quick agreements on technological change, etc, and the
less likely workers are to feel a bond and integrity for the company. See your book for more details.
Constant returns to scale (CRS)-the range of output between where economies of scale and
diseconomies of scale begin. Here, a 10% increase in all inputs will cause a 10% increase in output.
Average total costs are constant in this range.
ATC
Econ.
of scale
CRS
Diseconomies
of scale
LR ATC
Quantity