Businesses and the Costs of Production 07 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Costs The payment that must be made to obtain and retain the services of a resource Explicit Costs Monetary payments Implicit Costs Value of next best use Self-owned resources Includes normal profit LO1 7-2

Accounting Profit and Normal Profit Accounting profit = Revenue – Explicit Costs Economic profit = Accounting Profit – Implicit Costs Economic profit (to summarize) =Total Revenue – Economic Costs =Total Revenue – Explicit Costs – Implicit Costs LO1 7-3

Economic Profit LO1 Explicit costs Accounting costs (explicit costs only) Implicit costs (including a normal profit) Economic profit Accounting profit Economic (Opportunity) Costs Total Revenue 7-4

Short Run and Long Run Short Run Some variable inputs Fixed plant Long Run All inputs are variable Variable plant Firms enter and exit LO1 7-5

Short-Run Production Relationships Total Product (TP) Marginal Product (MP) Average Product (AP) LO2 Marginal Product Change in Total Product Change in Labor Input = Average Product Total Product Units of Labor = 7-6

Law of Diminishing Returns Resources are of equal quality Technology fixed Variable resources are added to fixed resources At some point, marginal product will fall Rationale LO2 7-7

The Law of Diminishing Returns LO2 Total, Marginal, and Average Product: The Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP) Change in (2)/ Change in (1) (4) Average Product (AP), (2)/(1) Increasing marginal returns Diminishing marginal returns Negative marginal returns

The Law of Diminishing Returns LO2 TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Total Product, TP Marginal Product, MP 7-9

Short-Run Production Costs Fixed Costs (TFC) Costs do not vary with output Variable Costs (TVC) Costs vary with output Total Costs (TC) Sum of TFC and TVC TC = TFC + TVC LO3 7-10

Short-Run Production Costs LO3 Costs Q $1100 TFC TC TVC Total Cost Variable Cost Fixed Cost 7-11

Per-Unit, or Average, Costs Average Fixed CostsAFC = TFC/Q Average Variable CostsAVC = TVC/Q Average Total CostsATC = TC/Q Marginal CostsMC = ΔTC/ΔQ LO3 7-12

Short-Run Production Costs LO3 Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run Total Cost DataAverage Cost Data Marginal Cost (1) Total Product (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) TC=TFC+TVC (5) Average Fixed Cost (AFC) AFC = TFC/Q (6) Average Variable Cost (AVC) AVC=TVC/Q (7) Average Total Cost (ATC) ATC = TC/Q (8) Marginal Cost (MC) MC =ΔTC/ΔQ 0 $100 $0$ $100.00$90.00$190.00$

Per-Unit, or Average, Costs LO3 Costs Q $200 AFC ATC AVC AFC 7-14

Marginal Cost LO3 Costs Q $200 AFC MC ATC AVC AFC 7-15

MC and Marginal Product LO3 Average Product and Marginal Product Cost (Dollars) MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves 7-16

Long-Run Production Costs The firm can change all input amounts, including plant size. All costs are variable in the long run. Long run ATC Different short run ATCs LO4 7-17

Firm Size and Costs LO4 Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output 7-18

The Long-Run Cost Curve LO4 Long-run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output 7-19

Economies and Diseconomies of Scale Economies of scale Labor specialization Managerial specialization Efficient capital Other factors Constant returns to scale LO4 7-20

Economies and Diseconomies of Scale Diseconomies of scale Control and coordination problems Communication problems Worker Alienation Shirking LO4 7-21

MES and Industry Structure Minimum Efficient Scale (MES): Lowest level of output where long- run average costs are minimized Can determine the structure of the industry LO4 7-22

MES and Industry Structure LO4 Output Average Total Costs Long-run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1q1 q2q2 7-23

MES and Industry Structure LO4 Output Average Total Costs Economies Of Scale Diseconomies Of Scale Long-run ATC 7-24

MES and Industry Structure LO4 Output Average Total Costs Long-run ATC Economies Of Scale Diseconomies Of Scale 7-25

Applications and Illustrations Rising gasoline prices Successful start-up firms Verson stamping machine The daily newspaper Aircraft and concrete plants LO3 7-26

Don’t Cry Over Sunk Costs Sunk costs Costs have already been incurred and thus are irrecoverable Rule: Do not engage in any activity where MB<MC Rule: Ignore sunk costs They are irrecoverable 7-27