Principles of Economics
Session 5
Topics To Be Covered
Categories of Costs
Costs in the Short Run
Costs in the Long Run
Economies of Scope
The Firm’s Objective
The economic goal of the firm
is to maximize profits.
A Firm’s Profit
Profit is the firm’s total revenue minus
its total cost.
Profit = Total revenue - Total cost
Costs as Opportunity Costs
A firm’s cost of production
includes all the opportunity
costs of making its output of
goods and services.
Opportunity Cost
The value of the next best use for
an economic good, or the value
of the sacrificed alternative.
Explicit and Implicit Costs
A firm’s cost of production include
explicit costs and implicit costs.
Explicit
costs involve a direct money
outlay for factors of production.
Implicit costs, also called normal
profit, refer to the opportunity cost of
using the owner’s own resources.
Economic Profit versus
Accounting Profit
Economists measure a firm’s economic
profit as total revenue minus all the
opportunity costs (explicit and implicit).
Accountants measure the accounting
profit as the firm’s total revenue minus
only the firm’s explicit costs. In other
words, they ignore the implicit costs.
Economic Profit versus
Accounting Profit
When total revenue exceeds both
explicit and implicit costs, the
firm earns economic profit.
 Economic profit is smaller than
accounting profit.
Economic Profit versus
Accounting Profit
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Explicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Total Cost of Production
Total cost of production
may be divided into fixed
costs and variable costs.
Fixed and Variable Costs
Fixed costs are those costs that do
not vary with the quantity of output
produced.
Variable costs are those costs that do
change as the firm alters the
quantity of output produced.
Family of Total Costs
TC  TFC  TVC
TC = Total Costs
TFC=Total Fixed Costs
TVC=Total Variable Costs
Fixed Cost vs. Sunk Cost
Fixed Cost
Cost paid by a firm that is in business
regardless of the level of output
Sunk Cost
Cost that have been incurred and
cannot be recovered
e.g. advertising expenditure
Variable Cost and Sunk Cost
Personal Computers: most costs
are variable
e.g. components, labor
Software: most costs are sunk
e.g. cost of developing the software
Total Cost
Output
(Units)
0
1
2
3
4
5
6
7
8
9
10
11
Fixed
Cost ($)
50
50
50
50
50
50
50
50
50
50
50
50
Variable Cost
($)
0
50
78
98
112
130
150
175
204
242
300
385
Total Cost
($)
50
100
128
148
162
180
200
225
254
292
350
435
Total Cost Curves
TC
Cost 400
Total cost
is the vertical
sum of FC
and VC.
($ per
year)
300
TVC
Variable cost
increases with
production and the
rate varies with
increasing &
decreasing returns.
200
Fixed cost does not
vary with output
100
50
0
TFC
1
2
3
4
5
6
7
8
9
10
11
12
13
Output
Average Costs
The average cost is the cost of each
typical unit of product.
Average costs can be determined by
dividing the firm’s costs by the
quantity of output produced.
Family of Average Costs
ATC  AFC  AVC
ATC=Average Total Costs
AFC=Average Fixed Costs
AVC=Average Variable Costs
Family of Average Costs
Total cost TC
ATC =
=
Quantity
Q
Fixed cost TFC
AFC =
=
Quantity
Q
Variable cost TVC
AVC =
=
Quantity
Q
Average Costs
Output
(Units)
0
1
2
3
4
5
6
7
8
9
10
11
TFC
($)
50
50
50
50
50
50
50
50
50
50
50
50
TVC
($)
0
50
78
98
112
130
150
175
204
242
300
385
TC
($)
50
100
128
148
162
180
200
225
254
292
350
435
AFC
($)
-50
25
16.7
12.5
10
8.3
7.1
6.3
5.6
5
4.5
AVC
($)
-50
39
32.7
28
26
25
25
25.5
26.9
30
35
ATC
($)
-100
64
49.3
40.5
36
33.3
32.1
31.8
32.4
35
39.5
Average Cost Curves
Cost
($ per
unit)
100
75
50
ATC
AVC
25
AFC
0
1
2
3
4
5
6
7
8
9
10
11
Output (units/yr.)
U-Shaped ATC and AVC Curves
The ATC curve is U-shaped.
 At
very low levels of output average total cost
is high because fixed cost is spread over only a
few units.
 Average total cost declines as output increases.
 Average total cost starts rising because average
variable cost rises substantially.
The AVC curve is also U-shaped for its
relationship with the ATC curve.
Marginal Cost
Marginal Cost (MC) is the cost of
expanding output by one unit. Since
fixed cost have no impact on marginal
cost, it can be written as:
VC TC
MC 

Q
Q
Marginal Cost
Output TFC
(Units)
($)
0
50
1
50
2
50
3
50
4
50
5
50
6
50
7
50
8
50
9
50
10
50
11
50
TVC
($)
0
50
78
98
112
130
150
175
204
242
300
385
TC
($)
50
100
128
148
162
180
200
225
254
292
350
435
AFC
($)
-50
25
16.7
12.5
10
8.3
7.1
6.3
5.6
5
4.5
AVC
($)
-50
39
32.7
28
26
25
25
25.5
26.9
30
35
ATC
($)
-100
64
49.3
40.5
36
33.3
32.1
31.8
32.4
35
39.5
MC
($)
-50
28
20
14
18
20
25
29
38
58
85
Marginal Cost Curve
Cost
($ per
unit)
100
MC
75
50
25
0
1
2
3
4
5
6
7
8
9
10
11
Output (units/yr.)
Cost Curves for a Firm
Cost
($ per
unit)
100
MC
75
50
ATC
AVC
25
AFC
0
1
2
3
4
5
6
7
8
9
10
11
Output (units/yr.)
From TC to AC and MC
AFC= slope of line from origin to a point on TFC
AVC = slope of line from origin to a point on TVC
ATC = slope of line from origin to a point on TC
MC = slope of tangent to a point on TC or TVC
P
P
TC
400
100
TVC
MC
75
300
B
50
200
B'
A
1 2 3 4 5 6 7 8 9 10 11 12 13
AVC
A'
25
100
0
ATC
TFC
Q
AFC
0
1
2
3
4
5
6
7
8
9
10
11
Q
Properties of Cost Curves
Cost
($ per
unit)
AFC falls continuously
 When MC < AVC or
MC < ATC, AVC and
ATC decrease
 When MC > AVC or
MC > ATC, AVC and
ATC increase

100
MC
75
50
ATC
AVC
25
AFC
0
1
2
3
4
5
6
7
8
Output (units/yr.)
9
10
11
Properties of Cost Curves
Cost
($ per
unit)
100
MC
75
50
ATC
AVC
25
AFC
0
1
2
3
4
5
6
7
8
Output (units/yr.)
9
10
11
MC crosses AVC and
ATC at the minimums
of AVC and ATC,
respectively.
Minimum AVC occurs
at a lower output than
minimum ATC
Costs in the Long Run
For many firms, the division of total
costs between fixed and variable costs
depends on the time horizon being
considered.
In the short run some costs are fixed.
 In the long run fixed costs become variable
costs.

Costs in the Long Run
Because many costs are fixed in
the short run but variable in the
long run, a firm’s long-run cost
curves differ from its short-run
cost curves.
Long-Run Average and
Marginal Cost
If LMC < LAC, LAC will fall
If LMC > LAC, LAC will rise
 LMC = LAC at the minimum of LAC
Long-Run Average and
Marginal Cost
Cost
($ per unit
of output
LMC
LAC
A
Output
Average Total Cost in the Short
and Long Runs
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
run with
medium factory
ATC in short
run with
large factory
ATC in long run
0
Quantity of
Cars per Day
Long-Run Costs and
Returns to Scale
The optimal plant size will depend on the
anticipated output.
 Firms
can change scale to change
output in the long-run.
 The
long-run average cost curve is the
envelope of the firm’s short-run average
cost curves.
Long-Run Cost with Economies
and Diseconomies of Scale
Cost
($ per unit
of output
SAC1
SAC3
SAC2
A
$10
LAC
$8
B
SMC1
SMC3
LMC
SMC2
Q1
If the output is Q1 a manager
would choose the small plant
SAC1 and SAC $8.
Output
Economies and Diseconomies
of Scale
Economies of scale occur when long-run
average total cost declines as output
increases.
Diseconomies of scale occur when longrun average total cost rises as output
increases.
Constant returns to scale occur when
long-run average total cost does not
vary as output increases.
Economies and Diseconomies
of Scale
Average
Total
Cost
ATC in long run
Economies
of scale
0
Constant Returns
to scale
Diseconomies
of scale
Quantity of
Cars per Day
Economies of Scope
Economies of scope exist when the joint output
of a single firm is greater than the output that
could be achieved by two different firms each
producing a single output.
Chicken farm—poultry and eggs
Automobile company—cars and trucks
University—Teaching and research
Advantages of Economies
of Scope
Both use similar, relative, and even the
same capital and labor.
The firms share management resources.
The production of one good results in the
production of another good at little or no
extra cost.
Measuring Degree of
Economies of Scope
C(Q1)  C (Q 2)  C (Q1, Q 2)
SC 
C (Q1, Q 2)
C(Q1)= cost of producing Q1
C(Q2)=cost of producing Q2
C(Q1Q2)=joint cost of producing both products
If SC > 0 — Economies of scope
If SC < 0 — Diseconomies of scope
Economies of Scope vs.
Economies of Scale
There is no direct relationship between
economies of scope and economies of
scale.
A firm may experience economies of
scope and diseconomies of scale
A firm may have economies of scale and
not have economies of scope
Assignment
Review Chapter 7
Answer questions on P130
Preview Chapter 8
Thanks