Chapter 7 Production Costs Lecture Slides Economics for Today Irvin B. Tucker © 2011 South-Western, a part of Cengage Learning

What is the purpose of this chapter? The purpose of this chapter is to study production and its relationship to various types of costs © 2011 South-Western, a part of Cengage Learning

What is a basic assumption in economics? The motivation for business decisions is profit maximization © 2011 South-Western, a part of Cengage Learning

To understand profit, what is necessary? To distinguish between the way economists measure costs and the way accountants measure costs © 2011 South-Western, a part of Cengage Learning

What are explicit costs? Payments to nonowners of a firm for their resources © 2011 South-Western, a part of Cengage Learning

What are implicit costs? The opportunity costs of using resources owned by the firm © 2011 South-Western, a part of Cengage Learning

What is an example of implicit costs? When a firm uses its own resources, such as the owner’s labor, land, building, or savings, the firm gives up the opportunity of earning a return on its resources. © 2011 South-Western, a part of Cengage Learning

What are total opportunity costs? Explicit costs + Implicit costs © 2011 South-Western, a part of Cengage Learning

What is economic profit? Total revenue minus explicit and implicit costs, or total revenue minus total opportunity costs © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is normal profit? The minimum profit necessary to keep a firm in operation © 2011 South-Western, a part of Cengage Learning

What about opportunity cost? A firm that earns normal profits earns total revenue equal to its total opportunity cost © 2011 South-Western, a part of Cengage Learning

How is accounting profit defined? Total revenue minus total explicit costs © 2011 South-Western, a part of Cengage Learning

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What conclusion can we make? Since business decision making is based on economic profit, rather than accounting profit, the word profit in this text always means economic profit © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is a fixed input? Any resource for which the quantity cannot change during the period of time under consideration © 2011 South-Western, a part of Cengage Learning

What is a variable input? Any resource for which the quantity can change during the period of time under consideration © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is the short run? A period of time so short that there is at least one fixed input © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is the long run? A period of time so long that all inputs are variable © 2011 South-Western, a part of Cengage Learning

What is the production function? The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs © 2011 South-Western, a part of Cengage Learning

What do technological advances make possible? More output is possible from a given quantity of inputs © 2011 South-Western, a part of Cengage Learning

What is marginal product? The change in total output produced by adding one unit of a variable input, with all other inputs used held constant © 2011 South-Western, a part of Cengage Learning

What is the law of diminishing returns? The principle that beyond some point the marginal product decreases as additional units of a variable resource are added to a fixed factor © 2011 South-Western, a part of Cengage Learning

What does the law of diminishing returns assume? Fixed inputs; it is therefore a short-run concept © 2011 South-Western, a part of Cengage Learning

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Exhibit 2 (a) Total Output Curve 60 50 40 Total Product (bushels of grapes per day) 30 Total Output 20 10 1 2 3 4 5 6 Quantity of Labor © 2011 South-Western, a part of Cengage Learning 25 (number of workers per day)

Exhibit 2(b) Marginal Product Curve 12 10 8 Marginal Product 6 (bushels of grapes per day) Marginal Product Law of Diminishing Returns 4 2 1 2 3 4 5 6 Quantity of Labor © 2011 South-Western, a part of Cengage Learning 26 (number of workers per day)

What is total fixed cost? Costs that do not vary as output varies and that must be paid even if output is zero. For example, rent, interest on loans, and property taxes. © 2011 South-Western, a part of Cengage Learning

What is total variable cost? Costs that are zero when output is zero and vary as output varies. Examples are wages, electricity, fuel, and materials. © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is total cost? The sum of total fixed cost and total variable cost at each level of output TC = TFC + TVC © 2011 South-Western, a part of Cengage Learning

What is average fixed cost? Total fixed cost divided by the quantity of output produced AFC = TFC / Q © 2011 South-Western, a part of Cengage Learning

What is average variable cost? Total variable cost divided by the quantity of output produced AVC = TVC / Q © 2011 South-Western, a part of Cengage Learning

What is average total cost? Total cost divided by the quantity of output produced. Also called per-unit cost. ATC = TC/Q OR ATC=AFC +AVC © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is marginal cost? The change in total cost when one unit of output is produced MC = TC/Q © 2011 South-Western, a part of Cengage Learning

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Exhibit 4(a) Short-Run Cost Curves Quantity of Output (units per hour) 800 TC 700 TVC 600 500 Total Costs (dollars) 400 TFC 300 200 TFC 100 2 4 6 8 10 12 Quantity of Output (units per hour) 35 © 2011 South-Western, a part of Cengage Learning

Exhibit 4(b) Short-Run Cost Curves 160 140 MC 120 100 Cost per unit (dollars) 80 ATC 60 AVC AFC 40 20 AFC 2 4 6 8 10 12 Quantity of output (units per hour) 36 © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning 5 © 2011 South-Western, a part of Cengage Learning

What is the marginal-average rule? When MC < AC, AC falls When MC > AC, AC rises If MC = AC, AC at minimum © 2011 South-Western, a part of Cengage Learning

What is the relationship between slopes of the MC and MP curves? The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa © 2011 South-Western, a part of Cengage Learning

© 2011 South-Western, a part of Cengage Learning What is the relationship between the minimum and maximum points of the MR and MP curves? The maximum point of the MP curve corresponds to the minimum point of the MC curve © 2011 South-Western, a part of Cengage Learning

Marginal cost’s mirror image © 2011 South-Western, a part of Cengage Learning

Exhibit 6(a) Marginal Product Curve 12 10 8 Marginal Product 6 (bushels of grapes per day) Marginal Product Law of Diminishing Returns 4 2 1 2 3 4 5 6 Quantity of Labor © 2011 South-Western, a part of Cengage Learning (number of workers per day)

Minimum Exhibit 6(b) Marginal Cost Curve MC 24 20 16 Marginal Cost (dollars) 12 8 Minimum 4 0 10 20 30 40 50 60 Quantity of output (bushels of grapes per day) © 2011 South-Western, a part of Cengage Learning

What is the long-run average cost curve? The curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size © 2011 South-Western, a part of Cengage Learning

Cost per unit (dollars) Quantity of Output (units per hour) Exhibit 7 The Relationship Between Three Factory Sizes and the Long-Run Average Cost Curves SRATCs SRATCm SRATCl 50 Cost per unit (dollars) B D 40 LRAC 30 C A 20 10 2 4 6 8 10 12 14 16 Quantity of Output (units per hour) 45 © 2011 South-Western, a part of Cengage Learning

Short-run average total cost curves Exhibit 8 Long-run Average Cost Curves Short-run average total cost curves 12 10 Cost per unit (dollars) 8 6 4 2 Long-run average cost curve 2 4 6 8 10 12 14 16 Quantity of Output (units per hour) © 2011 South-Western, a part of Cengage Learning 46

What are economies of scale? A situation in which the long-run average cost curve declines as the firm increases output © 2011 South-Western, a part of Cengage Learning

What are constant returns to scale? A situation in which the long-run average cost curve does not change as the firm increases output © 2011 South-Western, a part of Cengage Learning

What are diseconomies of scale? A situation in which the long-run average cost curve rises as the firm increases output © 2011 South-Western, a part of Cengage Learning

Exhibit 9 Long-run Average Cost Curve Cost per unit (dollars) LRAC Cost per unit (dollars) Constant returns to scale Diseconomies of scale Economies of scale Q1 Q2 Quantity of Output 50 © 2011 South-Western, a part of Cengage Learning

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