Chapter 6 Production, Cost, and Profit © 2001 South-Western College Publishing

2 Production Function The physical relationship between resource inputs and product output

3 Principle of Diminishing Marginal Returns 4 As more units of a variable resource are added to a set of fixed resources, the resulting additions to output eventually become smaller 4 Marginal Product (MP): change in total output resulting from an additional unit of input 4 Average Product (AP): total output divided by the number of units of an input used.

4 Relationship of MP to AP Labor Output AP MP

5 Returns to Scale 4 Constant returns to scale: output changes in a fixed proportion to the change in total inputs 4 Decreasing returns to scale: output changes disproportionately little compared to a change in the scale of inputs 4 Increasing returns to scale: output changes disproportionately much in comparison to a change in the scale of inputs

6 Costs of Production 4 Alternative Uses and Opportunity Costs 4 Explicit and Implicit Costs 4 Classifications of Costs 4 Relationship between Product and Cost Curves

7 Opportunity Cost of Productive Resources Amount of payment needed to attract productive resources away from their next best opportunities for employment

8 Explicit and Implicit Costs 4 Explicit costs –expenditures for production that result from agreements or contracts 4 Implicit costs –a firm’s opportunity cost of using its own resources or those provided by its owners without a corresponding cash payment

9 Classifications of Production Costs 4 Fixed Costs –costs that remain constant as output varies 4 Average Fixed Costs (AFC) = 4 Variable Costs –costs that vary as output changes 4 Average Variable Costs (AVC) =

10 4 Total Cost (TC) –the sum of total fixed cost and total variable cost at a particular level of output 4 Average Total Cost (ATC) = and also, AFC+AVC 4 Marginal Cost (MC) –the change in total cost resulting from production of one more unit of output Classifications of Production Costs

11 Relationship of AFC, AVC, ATC, and MC Output $ Cost AFC ATC AVC MC

12 Relationship Between Product Curves and Cost Curves Output Input Cost 0 0 A A B B MC MP AP AVC (a) (b)

13 Revenue 4 Average revenue (AR) –revenue per unit of output sold 4 Total revenue (TR) –amount of revenue or income received from the sale of a given quantity of goods or services 4 Marginal revenue (MR) –change in TR that results from the sale of one more unit of output

14 Profit 4 Total Profit is the difference between total revenue and total cost total revenue – total cost = profit

15 Total Revenue v. Total Cost Break-Even Point –the output level at which total revenue equals total cost =

16 Break-Even Chart Output Cost and Revenue TFC TC TR Break-Even Point Maximum Profit

17 Short Run v. Long Run 4 Short Run –period of time in which some productive resources are fixed 4 Long Run –period of time in which all productive resources (including machinery, buildings, other capital items) are variable

18 Economic Profit 4 Normal Profit –amount of profit necessary to induce an entrepreneur to stay in business 4 Economic Profit –revenue in excess of all costs, including normal profit