A firm’s actual cash payments for its inputs IMPLICIT COSTS Opportunity costs of non-purchased inputs such as the entrepreneur’s time and money.Opportunity costs of non-purchased inputs such as the entrepreneur’s time and money. –opportunity cost of something is what you sacrifice to get it. Opportunity cost of the entrepreneur’s time:Opportunity cost of the entrepreneur’s time: Time given up to operate a firm; Time given up to operate a firm; Opportunity cost of funds:Opportunity cost of funds: Money given up to set up and run a business. Money given up to set up and run a business. EXPLICIT COSTS

Economic Cost The sum of explicit and implicit costs.The sum of explicit and implicit costs. The economic cost is higher because the economist includes implicit costs but the accountant does not.The economic cost is higher because the economist includes implicit costs but the accountant does not.

Accounting versus Economic Cost Explicit Cost (Purchased Inputs)$60,000$60,000 Implicit Cost (Opportunity cost of $30,000 entrepreneur) (Opportunity cost of$10,000 funds) Total Cost$60,000$100,000 AccountingEconomic AccountingEconomic ApproachApproach ApproachApproach

SHORT RUNSHORT RUN A period of time over which at least one input to production is fixed. For most firms, the fixed input is capital: firm cannot modify production facility or build a new facility. A period of time over which at least one input to production is fixed. For most firms, the fixed input is capital: firm cannot modify production facility or build a new facility. LONG RUNLONG RUN A period of time over which a firm is perfectly flexible in its choice of inputs. A period of time over which a firm is perfectly flexible in its choice of inputs. In the long run, a firm can build a new production facility (factory,store, office or restaurant) or modify an existing facility, hire a workforce, and buy raw materials. In the long run, a firm can build a new production facility (factory,store, office or restaurant) or modify an existing facility, hire a workforce, and buy raw materials. TIME PERIODS

Time Period Decisions Short RunShort Run How much output to produce; How much output to produce; Long RunLong Run What type of production facility to build; What type of production facility to build;

Principle of Diminishing Returns Suppose an output is produced with two or more inputs, and we increase one input while holding the other inputs fixed. Beyond some point -- called the point of diminishing returns -- output will increase at a decreasing rate.Suppose an output is produced with two or more inputs, and we increase one input while holding the other inputs fixed. Beyond some point -- called the point of diminishing returns -- output will increase at a decreasing rate.

Computer Chip Manufacturing As firm packs more and more workers into factory, total output increases, but at a decreasing rate.As firm packs more and more workers into factory, total output increases, but at a decreasing rate flipping this around As the firm steadily increases its output, the firm requires more and more workers to increase its output by a single chip.As the firm steadily increases its output, the firm requires more and more workers to increase its output by a single chip.

Diminishing Returns and Increasing Marginal Cost For One More Chip Quantity of Additional Additional Additional MarginalChips Labor Time Labor Cost Material CostCost For One More Chip Quantity of Additional Additional Additional MarginalChips Labor Time Labor Cost Material CostCost Small: 1002 hours$16$10 $26 Medium: 3006 hours$48$10 $58 Large: 40010hours$80$10 $90

Short-Run Marginal Cost The change in total cost resulting from a one-unit increase in the output of an existing production facility. The change in total cost resulting from a one-unit increase in the output of an existing production facility.

Short-Run Marginal and Average Cost Curves t e f m s short-run average total cost curve (SATC) short-run marginal cost curve (SMC) Marginal or Average Cost $$$ Quantity of Chips produced per hour QUANTITY SMC SATC

Short-Run Average Total Cost (SATC) Equals the total cost divided by the quantity of output, or the cost per unit output.Equals the total cost divided by the quantity of output, or the cost per unit output. Total cost is the sum of the fixed cost per chip, the labor cost per chip, and the material cost per chip.Total cost is the sum of the fixed cost per chip, the labor cost per chip, and the material cost per chip. U-shaped.U-shaped.

Short-Run Average Total Cost QUANTITY OF CHIPS QUANTITY OF CHIPS SMALL MEDIUM LARGE SMALL MEDIUM LARGE Number of Chips Fixed Cost / Chip($) Labor Hours ,000 Labor Cost ($) 800 7,20016,000 Labor Cost / Chip ($) Material Cost / Chip ($) Total Cost / Chip ($)

Short-Run Average Total Cost QUANTITY OF CHIPS QUANTITY OF CHIPS SMALL MEDIUM LARGE SMALL MEDIUM LARGE Number of Chips Fixed Cost ($) 7,200 7,2007,200 Fixed Cost / Chip($) Labor Hours ,000 Labor Cost ($) 800 7,20016,000 Labor Cost / Chip ($) Material Cost ($) 1,000 3,0004,000 Material Cost / Chip ($) Total Cost ($) 9,000 17,400 27,200 Total Cost / Chip ($)

Average Costs As production increases:As production increases: Fixed cost per chip decreases from $72 to $24 to $18; Fixed cost per chip decreases from $72 to $24 to $18; Labor cost per chip increases from $8 to $24 to $40; Labor cost per chip increases from $8 to $24 to $40; Material cost per chip doesn’t change $10. Material cost per chip doesn’t change $10. Cost is lowest ($58) at the medium level of production.Cost is lowest ($58) at the medium level of production.

Marginal & Average-Total Cost Relationship Short-run average total cost is at its minimum value where average total cost and marginal cost are equal. Average total cost slope = 0.Short-run average total cost is at its minimum value where average total cost and marginal cost are equal. Average total cost slope = 0. If marginal cost is less than average total cost, average total cost is decreasing -- has a negative slope.If marginal cost is less than average total cost, average total cost is decreasing -- has a negative slope. If marginal cost is greater than average total cost, average total cost is increasing -- has a positive slope.If marginal cost is greater than average total cost, average total cost is increasing -- has a positive slope.

Quantity SATC SAVC AFC SHORT-RUN AVERAGE COST CURVES Average cost per chip ($) t u m v p n f g h Short-runaverage total cost (SATC) Short-runaverage variable cost (SAVC) Average Fixed Cost Quantity of Chips per Hour SATC = SAVC + AFC

LONG-RUN AVERAGE COST Total cost divided by the quantity of output when the firm can choose a production facility of any sizeTotal cost divided by the quantity of output when the firm can choose a production facility of any size The long-run average cost curve is L-shaped, initially the result of economies of scale.The long-run average cost curve is L-shaped, initially the result of economies of scale.

Economies of Scale Cost saving associated with scaling up -- adding more capital, labor and materials to produce more output may be caused by either of two effects: Cost saving associated with scaling up -- adding more capital, labor and materials to produce more output may be caused by either of two effects: Indivisible inputs; Indivisible inputs; Specialization Specialization

b c d e f LONG-RUN AVERAGE COST CURVE FOR ALUMINUM PRODUCTION FOR ALUMINUM PRODUCTION Long-run average cost curve Average cost $ per pound Millions of Pounds of Aluminum per year

Indivisible Inputs Inputs which cannot be scaled down to produce a small quantity of output. Examples: Inputs which cannot be scaled down to produce a small quantity of output. Examples: Railroad track between two cities cannot be scaled from two to one track.Railroad track between two cities cannot be scaled from two to one track. An industrial mold must be complete to produce many copies or a single copy.An industrial mold must be complete to produce many copies or a single copy.

Specialization In a small operation with just a few workers, each performs a wide variety of tasks.In a small operation with just a few workers, each performs a wide variety of tasks. In a large operation with many workers, each worker specializes in one or two tasks, and is more productive because:In a large operation with many workers, each worker specializes in one or two tasks, and is more productive because: Repetition increases productivity; Repetition increases productivity; Workers spend less time switching from task to task. Workers spend less time switching from task to task.

Minimum Efficient Scale The output at which the long- run average cost curve becomes horizontal. The output at which the long- run average cost curve becomes horizontal.

INDUSTRIES EXPERIENCING MINIMUM EFFICIENT SCALE INDUSTRYMINIMUM EFFICIENT SCALE British Sulfuric Acid 1 million tons British Sulfuric Acid 1 million tons British Steel 9 million tons U.S. Automobiles 200,000 to 400,000 per year Large U.S. Breweries 4.5 million barrels

DISECONOMIES OF SCALE Increase in output leads to increases in the average cost of production: higher costs accompany scaling up.Increase in output leads to increases in the average cost of production: higher costs accompany scaling up. Diseconomies may occur for two reasons:Diseconomies may occur for two reasons: Coordination problems; Coordination problems; Increasing input costs. Increasing input costs.

Coordination Problems Large organizations require several layers of management (a bureaucracy) to coordinate the activities of the different parts of the organization. This leads to a positively sloped average-cost curve.Large organizations require several layers of management (a bureaucracy) to coordinate the activities of the different parts of the organization. This leads to a positively sloped average-cost curve.

Increasing Input Costs As a firm increases its output, it will demand more of each of its inputs, which may lead to higher prices for some inputs.As a firm increases its output, it will demand more of each of its inputs, which may lead to higher prices for some inputs. Higher prices increases the average cost of production, resulting in a positively sloped average-cost curve.Higher prices increases the average cost of production, resulting in a positively sloped average-cost curve.

FOUR TYPES OF MARKETS Perfect Competition ---Perfect Competition --- A market with a very large number of firms, each of which produces the same standardized product and takes the market price as given. A market with a very large number of firms, each of which produces the same standardized product and takes the market price as given. A price-taking firm. A price-taking firm.

FOUR TYPES OF MARKETS Perfect CompetitionPerfect CompetitionEXAMPLES The wheat farmer, The wheat farmer, The average stock investor The average stock investor

FOUR TYPES OF MARKETS Monopolistic Competition ---Monopolistic Competition --- There are many firms, each sells a differentiated product. Because products sold by different firms are not perfect substitutes, each firm has some control over price. There are no barriers to entering the market. There are many firms, each sells a differentiated product. Because products sold by different firms are not perfect substitutes, each firm has some control over price. There are no barriers to entering the market.

FOUR TYPES OF MARKETS Monopolistic competition ---Monopolistic competition ---EXAMPLES restaurants, restaurants, retail stores, retail stores, gas stations, gas stations, clothing clothing

FOUR TYPES OF MARKETS Oligopoly --- There are just a few firms in the market, a result of two sorts of barriers to entry:Oligopoly --- There are just a few firms in the market, a result of two sorts of barriers to entry: economies of scale, economies of scale, government may limit number of firms in the market government may limit number of firms in the market

FOUR TYPES OF MARKETS OligopolyOligopolyEXAMPLES automobiles, automobiles, airline travel, airline travel, breakfast cereals breakfast cereals

FOUR TYPES OF MARKETS Monopoly ---Monopoly --- A single firm serves the entire market. A monopoly occurs when the barriers to entry are very strong, which could result from very large economies of scale or a government limit on the number of firms. A single firm serves the entire market. A monopoly occurs when the barriers to entry are very strong, which could result from very large economies of scale or a government limit on the number of firms.

FOUR TYPES OF MARKETS Monopoly ---Monopoly ---EXAMPLES large scale economies: local phone service, local phone service, electric power generation, electric power generation, established by government policy: drugs covered by patents, drugs covered by patents, concessions in National Parks concessions in National Parks

Characteristics of Different Types of Markets Perfect MonopolisticOligopolyMonopoly Competition Competition Perfect MonopolisticOligopolyMonopoly Competition Competition Number very large many few one of firms Type of standardized differentiatedstd or diff. unique product Control none slightconsiderable considerable over priceif not regulated Entry no barriers no barrierslargelarge conditionsbarriersbarriers Examples wheat restaurantsautomobileslocal phone soybeans retail storesair traveland electric clothingbreakfast patented cerealdrugs

TOTAL REVENUE The money the firm gets from selling its product and is equal to price times quantity sold:The money the firm gets from selling its product and is equal to price times quantity sold: Total Revenue = price * quantity

ECONOMIC PROFIT Total revenue - total economic cost Total economic cost Total economic cost = explicit costs ( firm’s actual cash payments for inputs ) ( firm’s actual cash payments for inputs ) + implicit costs + implicit costs ( opportunity costs of non-purchased inputs, such as entrepreneur’s time or money ) ( opportunity costs of non-purchased inputs, such as entrepreneur’s time or money )