Chapter 8
The Cost of Production
 Explicit cost are money payment a firm makes to outside suppliers
of resources; Implicit costs are the opportunity costs associated with a
firm’s use of resources it owns.
 Normal profit is the implicit cost of entrepreneurship.
 Economics profit is total revenue less all explicit and implicit costs
including normal profit.
 In the short run, a firm’s plant capacity is fixed. In the long run, a
firm can very its plant size and firm can enter or leave the industry.
 The law of diminishing returns indicates that beyond some point,
output will increase by diminishing amount as more units of a variable
resource (Labor) are added to a fixed resource (Capital).
 In the short run, the total cost of any level of output is the sum of
fixed and variable costs (TC = TFC + TVC).
 Average fixed, Average variable and Average total costs are fixed,
variable and total costs per unit of output; marginal cost is the extra
cost of producing one more unit of output.
 Average fixed cost declines continuously as output increases;
Average variable costs and average total cost curves are U-shaped,
reflecting increasing and then diminishing returns; the marginal cost
curve falls but then rises, intersecting both the average variable cost
curve and the average total curve at their minimum point.
 Most firms have U-shaped long-run average total cost curves
reflecting economics and then diseconomies scale.
 Economics of scale are the consequences of greater specialization
of labor and management, more efficient capital equipment, and the
spreading of start-up costs among more units of output.
 Diseconomies scales are caused by the problems of coordination
and communication that arise in large firms.
 Minimum efficient scale is the lowest level of output at which a
firm’s long-run average total cost is at a premium.
MCQ’s on “The cost of Production”
I. The WXY Corporation has fixed costs of $50. Its total variable
costs (TVC) vary with output as shown in the following table: Refer to
the table. The average total cost of 4 units of output is:
o $27.50
o $40.00
o $52.50
o $210.00
II. Use the following graph to answer the next question: The diagram
shows the short-run average total cost curves for five different plant
sizes for a firm. The firm experiences economies of scale over the range
of plant sizes:
o 1 through 2 only
o 1 through 3 only
o 1 through 5
o 3 through 5 only
III.
Explicit costs and implicit costs:
o Are alike in that both represent opportunity costs
o Are alike in that both reflect an outlay of cash
o Are alike in that both are deducted from revenue to find
accounting profit
o Differ in that only explicit costs are deducted from revenue to
find economic profit
IV. Suppose that a business incurred implicit costs of $300,000 and
explicit costs of $1,300,000 over the past year. If the firm earned
$1,400,000 in revenue, its:
o Accounting profits were $400,000 and its economic profits were
o
o
o
$100,000
Accounting losses were $200,000 and its economic profits were
$100,000
Accounting profits were $100,000 and its economic profits were
zero
Accounting profits were $100,000 and its economic losses were
$200,000
V. Which one of the following short-run cost curves would not be
affected by an increase in the wage paid to a firm's labor?
o Average variable cost
o Average fixed cost
o Average total cost
o Marginal Cost
VI.
If marginal product is positive but falling:
o marginal cost must also be falling
o average product must be falling
o total product is increasing at a decreasing rate
o total product is falling
VII.
The distinguishing feature of the short run is that:
o at least one input is fixed
o Output is fixed
o Input prices are variable
o Technology is variable
VIII. The WXY Corporation has fixed costs of $30. Its total variable
costs (TVC) vary with output as shown in the following table: Refer to
the table. The marginal cost of the fourth unit of output is:
o $30
o $40
o $50
o $60
IX. Use the following average total cost data to answer the next
question. The letters A, B, and C designate three successively larger
plant sizes: Refer to the data. In the long run, the firm should use plant
size "A" for:
o All possible levels of output
o 100 to 200 units of output
o 300 to 600 units of output
o 600 or more units of output
X. Suppose a particular firm exhibits constant returns to scale as it
increases its output over any reasonable range. If it increases all its
inputs by 10%, its:
o total cost will increase by less than 10%
o average total cost will increase by 10%
o output will increase by 10%
o long run average cost curve will shift to the right by 10%
Problems on Elasticity, Consumer & Producer Surplus
Problem 1:
After working as a head chef for years, Jared gave up his $60,000 salary
to open his own restaurant last year. He withdrew $50,000 of his own
savings that had been earning 4% interest and borrowed another
$100,000 from the bank at a rate of 5%. As the restaurant space he was
leasing had no separate office, Jared converted his basement
apartment into office space. He had previously rented the apartment to
a student for $300/month. The following table summarizes his
operations for the past year.
Total Sales Revenue
$590,000
Employee wages
$120,000
Material
$350,000
Interest on loan
$5,000
Utilities
$10,000
Rent
$25,000
Total explicit costs
$510,000
a) What is Jared's accounting profit?
b) Suppose Jared could have used his talents to run a similar kind of
business instead. If he values his entrepreneurial skill at $10,000
annually, find Jared’s total implicit costs
c) What was Jared's economic profit last year?
Answer:
a) Jared's accounting profit is the difference between total sales
revenue and his explicit costs: $590,000 – $510,000 = $80,000.
b) Implicit costs include his foregone wages ($60,000), the value of
his entrepreneurial skill ($10,000), foregone rent on the apartment
($3,600 = 12 x $300) plus the foregone interest on his savings ($2,000 =
.04 x $50,000). These total $75,600.
c) Jared's total economic cost, explicit plus implicit, was $585,600 =
$510,000 + $75,600. His economic profit is the difference between
revenue and economic cost, or $4,400 (= $590,000 – $585,600).
Problem 2:
The following table summarizes the short-run relationship between a
firm's total labor input and its total output.
Inputs of
Total
Marginal
Average
Labour
Products
Products
Products
0
0
1
20
2
46
3
75
4
102
5
125
6
138
7
140
8
136
a) Fill in the columns labeled "Marginal Product" and "Average
Product."
b) Over what range of labor input does the firm experience
increasing marginal return? Diminishing marginal returns? And
Negative marginal returns?
c) Comparing marginal product to average product, under what
circumstances will average product rise? Under what circumstances will
average product fall?
Answer:
a) Formula of Marginal Product is:
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 2 (𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠) − 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 1 (𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑠)
And Formula of Average Product is:
𝑇𝑜𝑡𝑎𝑙 𝑃𝑟𝑜𝑑𝑢𝑐𝑡
𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑙𝑎𝑏𝑜𝑢𝑟 𝑖𝑛𝑝𝑢𝑡
Inputs of
Total
Marginal
Average
Labour
Products
Products
Products
0
0
1
20
20
20
2
46
26
23
3
75
29
25
4
102
27
25.5
5
125
23
25
6
138
13
23
7
140
2
20
8
136
-4
17
b) Increasing marginal returns corresponds to an increasing marginal
product of labor. Marginal product increases through the addition of
the third worker. Diminishing returns begins with the addition of the
fourth worker, while negative returns appear with the addition of the
eighth worker.
Marginal Products
20 Increasing
26 Marginal
29
Returns
27 Decreasing
23 Marginal
13
Returns
2
-4 Negative
c) Average product will rise provided marginal product exceeds
average product and fall if marginal product is below average product.
Problem 3:
Suppose a firm is currently producing 10 units. It is spending $100 on
fixed costs, $40 on variable costs. At an output level of 10 units, what is
the firm's current:
a) Total cost?
b) Average fixed cost?
c) Average variable cost?
d) Average total cost?
e) If the total cost of producing 11 units is $147, what is the marginal
cost of the eleventh unit?
f) Is average total cost rising or falling? How do you know?
g) Is average variable cost rising or falling? How do you know?
Answer:
a) 𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭 (𝐓𝐂) = 𝐭𝐨𝐭𝐚𝐥 𝐟𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭 + 𝐭𝐨𝐭𝐚𝐥 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭
TC = $100 + $40 = $140.
b) 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐟𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭 (𝐀𝐅𝐂) =
AFC =
𝐟𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭
𝐭𝐡𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐢𝐭𝐬 𝐩𝐫𝐨𝐝𝐮𝐜𝐞𝐝
.
$100
= $10.
10
c) A𝐯𝐞𝐫𝐚𝐠𝐞 𝐯𝐞𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭 (𝐀𝐕𝐂) =
𝐕𝐞𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭
𝐭𝐡𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐢𝐭𝐬 𝐩𝐫𝐨𝐝𝐮𝐜𝐞𝐝
.
$40
= $4.
10
𝐕𝐞𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭+𝐅𝐢𝐱𝐞𝐝 𝐂𝐨𝐬𝐭
d) A𝐯𝐞𝐫𝐚𝐠𝐞 𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭 (𝐀𝐓𝐂) =
AVC =
𝐭𝐡𝐞 𝐧𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐢𝐭𝐬 𝐩𝐫𝐨𝐝𝐮𝐜𝐞𝐝
$140
= $14.
10
𝐀𝐓𝐂 = 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐟𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭 + 𝐀𝐯𝐞𝐫𝐚𝐠𝐞 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭
ATC = $10 + $4 = $14.
ATC =
e) Marginal cost is the increase in total cost associated with the next
unit. From part a., the total cost of 10 units is $140. Since the cost of 11
units is $147, the marginal cost of the eleventh unit is $7 = $147 – $140.
f) Average total cost is falling. This is because marginal cost ($7) is
less than average total cost ($14). When the cost of the next (marginal)
one is below the average, the average must fall.
g) Average variable cost is rising. This is because marginal cost ($7) is
more than average variable cost ($4). When the cost of the next
(marginal) one is above the average, the average must rise.
Question on Elasticity, Consumer & Producer Surplus
Question 1:
Gomez runs a small pottery firm. He hires one helper at $12,000 per
year, pays annual rent of $5,000 for his shop, and spends $20,000 per
year on materials. He has $40,000 of his own funds invested in
equipment (pottery wheels, kilns, and so forth) that could earn him
$4,000 per year if alternatively invested. He has been offered $15,000
per year to work as a potter for a competitor. He estimates his
entrepreneurial talents are worth $3,000 per year. Total annual
revenue from pottery sales is $72,000. Calculate the accounting profit
and the economic profit for Gomez's pottery firm. Firm predict will
happen to its sales?
Answers:
Explicit costs= $12,000 for the helper + $5,000 of rent + $20,000 of materials.
Implicit costs= $4,000 of forgone interest + $15,000 of forgone salary +
$3,000 of entrepreneurship.
Explicit costs: $37,000
Implicit costs: $22,000
Now,
Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs)
Economic profit = $13,000 (= $72,000 - $37,000 of explicit - $22,000 of implicit costs).
Question 2:
a) Complete the table directly below by calculating marginal product
and average product.
b) Plot total, marginal, and average product. And explain in detail
the relationship between each pair of curves.
c) Explain why marginal product first rises, then declines, and
ultimately becomes negative.
d) What bearing does the law of diminishing returns have on shortrun costs? Be specific. "When marginal product is rising, marginal cost
is falling. And when marginal product is diminishing, marginal cost is
rising." Illustrate and explain graphically.
Answers:
Inputs of
Total
Marginal
Average
Labour
Products
Products
Products
0
0
1
15
15
15
2
34
19
17
3
51
17
17
4
65
14
16.25
5
74
9
14.8
6
80
6
13.33
7
83
3
11.86
8
82
-1
10.25
b) MP is the slope—the rate of change—of the TP curve. When
TP is rising at an increasing rate, MP is positive and rising. When TP is
rising at a diminishing rate, MP is positive but falling. When TP is
falling, MP is negative and falling. AP rises when MP is above it; AP falls
when MP is below it.
c)
MP first rises because the fixed capital gets used more
productively as added workers are employed. Each added worker
contributes more to output than the previous worker because the firm
is better able to use its fixed plant and equipment. As still more labor is
added, the law of diminishing returns takes hold. Labor becomes so
abundant relative to the fixed capital that congestion occurs and
marginal product falls. At the extreme, the addition of labor so
overcrowds the plant that the marginal product of still more labor is
negative—total output falls.
d) Illustrated by Figure 8.6.
Because labor is the only variable input and its price (its wage rate) is
constant, MC is found by dividing the wage rate by MP. When MP is
rising, MC is falling; when MP reaches its maximum, MC is at its
minimum; when MP is falling, MC is rising.
Question 3:
A firm has fixed costs of $60 and variable costs as indicated in the table
at the bottom of this page. Complete the table and check your
calculations by referring to question 4 at the end of Chapter 9.
a) Graph total fixed cost, total variable cost, and total cost. Explain
how the law of diminishing returns influences the shapes of the
variable-cost and total-cost curves.
b) Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of
each of these four curves and their relationships to one another.
Specifically, explain in nontechnical terms why the MC curve intersects
both the AVC and ATC curves at their minimum points.
c) Explain how the locations of each curve graphed in question 7b
would be altered if (1) total fixed cost had been $100 rather than $60,
and (2) total variable cost had been $10 less at each level of output.
Answers:
TP
TFC
TVC
TC
AFC
AVC
ATC
MC
0
-
-
-
-
-
-
-
1
60
45
105
60
45
105
45
2
60
85
145
30
42.5
72.5
40
3
60
120
180
20
40
60
30
4
60
150
210
15
37.5
52.5
35
5
60
185
245
12
37
49
40
6
60
225
285
10
37.5
47.5
45
7
60
270
310
8.57
38.57
47.14
55
8
60
325
385
7.5
40.63
48.13
65
9
60
390
450
6.67
43.33
50
75
10
60
465
525
6
46.5
52.5
-
a)
Over the 0 to 4 range of output, the TVC and TC curves slope upward at
a decreasing rate because of increasing marginal returns. The slopes of
the curves then increase at an increasing rate as diminishing marginal
returns occur.
b)
See the graph.
AFC falls continuously since a fixed amount of capital cost is spread
over more units of output. The MC, AVC, and ATC curves are U-shaped,
reflecting the influence of first increasing and then diminishing returns.
The ATC curve sums AFC and AVC vertically. The ATC curve falls, when
the MC curve is below it; the ATC curve rises, when the MC curve is
above it. This means the MC curve must intersect the ATC curve at its
lowest point. The same logic holds for the minimum point of the AVC
curve.
c)
(1) If TFC has been $100 instead of $60, the AFC and ATC
curves would be higher—by an amount equal to $40 divided by the
specific output. Example: at 4 units, AVC = $25.00 [= ($60 + $40)/4];
and ATC = $62.50 [= ($210 + $40)/4]. The AVC and MC curves are not
affected by changes in fixed costs.
c)
(2) If TVC has been $10 less at each output, MC would be $10
lower for the first unit of output but remain the same for the remaining
output. The AVC and ATC curves would also be lower—by an amount
equal to $10 divided by the specific output. Example: at 4 units of
output, AVC = $35.00 [= $150 - $10)/4], ATC = $50 [= ($210 - $10)/4].
The AFC curve would not be affected by the change in variable costs.
Question 4:
Use the concepts of economies and diseconomies of scale to explain
the shape of a firm's long-run ATC curve. What is the concept of
minimum efficient scale? What bearing can the shape of the long-run
ATC curve have on the structure of an industry?
Answers:
The long-run ATC curve is U-shaped. At first, long-run ATC falls as the
firm expands and realizes economies of scale from labor and
managerial specialization and the use of more efficient capital. The
long-run ATC curve later turns upward when the enlarged firm
experiences diseconomies of scale, usually resulting from managerial
inefficiencies.
The MES (minimum efficient scale) is the smallest level of output
needed to attain all economies of scale and minimum long-run ATC.
If long-run ATC drops quickly to its minimum cost which then extends
over a long range of output, the industry will likely be composed of
both large and small firms. If long-run ATC descends slowly to its
minimum cost over a long range of output, the industry will likely be
composed of a few large firms. If long-run ATC drops quickly to its
minimum point and then rises abruptly, the industry will likely be
composed of many small firms.