Costs Curves Diminishing Returns Accounting Costs Economic Costs Supply

ACCOUNTING COSTS Accounting costs are monetary (usually explicit). Accounting profit = Revenue – Accounting costs.

ECONOMIC COSTS Economic costs = accounting costs + opportunity costs. Economic profit = revenue – economic costs. Economic profit = revenue – (accounting costs + opportunity costs).

ECONOMIC COSTS Economic costs = accounting costs + opportunity costs. In economic analysis we use economic costs. To make a wise decision we need to consider all costs and not only monetary costs. Opportunity costs should be considered as they have an important bearing on our decision making. These include opportunity cost for resources owned by the firm itself.

OPPORTUNITY COSTS Accounting profit Economic profit $$40,000 Bill owns a farm worth $1m. His yearly revenue is $100,000 and his expenses are $60,000. The current interest rate is 5% for savings. What is Bill’s accounting profit and what is his economic profit? Accounting profit $$40,000 Economic profit -($10,000)

OPPORTUNITY COSTS Economic profit Accounting profit -($5000) $20000 Chen runs her own business. She receives no wage or salary. She could work full-time for $25,000pa. Her business revenue for last year was $30,000 and her expenses $10,000. What is her accounting profit and her economic profit? Economic profit -($5000) Accounting profit $20000

OPPORTUNITY COSTS Tao must travel from Wellington to Auckland for business. Tao is paid $20 per hour and he must travel in work time. Prices and times are: Mode Price $ Hours Plane $150 1 Car $100 6 Bus $70 10 Plane is cheapest. If we consider opportunity costs, total cost for plane travel is $170 – much cheaper than the other options. Which is cheapest?

Economic costs in more detail Rent- Economic return to land (return to any factor that is in fixed supply) Wages- Economic return to labour. It includes all ways people a compensated for providing their time, efforts and skills. (except for enterprise) Interest- Economic return on capital. Profit- Economic return to enterprise for taking risk. It is the reward to those who run the risk of failure when they bring together all the other factors of production

Do this Now Last year Mona had a job as a manager for a fishing company, which paid her $65,000 a year, She had $80,000 in savings, which gave her a rate of return of 10%. She thought she could do better by going fishing herself, so gave up her job and invested $80,000 of her own money in buying a fishing boat and quota. By the end of the first year she had sold $140,000 worth of fish and her costs of running the business had been $70,000. She expected the costs to be quite high in the first year, because she was getting the business established, but though these would fall in future years. 1. Calculate her accounting profit 2. Calculate her economic profit 3. Which are always greater? Economic or accounting profits? Explain

Answers! 1. Calculate her accounting profit Revenue - Accounting costs 140,000 – 70,000 = 70,000 2. Calculate her economic profit Revenue – Economic Costs (accounting costs + opportunity costs) 140,000 – 70,000 – 65,000- (80,000 x0.10) = -3000 3. Which are always greater? Economic or accounting profits? Explain Accounting profits are equal to Revenue minus accounting costs. Economic profits are equal to revenue minus accounting costs and opportunity costs. Thus Accounting profits will always be greater than Economic profits due to economic profits taking into account an extra cost, opportunity costs.

Fixed costs are costs that do not vary with output Q FC VC TC 100 1 2 3

Fixed costs are costs that do not vary with output Q FC VC TC 100 1 30 2 50 3 80 Variable costs are costs that increase as output increases

Fixed costs are costs that do not vary with output Q FC VC TC 100 1 30 130 2 50 150 3 80 180 Variable costs are costs that increase as output increases Total costs = Fixed + Variable costs

FC, VC & TC Fixed costs are costs that do not vary with output TC Total costs = Fixed + Variable costs Costs($) VC Variable costs are costs that increase as output increases Quantity

Average and Marginal Cost Output (Q) Total Cost Average Cost Marginal Cost 100 - 1 200 2 320 160 120 3 420 140 4 640 220 5 1100 460 AC = TC/Q

Average and Marginal Cost Output (Q) Total Cost Average Cost Marginal Cost 100 - 1 200 2 320 160 120 3 420 140 4 640 220 5 1100 460 AC = TC/Q MC = TC2 - TC1

Starter Activity Number of people in the group (Workers) Total Product Marginal Product 1 2 3 4 We will assume all groups are equally skilled, so the marginal product is the difference between group one’s total and group two’s total product. Graph the number of workers on the horizontal axis against the number of blocks sorted on the vertical axis. What do you notice?

Short-run costs In economics we distinguish between various time periods - ie short and long run. The short run, which our particular concern, is a period when at least one input to the production process is fixed. This means that in the short run all production will be subject to the law of diminishing return. fig

Diminishing Returns The law of diminishing returns states that where additional units of a variable input are added to a fixed amount of another input, the additional output, or marginal product, will eventually fall.

Diminishing Returns Fixed Input Variable input The additional output(MP) eventually falls Fixed Input Variable input

The Shape of the MC curve Costs($) MC decreases initially because of increasing returns Note: always plot the MC curve at the mid-point! MC increases because of diminishing returns Quantity

The Shape of Average Cost Curves Costs($) FC are constant so AFC will continually decline as FC are spread over increasing output AFC FC Quantity

The Shape of Average Cost Curves Costs($) AC AC decreases because of short run economies: Technical Marketing Managerial Financial AFC Quantity

The Shape of Average Cost Curves Costs($) AC AC increases as short run diseconomies set in. AFC Quantity

The Shape of Average Cost Curves Costs($) AC The difference between AC and AVC is equal to AFC AVC AFC Quantity

Marginal Cost & Average Cost MC Costs($) AC If MC<AC then AC will be decreasing Quantity

Marginal Cost & Average Cost MC Costs($) AC If MC>AC then AC will be increasing Quantity

Marginal Cost & Average Cost MC Costs($) AC MC cuts AC at its minimum point - this is the technical optimum Quantity

Marginal Cost & Average Variable Cost MC Costs($) AC MC also cuts AVC at its minimum point AVC Quantity

Break Even & Shut Down MC AC Costs($) AC A firm must cover AC if it is to break even AVC This is the break even point Break even point is where AR=AC. Where the price is enough to cover all costs and the firms make normal profits. Quantity

Break Even & Shut Down MC AC Costs($) AC In the SR a firm can survive if P > AVC AVC This is the shut down point Quantity

The Supply Curve MC =S AC AVC A firm’s Supply curve is derived from the MC curve above the shut-down point The Supply Curve MC =S Why do you think the supply curve is upwards sloping? Costs($) AC AVC Because of diminishing returns! Producing higher levels of output results in progressively less efficient resource combinations. Because of this the firm will only supply a larger quantity at higher prices. Quantity