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ECON 1023
SPRING 2012
Instructor: Gibson Nene
LECTURE NOTES: CHAPTER 6: Businesses and their Costs
Source: Microeconomics Brief Edition, First Edition by McConnell,
Brue and Flynn.
Chapter Objectives
After reading this chapter, you should be able to:
• explain why economic costs include both explicit costs and
implicit costs
• explain how the law of diminishing returns relates to a firm’s
short-run production costs
• describe the distinctions between fixed and variable costs and
among total, average, and marginal costs
• learn the link between a firm’s size and its average costs in the
long run
Economic Cost:
Economic costs are the payments a firm must make, or incomes it must
provide, to resource suppliers to attract those resources away from their
best alternative production opportunities.
• _________ costs are costs paid in money to obtain a resource.
• _________ costs are opportunity costs incurred by a firm when it
uses a factor of production for which it does not make a direct
money payment.
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• Economic Costs = ___________________________________
Profit
• _____________ profit = Total revenue – explicit cost
• _____________ profits = Return to entrepreneurship
•
Normal profits = implicit costs because they are the
minimum payments required to keep the owner’s
entrepreneurial abilities self-employed.
• It is a form of opportunity cost because to keep the firm (the
resources that the firm needs) engaged in a particular activity
you have to reward them sufficiently to attract them from the
next best alternative.
• ___________ or Pure Profit = Total Revenue – explicit cost –
implicit cost
• Total revenue = amount received from the sale of the product
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Example 1
• Adam opens a new flower store business. He owns the building
and uses his own labor and money capital. He incurs no explicit
rental or wage costs. Before starting his own business he earned
$1,000/month by renting out his store and earned $2,500/month
working as a store manager at another store. He also gained
$1,000/month in interest earned on his capital. His monthly
revenue from running his store is $10,000 and his expenses for
supplies and other bills are $ 6,000.
• What is his monthly accounting and economic profit?
Solution to example 1
• Accounting profit = _____________________________
• Economic Profit?
• Implicit Costs:
•
Forgone _____________________
• Forgone ______________________
• Forgone __________________________
• Total implicit cost
= $ _____________
• Economic Profit (loss) = __________________________
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Short and Long Run
To study the relationship between a firm’s output decision and its costs,
we distinguish between two decisions time frame: the short run and the
long run.
• The short run is the time period that is too brief for a firm to alter
its plant capacity. The plant size is fixed in the short run.
Short-run costs, then, are the wages, raw materials, etc., used for
production in a fixed plant.
• The long run is a period of time long enough for a firm to change
the quantities of all resources employed, including the plant size.
Long-run costs are all costs, including the cost of varying the size
of the production plant.
Short-Run Production Relationships
• ________________ (TP) is the total quantity, or total output, of a
particular good produced.
• _________________ (MP) is the change in total output resulting
from each additional input of labor.
• __________________ (AP) is the total product divided by the total
number of workers.
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The Relationship Between Marginal, Average, and Total Product
Concepts
• When marginal product begins to diminish, the rate of increase in
total product stops accelerating and grows at a diminishing rate.
• The ________ product declines at the point at which the
________product slips below average product.
• _______ product declines when the __________ product becomes
negative.
Phases of Marginal Returns
• As the usage of an input increases Marginal product initially
increases, then begins to decline and eventually becomes negative.
• Example: When you are studying for exams, you have very likely
experienced various phases of marginal returns.
• The first few hours spent studying increase your grade much more
than the last few hours. Suppose the marginal improvement of
your grade as you put in more hours of study is summarized in the
table below:
Hours of study
Grade
Marginal
Improvement
0
0
0
10
75
(75-0)=75
20
100
(100-75)=25
30 (All night study)
80
(80-100)=-20
• Thus the marginal improvement in your grade initially increases
and diminishes as you spend additional hours studying.
• If you studied all night long and end up sleeping through an exam
or performing poorly due to a lack of sleep, you studied in the
range of negative marginal returns.
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Law of Diminishing Returns
• Short-run production reflects the law of diminishing returns that
states that as successive units of a variable resource are added to a
fixed resource, beyond some point the product attributable to each
additional resource unit will decline.
• The law of diminishing returns assumes all units of variable
inputs—workers in this case— are of equal quality. Marginal
product diminishes not because successive workers are inferior but
because more workers are being used relative to the amount of
plant and equipment available.
Units of the
variable
resource(Labor)
(1)
0
1
2
3
4
5
6
7
8
Total
Product (2)
Marginal
Product Change
in (2) divided by
Change in (1)
0
10
25
45
60
70
75
75
70
Figure 1[On page 128 of your textbook]
Average
Product
(2)divided by
(1)
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Short-Run Production Costs
• Fixed, variable and total costs are the short-run classifications of
costs
• __________________ (TFC) are those costs whose total does not
vary with changes in short-run output.
• __________________ (TVC) are those costs that change with the
level of output. They include payment for materials, fuel, power,
transportation services, most labor, and similar costs.
• __________________ is the sum of total fixed and total variable
costs at each level of output
TC = ____________________________
Figure 2 [This Figure is not in your textbook, I will provide a pdf
file of this]
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Per-Unit or Average Production Costs
• _______________ is the total fixed cost divided by the level of
output (AFC =TFC/Q). It will decline as output rises.
• _________________ is the total variable cost divided by the level
of output (AVC = TVC/Q).
• ______________ is the total cost divided by the level of output
(ATC = TC/Q), sometimes called unit cost or per unit cost. Note
thatATC = TC/Q = TFC/Q + TVC/Q = AFC+AVC
Average and Marginal Costs [Figure 3: Page 136 of your textbook]
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Marginal cost (MC)
• Marginal cost is the extra, or additional cost of producing one more
unit of output.
• MC = ________________________________________________
• Marginal decisions are very important in determining profit levels.
Marginal revenue and marginal cost are compared.
• Marginal cost is a reflection of marginal product and diminishing
returns. When diminishing returns begin, the marginal cost will
begin its rise
• The marginal cost is related to AVC and ATC. These average
costs will fall as long as the marginal cost is less than either
average cost. As soon as the marginal cost rises above the average,
the average will begin to rise.
Let’s relate the relationship between MC and AC to your GPA
• Think of the average as your GPA=B. Think of the marginal as the
additional grades/classes. If you get a grade in ECON1023 that is
below your current average, i.e. below B, what will happen to your
average? It will drop.
• It will keep dropping for as long as additional grades are below
average. If your marginal is above average, the average increases
and vice versa
• Cost curves will shift if the resource prices change or if
technology or efficiency change.
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Average product, Marginal product, Average Cost, Marginal cost
curves [Figure 4:Not in your textbook, I will provide a pdf file of
this)
Long-Run Production Costs
• In the long-run, all production costs are variable, i.e., long-run
costs reflect changes in __________ and _________ size can be
changed (expand or contract).
• The long-run ATC curve shows the least per unit cost at which any
output can be produced after the firm has had time to make all
appropriate adjustments in its __________.
• Economies or diseconomies of scale exist in the long run.
Long-Run ATC Curve
The long-run ATC curve just“envelopes” the ______ run ATCs
Figure 5 [The Figure is on page 136 of your textbook]
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Long Run Production Cost
• ______________ or economies of mass production explain the
downward sloping part of the long-run ATC curve, i.e. as plant
size increases, long-run ATC decrease.
 Labor and managerial ____________ is one reason for this.
 _________ to purchase and use more _______ capital goods
also may explain economies of scale.
 Other factors may also be involved, such as design,
development, or other “____________” costs such as
advertising and “learning by doing.”
• Diseconomies of scale
• Caused mainly by the difficulty of efficiently controlling and
coordinating a firm’s operations as it becomes a large scale
producer. Some reasons for this include:
 __________________________,
 ___________________, and
 ____________________________________.
• Constant returns to scale will occur when ATC is constant over a
variety of plant sizes.
• Both economies of scale and diseconomies of scale can be
demonstrated in the real world.
 __________ corporations at first may be successful in
lowering costs and realizing economies of scale.
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 To keep from experiencing diseconomies of scale, they may
decentralize decision making by utilizing smaller production
units.
• The concept of minimum ____________ defines the smallest level
of output at which a firm can minimize its average costs in the long
run.
 The firms in some industries realize this at a small plant size:
apparel, food processing, furniture, wood products,
snowboarding, and small-appliance industries are examples.
 In other industries, in order to take full advantage of
economies of scale, firms must produce with very large
facilities that allow the firms to spread costs over an
extended range of output. Examples would be: automobiles,
aluminum, steel, and other heavy industries.
• Alternative Long-Run ATC Shapes
Figure 6-Figure 6.6(a) in your textbook: P137
Figure 7-Figure 6.6(b) in your textbook: P137
Figure 8-Figure 6.6 (c) in your textbook: P137
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Sunk Costs
• Sunk costs are irrelevant in ____________.
– A sunken ship on the ocean floor is lost, it cannot be
recovered. It is what economists’ call a “_____________.”
– Economic analysis says that you should not take actions for
which marginal cost exceeds marginal benefit.
– Suppose you have purchased an expensive ticket to a football
game and you are sick the day of the game; the price of the
ticket should not affect your decision to attend.
• In making a new decision, you should ignore all costs that are not
affected by the decision
– A prior bad decision should not dictate a second decision for
which the marginal benefit is less than marginal cost.
– Suppose a firm spends a million dollars on Research and
Development only to discover that the product sells very
poorly. The loss cannot be recovered by losing still more
money in continued production.
– If a cost has been incurred and cannot be partly or fully
recouped by some other choice, a rational consumer or firm
should ignore it.
The end