20
The Costs of
Production
20-1
Copyright 2008 The McGraw-Hill Companies
Chapter Objectives
• Why Do Economic Costs Include Both Explicit
Costs and Implicit Costs
• How Does the Law of Diminishing Returns
Relate to a Firm’s Short-Run Production Costs
• Learn 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
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Copyright 2008 The McGraw-Hill Companies
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.
• Payments may be explicit or implicit.
Explicit costs
• are payments to non-owners - of the firm - for resources they
supply.
Implicit costs
• are the money payments the self-employed resources could
have earned in their best alternative employments.
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Copyright 2008 The McGraw-Hill Companies
Example
• Ali runs a small 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 equipments that could earn him $4,000 per
year if alternatively invested. He has been offered $15,000
per year to work as a manager for a competitor. He also
estimates his entrepreneurial talents are worth $3,000 per
year. Total annual revenue from his firm sales is $72,000.
Calculate accounting profits and economic profits for
Ali.
• Explicit costs: $37,000 (= $12,000 for the helper + $5,000
of rent + $20,000 of materials).
• Implicit costs: $22,000 (= $4,000 of forgone interest +
$15,000 of forgone salary + $3,000 of entrepreneurship).
Accounting profit = $35,000 (= $72,000 of revenue $37,000 of explicit costs);
• Economic profit = $13,000 (= $72,000 - $37,000 of explicit
costs - $22,000 of implicit costs).
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Copyright 2008 The McGraw-Hill Companies
Normal profits
• are considered an implicit cost because they are the
minimum payments required to keep the owner’s
entrepreneurial abilities self-employed. This is $3,000 in the
example.
Accounting profits
• Are the total revenue less explicit costs.
Economic or pure profits
• are total revenue less all costs (explicit and implicit
including a normal profit).
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Copyright 2008 The McGraw-Hill Companies
Profits Compared
Economic Profit Versus Accounting Profits
20-6
Economic
Profit
Implicit Costs
(Including a
Normal Profit)
Explicit
Costs
Copyright 2008 The McGraw-Hill Companies
Accounting
Total Revenue
Economic
(Opportunity)
Costs
Economics
Accounting
Profit
Accounting
Costs (Explicit
Costs Only)
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, 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
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 (MP) will
decline”.
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Copyright 2008 The McGraw-Hill Companies
Total product (TP)
• is the total quantity, or total output, of a particular good
produced.
Marginal product (MP)
• is the change in total output resulting from each additional
input of labor.
Average product (AP)
• is the total product divided by the total number of workers.
• The following figure illustrates the law of diminishing returns
graphically and shows the relationship between marginal,
average, and total product concepts.
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Copyright 2008 The McGraw-Hill Companies
Law of Diminishing Returns
O 20.1
(1)
Units of the
(2)
Variable Resource Total Product
(Labor)
(TP)
0
0
]
10
1
]
25
2
]
45
3
]
60
4
]
70
5
]
75
6
]
75
7
]
70
8
20-9
Copyright 2008 The McGraw-Hill Companies
(3)
Marginal Product
(MP),
Change in (2)/
Change in (1)
10
15
20
15
10
5
0
-5
(3)
Average
Product
(AP),
(2)/(1)
Increasing
10.00
Marginal
12.50
Returns
15.00
Diminishing
15.00
Marginal
14.00
Returns
12.50
Negative
10.71
Marginal
Returns
8.75
Total Product, TP
Law of Diminishing Returns
• Graphical Portrayal
30
20
10
Marginal Product, MP
0
20-10
TP
1
2
3
Increasing
Marginal
20 Returns
4
5
6
7
9
Negative
Marginal
Returns
Diminishing
Marginal
Returns
10
Copyright 2008 The McGraw-Hill Companies
8
AP
1
2
3
4
5
6
7
8 9
MP
O 20.2
Note:
• When marginal product begins to diminish, the rate of
increase in total product stops accelerating and grows at a
diminishing rate.
• The average product declines at the point at which the
marginal product slips below average product.
• Total product declines when the marginal product becomes
negative.
• 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.
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Copyright 2008 The McGraw-Hill Companies
Short Run Production Costs
• Fixed, variable and total costs are the short-run
classifications of costs;
Total fixed costs
• Are those costs whose total does not vary with changes in
short-run output.
Total variable costs
• Are those costs that change with the level of output. They
include payment for materials, fuel, power, transportation
services, most labor, and similar costs.
Total cost
• Is the sum of total fixed and total variable costs at each level
of output (see Figure 20.3).
20-12
Copyright 2008 The McGraw-Hill Companies
Short-Run Production Costs
Total Cost, Fixed and Variable Costs
$1100
TC
1000
900
TVC
800
Costs
700
600
Fixed
Cost
500
400
Total
Cost
300
Variable
Cost
200
100
TFC
0
20-13
1
Copyright 2008 The McGraw-Hill Companies
2
3
4
5
6
7
8
9
10
Q
Per unit or average costs
• There are three types of average or per unit costs:
Average fixed cost: is the total fixed cost divided by the level
of output (TFC/Q). It will decline as output rises.
Average variable cost: is the total variable cost divided by the
level of output (AVC = TVC/Q).
Average total cost: is the total cost divided by the level of
output (ATC = TC/Q), sometimes called unit cost or per unit
cost. Note that ATC also equals AFC + AVC.
Marginal cost
• Is the additional cost of producing one more unit of output
(MC = change in TC/change in Q).
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Copyright 2008 The McGraw-Hill Companies
• Marginal cost can also be calculated as MC = change in
TVC/change in Q.
• 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.
• Cost curves will shift if the resource prices change or if
technology or efficiency change.
20-15
Copyright 2008 The McGraw-Hill Companies
Short-Run Production Costs
Average and Marginal Costs
$200
MC
Costs
150
AFC
ATC
AVC
100
50
AVC
AFC
0
1
2
3
4
5
6
7
8
9
10
Q
G 20.1
20-16
Copyright 2008 The McGraw-Hill Companies
Average Product and
Marginal Product
Short-Run
Production
Costs
Production Curves
Cost Curves
AP
MP
Quantity of Labor
MC
Cost (Dollars)
AVC
Quantity of Output
20-17
Copyright 2008 The McGraw-Hill Companies
• Long-Run Production Costs
• In the long-run, all production costs are variable, i.e., longrun costs reflect changes in plant size and industry size can
be changed (expand or contract).
• The following figure illustrates different short-run cost curves
for five different plant sizes.
• 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 plant size.
20-18
Copyright 2008 The McGraw-Hill Companies
Long-Run Production Costs
Average Total Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Output
Any Number of Short-Run Optimum
Size Cost Curves Can Be Constructed
20-19
Copyright 2008 The McGraw-Hill Companies
Long-Run Production Costs
Average Total Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Long-Run
ATC
Output
The Long-Run ATC Curve Just
“Envelopes” the Short Run ATCs
20-20
Copyright 2008 The McGraw-Hill Companies
Economies of Scale
• Economies or diseconomies of scale exist in the long run.
Economies of scale 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.
Reasons for economies of scale
• Labor and managerial specialization is one reason for this.
• Ability to purchase and use more efficient capital goods also
may explain economies of scale.
• Other factors may also be involved, such as design,
development, or other “start up” costs such as advertising
and “learning by doing.”
20-21
Copyright 2008 The McGraw-Hill Companies
Diseconomies of scale
• may occur if a firm becomes too large as illustrated by the
rising part of the long-run ATC curve. For example, if a 10
percent increase in all resources result in a 5 percent
increase in output, ATC will increase. Some reasons for this
include distant management, worker alienation, and
problems with communication and coordination.
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. Larger corporations at first
may successful in lowering costs and realizing economies of
scale. To keep from experiencing diseconomies of scale,
they may decentralize decision making by utilizing smaller
production units.
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Copyright 2008 The McGraw-Hill Companies
Long-Run Production Costs
Average Total Costs
Alternative Long-Run ATC Shapes
Constant Returns
To Scale
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
q1
q2
Output
Long-Run ATC Curve Where Economies
Of Scale Exist
20-23
Copyright 2008 The McGraw-Hill Companies
Long-Run Production Costs
Average Total Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Output
Long-Run ATC Curve Where Costs Are
Lowest Only When Large Numbers Are
Participating
20-24
Copyright 2008 The McGraw-Hill Companies
Long-Run Production Costs
Average Total Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Output
Long-Run ATC Curve Where Economies
Of Scale Exist, are Exhausted Quickly,
And Turn Back Up Substantially
20-25
Copyright 2008 The McGraw-Hill Companies
Minimum efficient scale
• The concept of minimum efficient scale 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. This pattern
also is found in several new information technology
industries.
20-26
Copyright 2008 The McGraw-Hill Companies
Applications and illustrations
• The terrorist attacks on September 11, 2001, have led to
rising insurance and security costs. Some of these costs are
fixed (insurance premiums and security cameras), while
others are variable (number of security guards). Both have
resulted in an upward shift of the ATC curves.
• Recently there have been a number of start-up firms that
have been able to take advantage of economies of scale by
spreading product development costs and advertising costs
over larger and larger units of output and by using greater
specialization of labor, management, and capital.
• In 1996 Verson (a firm located in Chicago) introduced a
stamping machine the size of a house weighing as much as
12 locomotives. This $30 million machine enables
automakers to produce in 5 minutes what used to take 8
hours to produce.
20-27
Copyright 2008 The McGraw-Hill Companies
• Newspapers can be produced for a low cost and thus sold
for a low price because publishers are able to spread the
cost of the printing equipment over an extremely large
number of units each day.
• The aircraft assembly and ready-mixed concrete industries
provide extreme examples of differing MESs. Economies of
scale are extensive in manufacturing airplanes, especially
large commercial aircraft. As a result, there are only two
firms in the world (Boeing and Airbus) that manufacture large
commercial aircraft. The concrete industry exhausts its
economies of scale rapidly, resulting in thousands of firms in
that industry.
20-28
Copyright 2008 The McGraw-Hill Companies
LAST WORD: Don’t Cry over Sunk Costs
• Sunk costs are irrelevant in decision-making.
• The old saying “Don’t cry over spilt milk” sends the message
that if there is nothing you can do about it, forget about it.
• A sunken ship on the ocean floor is lost, it cannot be
recovered. It is what economists’ call a “sunk cost.”
• 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.
20-29
Copyright 2008 The McGraw-Hill Companies
• Suppose a firm spends a million dollars on R&D 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.
• Sunk costs are irrelevant! Don’t cry over spilt milk or sunk
costs!
20-30
Copyright 2008 The McGraw-Hill Companies
Key Terms
• economic (opportunity)
cost
• explicit costs
• implicit costs
• normal profit
• economic profit
• short run
• long run
• total product (TP)
• marginal product (MP)
• average product (AP)
• law of diminishing returns
• fixed costs
20-31
Copyright 2008 The McGraw-Hill Companies
•
•
•
•
•
•
•
•
•
•
variable costs
total cost
average fixed cost (AFC)
average variable cost (AVC)
average total cost (ATC)
marginal cost (MC)
economies of scale
diseconomies of scale
constant returns to scale
minimum efficient scale
(MES)
• natural monopoly
Next Chapter Preview…
Pure
Competition
20-32
Copyright 2008 The McGraw-Hill Companies