The Costs of Production Chp: 8 Lecture: 15 & 16

Economic Costs  Equal to opportunity costs  Explicit + implicit costs  Explicit costs  Monetary payments  Implicit costs  Value of next best use  Self-owned resources  Self-employed resources 8-2

Profit  Accounting profit  Total revenue less explicit cost  Normal profit  Equal to implicit cost  Economic or pure profit  Total revenue less economic cost 8-3

Profits Compared Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including Normal Profit) Economic (Opportunity) Costs Total Revenue Economic Accounting 8-4

Short and Long Run  The short run  Fixed plant capacity  Variable intensity of plant use  Variable output  The long run  Variable plant capacity  Firms enter and exit 8-5

Production Relationships  Total product (TP)  Marginal product (MP)  Average product (AP) Average Product Total Product Units of Labor = Marginal Product Change in Total Product Change in Labor Input = 8-6

Law of Diminishing Returns  Fixed technology  Add variable resource to fixed resource  Marginal product will decline  Beyond some point  Rationale 8-7

Increasing Marginal Returns Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 8-8

Total Product, TP Marginal Product, MP TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns 8-9

Short-Run Production Costs  Fixed Costs  Do not vary with output  Variable Costs  Materials, most labor  Total Cost  TC = TFC + TVC 8-10

Per-Unit Production Costs  Average fixed cost AFC = TFC/Q  Average variable cost AVC = TVC/Q  Average total cost ATC = TC/Q = TFC/Q + TVC/Q ATC = AFC+AVC  Marginal cost MC = change in TC/change in Q 8-11

Short-Run Production Costs Costs Q $1100 TFC TC TVC Total Cost Variable Cost Fixed Cost 8-12

Short-Run Production Costs Costs Q $200 AFC MC ATC AVC AFC 8-13

Production Relationships  Marginal cost and diminishing returns  Marginal cost and marginal product  Marginal cost and average variable cost  Marginal cost and average total cost  Production curves and cost curves  Shifts in cost curves 8-14

Average Product and Marginal Product Cost (Dollars) Graphical Relationships MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves 8-15

Long-Run Production Costs  Choose your plant size  Minimize ATC  Different ATC curves  Short run  Long run ATC  Envelope of short run ATC 8-16

Long-Run ATC Curve Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output Any number of short-run optimum size cost curves can be constructed 8-17

Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The long-run ATC curve just “envelopes” the short run ATCs 8-18

Long Run Production Cost  Economies of Scale  Labor specialization  Managerial specialization  Efficient capital  Diseconomies of Scale  Constant Returns to Scale 8-19

Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1q1 q2q2 8-20

Output Long-run ATC curve where costs are lowest only when large numbers are participating Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC Long-Run ATC Shapes 8-21

Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale Long-Run ATC Shapes 8-22