Chapter 7: The Costs of Production What are costs? Can you distinguish between fixed and variable costs? Can you define and calculate total, average, and marginal costs. How do costs and economies of scale relate? Now we turn to understanding the behavior of producers!

Costs defined Economic costs (aka opportunity costs)—payments a firm/producer must make to attract the resources it needs away from alternative production opportunities. Explicit Costs—monetary payments for resources (this is what an accountant would want to know.) Implicit Costs—monetary income a firm sacrifices or foregoes when it uses a resource it owns rather than supplying it to the market (to earn in an alternative use.) Example:

Normal profits vs. Economic Profits Normal profits are an implicit cost; it is a cost of doing business. An entrepreneur needs a normal profit to stay in business (otherwise, he or she would choose an alternative endeavor.) Economic Profit is “pure” profit Economic Profit = Total Revenue – Economic Cost

Short Run vs. Long Run Usually, we will focus on short run adjustments to production and resources when analyzing costs. Short Run is a period of time too brief for a firm to alter its plant capacity (real capital takes a long time to acquire/build,) but labor & materials can be changed more quickly. Long Run is a period of time long enough to adjust the quantities of all resources a firm employs.

Short Run Production Relationships Definitions: Total Product (TP)—total quantity/output produced in terms of units. Marginal Product (MP)—additional output produced when one additional unit of a resource (i.e. labor) is employed. Average Product (AP)—output per unit of labor input, also called labor productivity. Graph/Handout:

Law of Diminishing Returns More precisely: “law of diminishing marginal product” Key Assumptions: Fixed technology Equal quality of variable resources (labor) As additional units of a variable resource (labor) are added to a fixed resource (capital or land), the marginal product of the variable resource will eventually decline. Pizzeria, farming…

Short Run Production Costs Fixed Costs—costs which do not vary with changes in output. Must be paid even if output is zero Cannot be avoided in the short run Examples include rent, interest on debt, insurance Variable Costs—costs which change with the level of output (may be altered in the short run.) Initially, variable costs increase by decreasing amounts. But eventually, they rise by increasing amounts. (law of diminishing returns) Examples include most labor, fuel, materials, shipping

Total Cost is the sum of fixed costs and variable costs at each level of output. TC = TFC + TVC At zero output, TC=FC

Per Unit Costs (Average Costs) Average Fixed Cost: AFC = TFC/Q Declines as output increases (at a decreasing rate) Average Variable Cost: AVC = TVC/Q AVC declines initially, reaches a minimum, then increases again U-shaped curve, which reflects law of diminishing returns AVC and AP are exact opposites Average Total Costs: ATC = TC/Q = AFC + AVC “spreading effect” vs. “diminishing returns effect”

Marginal Cost—additional cost of producing one more unit of output. Change in TC/change in Q, or change in TVC/change in Q Know this stuff!! : Firm output decisions are based on MC U-shaped curve (law of diminishing returns) Mirror opposite of MP curve (MP max = MC min) MC intersects both AVC and ATC at their min pts. No relationship between MC and AFC since fixed costs are independent of output in the short run.

Shifting Curves If fixed costs change, then shift both AFC and ATC. If variable costs change, shift AVC, ATC, and MC. Change in technology would cause all cost curves to shift. Which curves shift when wages rise? Price of electricity rises? Insurance premiums decline? Property tax increases? Transportation costs rise?

Long Run Production Costs All costs are variable in the long run. (no law of D.R.) The long run ATC curve shows the lowest ATC at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size (often called a “planning curve”.) The long run ATC curve is made up of all of the points of tangency from the short run ATC curves.

Economies of Scale Economies of scale (“size”)—decreasing ATC as the firm expands in the long run due to Labor specialization Managerial specialization Efficient capital Diseconomies of scale—at some point, expansion causes ATC to increase Executives far removed from production, slow decision making, unresponsive to change Workers care little about productivity (slackers!)

Constant returns to scale: in this range, ATC is constant. Minimum Efficient Scale—lowest level of output at which a firm can minimize LRATC. Industries with wide ranging MES can include firms of many different sizes.

Natural Monopoly Rare occurrence when ATC is minimized when only one firm produces a particular good or service. Economies of scale occur only when the market is controlled by one producer. To share the market would be inefficient and too costly. (Cable TV, electric and gas utilities, water works)