Chapter 7
Production Costs
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is a basic
assumption in
economics?
The motivation for
business decisions is
profit maximization
2
To understand profit,
what is necessary?
To distinguish between
the way economists
measure costs and the
way accountants
measure costs
3
What are explicit costs?
Payments to nonowners of
a firm for their resources
4
What are
implicit costs?
The opportunity costs
of using resources
owned by the firm
5
What is an example of
implicit costs?
When you invest your nest
egg in your own enterprise,
you give up earning interest
on that money
6
How is accounting
profit defined?
Total revenue minus
total explicit costs
7
What are total
opportunity costs?
Explicit costs + Implicit costs
8
What is
economic profit?
Total revenue minus
total opportunity
costs
9
What is normal profit?
The minimum profit
necessary to keep a
firm in operation
10
When economists use
the term “profit”, which
profit do they mean?
Economic profit which,
unlike accounting profit,
includes implicit costs
11
What is a fixed input?
Any resource for which
the quantity cannot
change during the
period of time under
consideration
12
What is the short run?
A period of time so
short that there is at
least one fixed input
13
What is the long run?
A period of time so long
that all inputs are variable
14
What is a
variable input?
Any resource for which
the quantity can
change during the
period of time under
consideration
15
What is the
production function?
The relationship between
the maximum amounts
of outputs a firm can
produce and various
quantities of inputs
16
What do technological
advances make
possible?
More output is possible
from a given quantity of
inputs
17
What is
marginal product?
The change in total output
produced by adding one
unit of a variable input,
with all other inputs used
held constant
18
What is the law of
diminishing returns?
The principle that
beyond some point the
marginal product
decreases as additional
units of a variable
resource are added to
a fixed factor
19
What does the law
of diminishing
returns assume?
Fixed inputs; it is therefore
a short-run concept
20
60
40
30
20
Total Output
50
Production Function
Total Output
1
0
Quantity of Labor
1
2
3
4
5
6
21
Marginal Product Curve
10
8
6
4
2
Marginal Output
12
Law of
Diminishing
Returns
Quantity of Labor
1
2
3
4
5
6
22
What is
total fixed cost?
Costs that do not vary
as output varies and
that must be paid
even if output is zero
23
What is
total variable cost?
Costs that are zero when
output is zero and vary
as output varies
24
What is total cost?
The sum of total fixed cost
and total variable cost at
each level of output
25
26
What is
average fixed cost?
Total fixed cost divided
by the quantity of
output produced
27
28
What is average
variable cost?
Total variable cost
divided by the quantity
of output produced
29
30
What is
average total cost?
Total cost divided by the
quantity of output produced
31
32
What is marginal cost?
The change in total
cost when one unit of
output is produced
33
34
Short-Run Cost Curves
Cost per unit
$800
$700
$600
$500
$400
$300
$200
$100
TFC
TC
TVC
TFC
1 2 3 4 5 6 7 8 9
Q
35
Cost per unit
$80
$70
$60
$50
$40
$30
$20
$10
Short-Run Cost Curves
MC
ATC
AFC
AVC
AFC
1 2 3 4 5 6 7 8 9
Q
36
What is the
marginal-average rule?
When MC < AC, AC falls
When MC > AC, AC rises
If MC = AC, AC at minimum
37
What is the
relationship between
slopes of the MC and
MP curves?
The rising portion of the MP
curve corresponds to the
declining portion of the MC
curve, and vice versa
38
What is the
relationship between
the minimum and
maximum points of the
MR and MP curves?
The maximum point of the
MP curve corresponds to
the minimum point of the
MC curve
39
Marginal Product Curve
12
8
6
4
2
Total Output
10
Maximum
1
2
Quantity of Labor
3
4
5
6
40
Cost per unit
$80
$70
$60
$50
$40
$30
$20
$10
Short-Run Cost Curves
Minimum MC
ATC
AVC
1 2 3 4 5 6 7 8
Q
9
41
What is the long-run
average cost curve?
The curve that traces the
lowest cost per unit at
which a firm can produce
any level of output when
the firm can build any
desired plant size
42
Short and Long-run Average Cost Curves
$80
Short-run average
$70
total cost curves
$60
$50
$40
$30
$20
$10Long-run average cost curve
2 4 6
Q
8 10 12 14 16 18
43
What are
economies of scale?
A situation in which the
long-run average cost
curve declines as the
firm increases output
44
What are constant
returns to scale?
A situation in which the
long-run average cost
curve does not change as
the firm increases output
45
What are
diseconomies of scale?
A situation in which the
long-run average cost
curve rises as the firm
increases output
46
Long-run Average Cost Curve
$80
Constant returns to scale
$70
$60 Economies of scale
$50
Diseconomies of scale
$40
$30
$20
$10
2 4 6
Q
8 10 12 14 16 18
47
Key Concepts
48
Key Concepts
•
•
•
•
•
•
•
What is a basic assumption in economics?
What are explicit costs?
What are implicit costs?
How is accounting profit defined?
What are total opportunity costs?
What is economic profit?
What is normal profit?
49
Key Concepts cont.
• When economists use the term “profit”,
which profit do they mean?
• When economists study the economy, what
time frame do they assume?
• What is a fixed Input?
• What is the short run?
• What is the long run?
• What is a variable input?
• What is marginal product?
50
Key Concepts cont.
•
•
•
•
•
•
•
•
•
•
What is the Law of diminishing returns?
What is total fixed cost?
What is total variable cost?
What is total cost?
What is average fixed cost?
What is average variable cost?
What is average total cost?
What is marginal cost?
What are economies of scale?
What are diseconomies of scale?
51
Summary
52
Economic profit is equal total
revenue minus both explicit and
implicit costs. Implicit costs are the
opportunity costs of foregone
returns to resources owned by the
firm. Economic profit is important
for decision-making purposes
because it includes implicit costs
and accounting profit does not.
Accounting profit equals total
revenue minus explicit costs.
53
The short run is a time period
during which a firm has at least
one fixed input, such as its
factory size. The long run for a
firm is defined as as a period
during which all inputs are
variable.
54
A production function is the
relationship between output and
inputs. Holding all other factors
of production constant, the
production function shows the
total output as the amount of
one input, such as labor, varies.
55
Marginal product is the change in
total output caused by a one-unit
change in a variable input, such
as the number of workers hired,
the law of diminishing returns
states that after some level of
output in the short run, each unit
of the variable input yields
smaller and smaller marginal
product. This range of declining
marginal product is the region of
diminishing returns.
56
Total fixed costs consists of costs
that cannot vary with the level of
output, such as rent for office
space. Total fixed costs is the cost
of inputs that do not change as the
firm changes output in the short
run. Total variable cost consists of
costs that vary with the level of
output, such as wages. Total
variable cost is the cost of variable
inputs used in production. Total cost
is the sum of total fixed cost and
total variable cost.
57
Cost per unit
$800
$700
$600
$500
$400
$300
$200
$100
Short-Run Cost Curves
TFC
TC
TVC
TFC
1 2 3 4 5 6 7 8 9
Q
58
Marginal cost is the change is
total cost associated with one
additional unit of output. Average
fixed cost is the total fixed cost
divided by total output. Average
variable cost is the total variable
cost divided by total output.
Average total cost is the total
cost, or the sum of average fixed
cost and average variable cost,
divided by output.
59
Cost per unit
$80
$70
$60
$50
$40
$30
$20
$10
Short-Run Cost Curves
MC
ATC
AFC
AVC
AFC
1 2 3 4 5 6 7 8 9
Q
60
The marginal-average rule
explains the relationship between
marginal cost and average cost.
When the marginal cost is less
than the average cost, the
average cost falls. When the
marginal cost is greater than the
average cost, the average cost
rises. Following this rule, the
marginal cost curve intersects the
average total cost curve at their
minimum points.
61
Marginal cost and marginal product
are mirror images of each other.
Assuming a constant wage rate,
marginal cost equals the wage rate
divided by the marginal product.
Increasing returns cause marginal
cost to fall, and diminishing returns
cause marginal cost to rise. This
explains the U-shaped marginal
cost curve.
62
Marginal Product Curve
12
8
6
4
2
Total Output
10
Maximum
1
2
Quantity of Labor
3
4
5
6
63
Marginal cost
$80
$70
$60
$50
$40
$30
$20
$10
Minimum MC
1 2 3 4 5 6 7 8
Q
9
64
The long-run average cost curve
is a curve drawn tangent to all
possible short-run average total
curves. When the long-run
average cost curve decreases as
output increases, the firm
experiences economies of scale.
65
If the long-run average cost curve
remains unchanged as output
increases, the firm experiences
constant returns to scale. If the
long-run average cost curve
increases, the firm experiences
diseconomies of scale.
66
Long-run Average Cost Curve
$80
Constant returns to scale
$70
$60 Economies of scale
$50
Diseconomies of scale
$40
$30
$20
$10
2 4 6
Q
8 10 12 14 16 18
67
Chapter 7 Quiz
©2002 South-Western College Publishing
68
1. Explicit costs are payments to
a. hourly employees.
b. insurance companies.
c. utility companies.
d. all of the above.
D. Explicit costs are payments to
non owners of a firm.
69
2. Implicit costs are the opportunity
costs of using the resources of
a. outsiders.
b. owners.
c. banks.
d. retained earnings.
B. Implicit costs are opportunity costs that
a business owner incurs when using
resources owned by the firm.
70
3. Which of the following equalities is true?
a. Economic profit = total revenue accounting profit.
b. Economic profit = total revenue explicit costs - accounting profit.
c. Economic profit = total revenue implicit costs - explicit costs.
d. Economic profit = opportunity costs +
accounting costs.
C. The difference between accounting
profit and economic profit is that
economic profit is total revenue minus
both explicit and implicit costs.
Accounting profit is total revenue minus
71
explicit costs only.
4. Fixed inputs are factors of production that
a. are determined by a firm’s size.
b. can be increased or decreased quickly
as output changes.
c. cannot be increased or decreased
quickly as output changes.
d. none of the above.
C. In the short run, there are two types of
inputs, fixed and variable. Because a
firm cannot change its plant capacity,
some of its inputs are fixed. In the long
run, all costs are variable.
72
5. An example of a variable input is
a. raw materials.
b. energy.
c. hourly labor.
d. all of the above
D. As a firm produces more, it will use
more raw materials, energy, and
labor. Therefore, all are variable
costs.
73
6. Suppose a car wash has 2 washing
stations and 5 workers and is able to wash
100 cars per day. When it adds a third
station, but no more workers, it is able to
wash 150 cars per day. The marginal
product of the third washing station is
a. 100 cars per day.
b. 150 cars per day.
c. 5 cars per day.
d. 50 cars per day.
D. 50 cars is how many extra cars can be
washed by adding a new machine,
ceteris paribus.
74
7. If the units of variable input in a
production process are 1, 2, 3, 4, and 5
and the corresponding total outputs are
10, 22, 33, 42, and 48, respectively, the
marginal product of the fourth unit is
a. 2.
b. 6.
c. 9.
d. 42.
C. The difference between 42 and 33 is
9, the extra output when producing 4
units instead of 3.
75
8. The total fixed cost curve is
a. upward sloping.
b. downward sloping.
c. upward, then downward sloping.
d. unchanged with the level of output.
D. Fixed costs never change regardless of the
units of output; therefore its curve has to be
horizontal at a fixed cost dollar value.
76
9. Assuming that the marginal cost curve
is a smooth U-shaped curve, the
corresponding total cost curve has a
(an)
a. linear shape.
b. S-shape.
c. U-shape.
d. reverse S-shape.
D. Marginal cost decreases as output
increases from zero, and then increases
beyond a certain output level. A reverse-SShape total cost curve corresponds to the
changes in its slope (MC) as output
expands.
77
$1,250
$1,000
$750
Total Cost
$1,500
Total Cost Curve
Exhibit 10
TC
$500
$250
Quantity of Output
50
100
150
200
250
300
78
10. If both the marginal cost and the
average variable cost curves are Ushaped, at the point of minimum
average variable cost, the marginal
cost must be
a. greater than the average variable
cost.
b. less than the average variable cost.
c. equal to the average variable cost.
d. at its minimum.
C. If the margin is above the average, the
average will increase. If the margin is
less than the average, the average will
decrease. If the margin equals the
average, average does not change, that79
is, it is a horizontal curve.
11. Which of the following is true at the
point where diminishing returns set in?
a. Both marginal product and marginal
cost are at a maximum.
b. Both marginal product and marginal
cost are at a minimum.
c. Marginal product is at a maximum
and marginal cost at a minimum.
d. Marginal product is at a minimum
and marginal cost at a maximum.
C. The rising portion of the MP curve
corresponds to the declining portion of
the MC curve, and vice versa
80
12. As shown in Exhibit 10, total fixed
cost for the firm is
a. Zero.
b. $250
c. $500.
d. $750
e. $1,000
B. $250 is the answer because total cost is
0 when output is zero. These are costs
that have to be paid even when output is
zero.
81
13. As shown in Exhibit 10, the total
cost of producing 100 units of output
per day is
a. Zero.
b. $250
c. $500
d. $750
e. $1,000
C. A vertical line drawn at 100
units crosses the total cost
curve at $500.
82
14. In Exhibit 10, if the total cost of
producing 99 units of output per day is
$475, the marginal cost of producing
the 100th unit of output per day is
approximately
a. Zero.
b. $25.
c. $475.
d. $500
B. When total cost at 99 units is $475
and total cost at 100 units is $500, the
cost of producing the 100th unit is $25.
83
15. Each potential short-run average
total cost curve is tangent to the
long-run average cost curve at
a. the minimum point of the average
total cost curve.
b. a single point on the long-run
average cost curve.
c. the minimum point of the long-run
average cost curve.
C. The long-run LRAC is the summation
of all the SRAC. Geometrically, the only
way to draw this is to connect all the
curves by a smooth curve; thus, the
LRAC curve touches each SRAC curve
84
at only one place.
Short and Long-run Average Cost Curves
$80
Short-run average
$70
total
cost
curves
$60
$50
$40
$30
$20
$10 Long-run average cost curve
2 4 6
Q
8 10 12 14 16 18
85
16. Suppose a typical firm is producing X
units of output per day. Using any other
plant size, the long-run average cost
would increase. The firm is operating at a
point in which its
a. long-run average cost curve is at a
minimum.
b. short-run average total cost curve is
at a minimum.
c. both (a) and (b).
d. neither (a) nor (b).
C. When a firm is producing at the
minimum points of the long-run average
cost curve, it is operating at the most
efficient level possible.
86
17. The downward-sloping segment of the
long-run average cost curve corresponds
to
a. diseconomies of scale.
b. both economies and diseconomies of
scale.
c. the decrease in average variable cost.
d. economies of scale.
D. Economies of scale takes place when
a firm increases its efficiency by
producing more units of output.
87
Long-run Average Cost Curve
$80
Constant returns to scale
$70
$60 Economies of scale
$50
Diseconomies of scale
$40
$30
$20
$10
2 4 6
Q
8 10 12 14 16 18
88
18. Long-run diseconomies of scale
exist when the
a. short-run average total cost curve
falls.
b. long-run marginal cost curve rises.
c. long-run average cost curve falls.
d. short-run average cost curve rises.
e. long-run average cost curve rises.
E. Diseconomies of scale are evident
when increasing output leads to
inefficiencies.
89
19. Long-run constant returns to scale
exist when the
a. short-run average total cost curve
is constant.
b. long-run average cost curve
rises.
c. long-run average cost curve is
flat.
d. long-run average cost curve falls.
C. Constant returns to scale are
evident when there is no change
in costs as output increases.
90
END
91