Economic cost: total cost of choosing one action over another. (Explicit +
Implicit costs)
Accounting costs: the actual expenses incurred in the production process
(explicit costs).
Explicit costs: the monetary payments for the factors of production and
other inputs bought or hired by the firm.
Eg. – rent, raw materials, wages, electricity.
Implicit costs: those opportunity costs which are not reflected in monetary
payments.
Eg. – salary that could have been earned.
A quick story to explain accounting and economic
costs…
Bob is a teacher who earns R100 000 a year (this
includes his salary, medical aid and pension
benefits). He also has R50 000 in a savings account.
Bob decides to retire from teaching and start his
own business making bean bags. He uses R50 000
from his savings account to purchase the machinery
and equipment required to start his business.
What are the accounting (explicit) costs involved
in this decision?
What are the economic (explicit + implicit) costs
involved in this decision?
Profit: revenue – cost of producing it.
Total (accounting) profit: total revenue – total
explicit costs
Normal profit: equal to the best return that the
firm’s resources could earn elsewhere
Economic profit: total revenue - total explicit and
implicit costs (including normal profit).
Total revenue
R320 000
Raw material costs
R30 000
Wages and salaries
R85 000
Interest paid on bank loan
R30 000
Salary that the owner could have earned elsewhere
R32 000
Interest forgone on capital invested in the business
R20 000
Calculate…
a) Normal Profit
b) Economic Profit
Production: the physical transformation of inputs
into output.
Short run production: a period of time when there
is at least one fixed factor input.
Fixed factor usually quantity of plant / machinery
Long run production: a time period in which all of
the factors of production can change.
Fixed input: input whose quantity cannot be
altered in the short run.
Variable input: input whose quantity can be
changed in the short run (as well as the long
run).
• The firm produces only one product.
• units of input are identical/homogeneous.
• Inputs can be used in infinitely divisible
amounts.
• Prices of the product and of inputs are given.
• Firm uses fixed inputs and one variable input.
Length of time between the short and the long
run will vary from industry to industry.
Fixed quantity of land = 20 units
Variable input = labour
Units of land
Units of Labour
20
20
20
20
20
20
20
20
20
20
20
0
1
2
3
4
5
6
7
8
9
10
Total Product
(tons of maize)
0
5
16
30
56
85
114
140
160
171
180
Units of labour
ACTIVITY: investigate relationship between
output (total product) and quantities of variable
factors of production used.
• By the end of this simulation you must
understand…
• The law of diminishing returns
• The difference between total, average and
marginal concepts
• The difference between 'production' and
'productivity'
• The difference between short run and long run
• You have an imaginary factory. You have to move hockey
balls from one bucket to another.
• On successful transfer of a ball from one bucket to the
other, your firm generates one unit of output.
• Fixed factors (capital) - 2 buckets, batch of hockey balls &
land.
• Variable factor – labour (that’s where you come in!)
• At the end of each production run, the firm will add an
extra unit of labour to production.
• Production levels will be recorded at the end of each
production run.
• Your must monitor the output levels with each different
combination of inputs.
• You may not throw the balls.
• Balls must not be dropped into the bucket - if
they are, they are counted as damaged goods
and do not count towards final output.
• Any balls dropped between the buckets also
become damaged goods.
• Each production run lasts for 30 seconds - you
must keep strictly to this time limit.
Can you explain the law of
diminishing returns using our
maize farmer example?
Marginal product: the number of additional
units of output produced by adding one
additional unit of the variable input.
Average product: the average number of total
output produced by each unit of variable input.
thproduct
nd
st product
Total
Highest
of
marginal
first
2units
labour
Once
Marginal
9maximum
unitproduct
of labour
MP
ofreached
21adds
unit
nothing
-of
of
it keeps
labouron
unit
of
labour
113200
–1678
=16
=200
44
35
tons
tons
(N
=
4)
44
––declining.
=
=
28
0
tons
tons
0 = 16 tons
AP of Highest
1st unit of
APlabour
16 ÷÷15==16
145
29tons
tons
AP
increases
zero
when
TP
MP
reaches
>long
AP asitsMP
TPMP
willequals
continue
towhere
increase
as
AP
& MP
shaped
like inverted
“U”s
MP
equals
AP
at
its
maximum
point.
rise
at declining
rates
reach
max
decrease
at
increasing
AP decreases
maximum.
when MP < AP rates
is positive
BOX 6-1 TOTAL, AVERAGE AND MARGINAL
MAGNITUDES
Costs: expenses faced by a business when producing a good or service for a market.
Short run - fixed and variable costs.
Fixed Costs
Fixed costs: cost that remains constant irrespective of the quantity of output produced.
Examples of fixed costs include:
• Rent
• Insurance charges.
• Salaries
• Interest charges on borrowed money.
• The costs of purchasing new capital equipment.
• Marketing and advertising costs.
Variable Costs
Variable costs: costs that vary directly with output.
As production rises - higher total variable costs as
extra resources purchased.
Examples of variable costs for a business include:
• The costs of raw materials
• Labour costs
• Consumables and components used directly in
the production process.
Total product
MC equals
AC lies
AVC
above
AC
AFC
and
theirAVC
respective
AFC
is L-shaped
AVC,
AC
&and
MC
areatU-shaped
minimum
it-ratesdeclines
includes
points
both
start high - decline
at decreasing
- reach minimum
points - increase
at increasing rates
starts because
very
high
tillthem
max TP
reached
The shape of the unit cost curves is determined
by the shape of the unit product curves.
OutputQ2
Q1isisthe
thetotal
totaloutput
outputproduced
producedby
byN2
N1units
unitsofoflabour
labour.
Output
Long run: a time period where there are no fixed inputs
– all the inputs (including all the factors of production)
are variable.
Enough time to build a new factory, install new machines,
use new techniques of production etc…
Law of diminishing returns does not apply - all the costs
are variable.
Marginal product has no meaning - can only be calculated
if all the other inputs are held constant.
Returns to scale: long-run relationship between inputs and output.
Measured by varying all inputs by a certain % and comparing resulting
percentage in production.
Three possible situations can result…
Constant returns to scale
Given % increase in inputs = same % increase in output
Increasing returns to scale
Given % increase in inputs = larger % increase in output
Decreasing returns to scale
Given % increase in inputs = smaller % increase in output
Decreasing returns to scale (long run concept) –
ALL inputs increase by the same proportion.
Diminishing marginal returns (short-run
concept) - only the variable input increases.
Economies of scale: occur when costs per unit of
output fall as the scale of production increases.
Diseconomies of scale: occur when unit costs rise
as output increases.
Both can be internal and external
Internal: specific to a firm –can be controlled.
External: outside the firm’s control – affects entire
industry/economy.
Technical economies: modern technology suited to mass
production
Managerial, organisational or administrative economies:
specialisation and division of labour
Marketing economies: bulk discounts & CPT decreases
Financial economies: easier/cheaper to raise. Average fixed
charges decline.
Spreading overheads: Average fixed costs lower as firm
grows.
Internal diseconomies of scale
Managerial diseconomies: longer lines of
communication, management less directly involved.
Worker alienation: specialised, boring and
repetitive jobs – motivation & productivity
affected.
Deteriorating industrial relations: increased work
stoppages and strikes.
Industry economies: Specialised markets – benefits
raw materials, selling finished product; specialised
labour skills
General economies: general infrastructural
development & better workers and may lower the
effective cost of labour.
Shortage: raw materials, skilled labour – unit
costs rise
Congestion: land prices, traffic, pollution.
Economies of scope: the cost savings achieved
by producing related goods in one firm rather
than in two.
All inputs variable in long run therefore no total
or average fixed costs.
The long run can be seen as a set of alternative
short-run situations between which the firm can
choose.