Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved. Understanding Economics 3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 4 Costs of Production Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives In this chapter you will: learn about economic costs (explicit and implicit) of production and economic profit analyze short-run (total, average, and marginal) products, and the law of diminishing marginal returns derive short-run (total, average, and marginal) costs examine long-run results of production (increasing returns to scale, constant to scale, and decreasing to scale) and long-run costs

T 1, Production,costs, and profit Define:”business”,”production”,”inputs”,”output”, See page 85. Types of Production There are three main sectors in the economy the primary sector consists of industries that extract or cultivate natural resources the secondary sector consists of industries that fabricate or process goods the service sector consists of trade and information industries

Productive Efficiency Productive efficiency: making a given quantity of output at the lowest cost Businesses choose from different production processes a labour-intensive process employs more labour and less capital a capital-intensive process employs more capital and less labour

Economic Costs & Economic profit Economic costs include explicit costs: payments made by a business to business or people outside of it implicit costs:the owner’s opportunity costs of being involved with a business. Economic costs = explicit costs + implicit costs Economic profit: the excess of a business’s total revenue over its economic costs Accounting profit: the excess of a business’s total revenue over its explicit costs Economic profit = total revenue – economic costs

Accounting Vs. Economic Profit Accounting profit is total revenue minus explicit costs Because accountants only consider explicit costs, accounting profit always exceeds economic profit by the amount of the business’s implicit costs.

T 2, Production in the Short Run (a) some inputs (such as capital) are fixed other inputs (such as labour) are variable Inputs are combined to make a business’s total product Total product: the overall quantity of output produced with a given workforce average product is total product divided by the number of workers marginal product is the extra total product with an additional worker

Average product = total product (q) number of workers (L) Marginal product = change in total product (Δ q) change in workforce (Δ L)

The Law of Diminishing Marginal Returns Short-run production is determined by the law of diminishing marginal returns the law of diminishing marginal returns: At some point, as more units of a variable input are added to a fixed input, the marginal product will start to decrease average product also falls after some point

Relating Average and Marginal Values Average and marginal values are related using three rules if an average value rises then the marginal value must be above the average value if an average value falls then the marginal value must be below the average value if an average value stays constant then the marginal value must equal the average value

Total, Marginal, and Average Products Figure 4.2, Page 89 and Figure 4.3, Page 91 1 2 3 4 5 6 Number of Workers Employed per Day T-Shirts Produced per Day 50 100 150 200 250 300 Labour (L) (workers per day) Total Product (q) (T-shirts Marginal (Δq/ΔL) Average (q/L) 1 2 3 4 5 6 TP 80 200 250 270 280 -- 80 100 83.3 67.5 56 45 80 120 50 20 10 -10 1 2 3 4 5 6 Number of Workers Employed per Day T-Shirts Produced per Day 40 60 80 100 120 -20 20 Diminishing returns set in AP MP

T 3, Costs in the Short Run Short-run costs include Marginal Cost (a) fixed costs (costs of all fixed inputs) variable costs (costs of all variable inputs) total cost (fixed costs + variable costs) Marginal Cost (a) Marginal cost is the extra cost of producing an extra unit of output it equals the change in total cost divided by the change in total product The marginal cost curve is shaped like a “J” because of the law of diminishing marginal returns

Marginal Cost (b) Figure 4.6, Page 93 50 100 150 200 250 300 Quantity of T-Shirts Produced Per Day $ per T-Shirt 2 4 6 8 10 12 MC Diminishing returns set in

Per-Unit Costs Per-unit costs include average fixed cost (fixed costs divided by total product) AFC = FC/Q average variable cost (variable costs divided by total product) AVC = VC/Q average cost either total cost divided by total product or average fixed cost + average variable cost AC= AFC + AVC

Short-Run Costs for Pure ‘n’ Simple T-Shirts Figure 4.5, Page 93 Marginal Product (MP) Labour (L) Total Product (q) Fixed Costs (FC) Variable (VC) Cost (TC) (FC + VC) Marginal (MC) (ΔTC/Δq) Average Fixed Costs (AFV) (FC/q) (AVC) (VC/q) (AC) (AFC + AVC) 1 2 3 4 5 80 200 250 270 280 $825 825 $0 140 300 425 535 640 $825 965 1125 1250 1360 1465 80 120 50 20 10 140 160 125 110 105 $1.75 1.33 2.50 5.50 10.50 $10.31 4.13 3.30 3.06 2.95 $1.75 1.50 1.70 1.98 2.29 $12.06 5.63 5.00 5.04 5.24

The Family of Short-Run Cost Curves Figure 4.7, page 95 12 MC 10 8 $ per T-Shirt 6 AC b 4 AFC 2 AVC a 50 100 150 200 250 300 Quantity of T-Shirts Produced Per Day

T 4, Returns to Scale (a) All inputs can be changed by the same proportion in the long run increasing returns to scale means the % change in output > the % change in inputs constant returns to scale means the % change in output = the % change in inputs decreasing returns to scale means the % change in output < the % change in inputs

Returns to Scale (b) Increasing returns to scale are caused by the division of labour or specialized capital or specialized management (see page 97) Constant returns to scale arise whenever making more of a product means repeating exactly the same tasks Decreasing returns to scale are caused by management difficulties or limited natural resources (see page 98)

Costs in the Long Run (a) Long-run average cost is the minimum short-run average cost at every output The long-run average cost curve is saucer-shaped because of various ranges of returns to scale initial range of increasing returns to scale middle range of constant returns to scale final range of decreasing returns to scale

Costs in the Long Run (b) Figure 4.8, page 99 Quantity of Magazines per Week $ per Magazine Range A Range B Range C Long-Run Average Costs AC1 AC4 Long-Run AC AC2 AC3

Costs in the Long Run (b) Figure 4.9, page 100 Possible Long-Run Average Costs Quantity of Output $ per Unit Extended Range of Increasing Returns to Scale Quantity of Output $ per Unit Extended Range of Constant Returns to Scale Quantity of Output $ per Unit Extended Range of Decrease Returns to Scale