Principles of Economics Session 5

Topics To Be Covered  Categories of Costs  Costs in the Short Run  Costs in the Long Run  Economies of Scope

The Firm’s Objective The economic goal of the firm is to maximize profits.

A Firm’s Profit Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost

Costs as Opportunity Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services.

Opportunity Cost The value of the next best use for an economic good, or the value of the sacrificed alternative.

Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs.  Explicit costs involve a direct money outlay for factors of production.  Implicit costs, also called normal profit, refer to the opportunity cost of using the owner’s own resources.

Economic Profit versus Accounting Profit  Economists measure a firm’s economic profit as total revenue minus all the opportunity costs (explicit and implicit).  Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. In other words, they ignore the implicit costs.

Economic Profit versus Accounting Profit  When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. u Economic profit is smaller than accounting profit.

Economic Profit versus Accounting Profit Revenue Total opportunity costs How an Economist Views a Firm Explicit costs Economic profit Implicit costs Explicit costs Accounting profit How an Accountant Views a Firm Revenue

Total Cost of Production Total cost of production may be divided into fixed costs and variable costs.

Fixed and Variable Costs  Fixed costs are those costs that do not vary with the quantity of output produced.  Variable costs are those costs that do change as the firm alters the quantity of output produced.

Family of Total Costs TC = Total Costs TFC=Total Fixed Costs TVC=Total Variable Costs

 Fixed Cost Cost paid by a firm that is in business regardless of the level of output  Sunk Cost Cost that have been incurred and cannot be recovered e.g. advertising expenditure Fixed Cost vs. Sunk Cost

 Personal Computers: most costs are variable e.g. components, labor  Software: most costs are sunk e.g. cost of developing the software Variable Cost and Sunk Cost

Total Cost Output (Units) Fixed Cost ($) Variable Cost ($) Total Cost ($)

Total Cost Curves Output Cost ($ per year) TVC Variable cost increases with production and the rate varies with increasing & decreasing returns. TC Total cost is the vertical sum of FC and VC. TFC 50 Fixed cost does not vary with output

Average Costs  The average cost is the cost of each typical unit of product.  Average costs can be determined by dividing the firm’s costs by the quantity of output produced.

Family of Average Costs ATC=Average Total Costs AFC=Average Fixed Costs AVC=Average Variable Costs

Family of Average Costs

Average Costs Output (Units) TFC ($) TVC ($) TC ($) AFC ($) AVC ($) ATC ($)

Average Cost Curves Output (units/yr.) Cost ($ per unit) ATC AVC AFC

U-Shaped ATC and AVC Curves  The ATC curve is U-shaped.  At very low levels of output average total cost is high because fixed cost is spread over only a few units.  Average total cost declines as output increases.  Average total cost starts rising because average variable cost rises substantially.  The AVC curve is also U-shaped for its relationship with the ATC curve.

Marginal Cost Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:

Marginal Cost Output (Units) TFC ($) TVC ($) TC ($) AFC ($) AVC ($) ATC ($) MC ($)

Marginal Cost Curve Output (units/yr.) Cost ($ per unit) MC

Cost Curves for a Firm Output (units/yr.) Cost ($ per unit) MC ATC AVC AFC

From TC to AC and MC P Q TFC TVC A TC MC ATC AVC AFC B A' B' AFC= slope of line from origin to a point on TFC AVC = slope of line from origin to a point on TVC ATC = slope of line from origin to a point on TC MC = slope of tangent to a point on TC or TVC P Q

Properties of Cost Curves  AFC falls continuously  When MC < AVC or MC < ATC, AVC and ATC decrease  When MC > AVC or MC > ATC, AVC and ATC increase Output (units/yr.) Cost ($ per unit) MC ATC AVC AFC

Properties of Cost Curves  MC crosses AVC and ATC at the minimums of AVC and ATC, respectively.  Minimum AVC occurs at a lower output than minimum ATC Output (units/yr.) Cost ($ per unit) MC ATC AVC AFC

Costs in the Long Run For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.  In the short run some costs are fixed.  In the long run fixed costs become variable costs.

Costs in the Long Run Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

 If LMC < LAC, LAC will fall  If LMC > LAC, LAC will rise  LMC = LAC at the minimum of LAC Long-Run Average and Marginal Cost

Output Cost ($ per unit of output LAC LMC A

Average Total Cost in the Short and Long Runs Quantity of Cars per Day 0 Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run

 The optimal plant size will depend on the anticipated output.  Firms can change scale to change output in the long-run.  The long-run average cost curve is the envelope of the firm ’ s short-run average cost curves. Long-Run Costs and Returns to Scale

Long-Run Cost with Economies and Diseconomies of Scale Output Cost ($ per unit of output SMC 1 SAC 1 SAC 2 SMC 2 LMC If the output is Q 1 a manager would choose the small plant SAC 1 and SAC $8. $10 Q1Q1 $8 B A LAC SAC 3 SMC 3

Economies and Diseconomies of Scale  Economies of scale occur when long-run average total cost declines as output increases.  Diseconomies of scale occur when long- run average total cost rises as output increases.  Constant returns to scale occur when long-run average total cost does not vary as output increases.

Economies and Diseconomies of Scale Diseconomies of scale Quantity of Cars per Day 0 Average Total Cost ATC in long run Economies of scale Constant Returns to scale

Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output.  Chicken farm — poultry and eggs  Automobile company — cars and trucks  University — Teaching and research Economies of Scope

 Both use similar, relative, and even the same capital and labor.  The firms share management resources.  The production of one good results in the production of another good at little or no extra cost. Advantages of Economies of Scope

C(Q 1 )= cost of producing Q 1 C(Q 2 )=cost of producing Q 2 C(Q 1 Q 2 )=joint cost of producing both products Measuring Degree of Economies of Scope If SC > 0 — Economies of scope If SC < 0 — Diseconomies of scope

 There is no direct relationship between economies of scope and economies of scale.  A firm may experience economies of scope and diseconomies of scale  A firm may have economies of scale and not have economies of scope Economies of Scope vs. Economies of Scale

Assignment  Review Chapter 7  Answer questions on P130  Preview Chapter 8

Thanks