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

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

All inputs are variable Variable plant Firms enter and exit 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) Marginal Product Change in Total Product Change in Labor Input = Average Product Total Product Units of Labor = LO2 7-6

The Law of Diminishing Returns 30 TP Total Product, TP 20 10 1 2 3 4 5 6 7 8 9 Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns 20 Marginal Product, MP 10 AP 1 2 3 4 5 6 7 8 9 MP LO2 7-7

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 7-8

Short-Run Production Costs 1 2 3 4 5 6 7 8 9 10 Q 100 200 300 400 500 600 700 800 900 1000 $1100 TC TVC Fixed Cost Total Cost Variable Cost TFC LO3 7-9

Per-Unit, or Average, Costs Average Fixed Costs AFC = TFC/Q Average Variable Costs AVC = TVC/Q Average Total Costs ATC = TC/Q Marginal Costs MC = ΔTC/ΔQ LO3 7-10

Per-Unit, or Average, Costs 1 2 3 4 5 6 7 8 9 10 Q 50 100 150 $200 ATC AVC AFC AVC AFC LO3 7-11

Marginal Cost MC ATC Costs AVC AFC AVC AFC Q 1 2 3 4 5 6 7 8 9 10 50 Q 50 100 150 $200 MC ATC AVC AFC AVC AFC LO3 7-12

MC and Marginal Product Average Product and Marginal Product Cost (Dollars) Production Curves AP MP Quantity of Labor MC AVC Cost Curves Quantity of Output LO3 7-13

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 7-14

The Long-Run Cost Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Long-Run ATC Average Total Costs Output LO4 7-15

Economies and Diseconomies of Scale Labor specialization Managerial specialization Efficient capital Other factors Constant returns to scale LO4 7-16

Economies and Diseconomies of Scale Control and coordination problems Communication problems Worker alienation Shirking LO4 7-17

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 7-18

MES and Industry Structure Economies Of Scale Constant Returns To Scale Diseconomies Of Scale Average Total Costs Long-Run ATC q1 q2 Output LO4 7-19

Don’t Cry Over 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 7-20