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The Costs of Production

Chapter 8. The Costs of Production. Chapter Objectives. Explicit and implicit costs Law of diminishing returns Fixed and variable costs Total, average, and marginal costs The firm’s size in the long run. 8- 2. Economic Costs. Equal to opportunity costs Explicit + implicit costs

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The Costs of Production

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  1. Chapter 8 The Costs of Production

  2. Chapter Objectives • Explicit and implicit costs • Law of diminishing returns • Fixed and variable costs • Total, average, and marginal costs • The firm’s size in the long run 8-2

  3. Economic Costs • Equal to opportunity costs • Explicit + implicit costs • Explicit costs • Monetary payments • Implicit costs • Value of next best use • Self-owned resources • Self-employed resources 8-3

  4. Profit • Accounting profit • Total revenue less explicit cost • Normal profit • Equal to implicit cost • Economic or pure profit • Total revenue less economic cost 8-4

  5. Profits Compared Economic Accounting Accounting Profit Economic Profit Implicit Costs (Including a Normal Profit) Total Revenue Economic (Opportunity) Costs Explicit Costs Accounting Costs (Explicit Costs Only) 8-5

  6. Short and Long Run • The short run • Fixed plant capacity • Variable intensity of plant use • Variable output • The long run • Variable plant capacity • Firms enter and exit 8-6

  7. Production Relationships Change in Total Product = Marginal Product Change in Labor Input Total Product = Average Product Units of Labor • Total product (TP) • Marginal product (MP) • Average product (AP) 8-7

  8. Law of Diminishing Returns • Fixed technology • Add variable resource to fixed resource • Marginal product will decline • Beyond some point • Rationale 8-8

  9. Law of Diminishing Returns (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) (1) Units of the Variable Resource (Labor) (2) Total Product (TP) ] ] ] ] ] ] ] ] - 10.00 12.50 15.00 15.00 14.00 12.50 10.71 8.75 0 10 25 45 60 70 75 75 70 0 1 2 3 4 5 6 7 8 10 15 20 15 10 5 0 -5 Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns 8-9

  10. Law of Diminishing Returns 30 Total Product, TP 20 10 0 20 Marginal Product, MP 10 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 TP Increasing Marginal Returns Negative Marginal Returns Diminishing Marginal Returns AP MP 8-10

  11. Short-Run Production Costs • Fixed Costs • Do not vary with output • Variable Costs • Materials, most labor • Total Cost • TC = TFC + TVC 8-11

  12. Per-Unit Production Costs • Average fixed cost AFC = TFC/Q • Average variable cost AVC = TVC/Q • Average total cost ATC = TC/Q = TFC/Q + TVC/Q ATC = AFC+AVC • Marginal cost MC = change in TC/change in Q 8-12

  13. Short-Run Production Costs $1100 1000 900 800 700 600 Costs 500 400 300 200 100 0 10 1 2 3 4 5 6 7 8 9 Q TC TVC Fixed Cost Total Cost Variable Cost TFC 8-13

  14. Short-Run Production Costs $200 150 100 Costs 50 0 10 1 2 3 4 5 6 7 8 9 Q MC ATC AVC AFC AVC AFC 8-14

  15. Production Relationships • Marginal cost and diminishing returns • Marginal cost and marginal product • Marginal cost and average variable cost • Marginal cost and average total cost • Production curves and cost curves • Shifts in cost curves 8-15

  16. Graphical Relationships Average Product and Marginal Product Cost (Dollars) Production Curves AP MP Quantity of Labor MC AVC Cost Curves Quantity of Output 8-16

  17. Long-Run Production Costs • Choose your plant size • Minimize ATC • Different ATC curves • Short run • Long run ATC • Envelope of short run ATC 8-17

  18. Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-4 ATC-3 Average Total Costs Output Any number of short-run optimum size cost curves can be constructed 8-18

  19. Long-Run ATC Curve ATC-1 ATC-5 ATC-2 Long-Run ATC ATC-4 ATC-3 Average Total Costs Output The long-run ATC curve just “envelopes” the short run ATCs 8-19

  20. Long Run Production Cost • Economies of Scale • Labor specialization • Managerial specialization • Efficient capital • Diseconomies of Scale • Constant Returns to Scale 8-20

  21. Long-Run ATC Shapes Diseconomies Of Scale Constant Returns To Scale Economies Of Scale Average Total Costs Long-Run ATC q1 q2 Output Long-run ATC curve where economies of scale exist 8-21

  22. Long-Run ATC Shapes Economies Of Scale Diseconomies Of Scale Average Total Costs Long-Run ATC Output Long-run ATC curve where costs are lowest only when large numbers are participating 8-22

  23. Long-Run ATC Shapes Diseconomies Of Scale Economies Of Scale Long-Run ATC Average Total Costs Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially 8-23

  24. Industry Structure • Minimum efficient scale (MES) • Natural monopoly • Applications and illustrations • Price of corn • Successful start-up firms • The Verson stamping machine • The daily newspaper • Aircraft and concrete plants 8-24

  25. Sunk Costs • Irrelevant in decision making • Cannot be recovered • Do not affect marginal benefit and marginal cost • Firm example: • R&D costs 8-25

  26. 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 • 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 8-26

  27. Next Chapter Preview… Pure Competition 8-27

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