SAYRE | MORRIS Seventh Edition A Firm’s Production Decisions and Costs in the Short Run CHAPTER 6 6-1© 2012 McGraw-Hill Ryerson Limited

Explicit and Implicit Costs Explicit Costs a cost that is actually paid out in money Implicit Costs a cost that does not require an actual expenditure of money 6-2© 2012 McGraw-Hill Ryerson Limited LO1

Explicit and Implicit Costs Profit and Loss Statement 6-3© 2012 McGraw-Hill Ryerson Limited LO1 Total Revenue:Cash sales (excluding sales tax) $ Explicit Costs:Rent $1500 Materials and Supplies 4200 Utilities 1000 Hired labour Depreciation on equipment 500 Total Explicit Costs: Accounting Profit: Implicit Costs:Opportunity costs of $ put into business 800 Labour put in by owners 4000 Total Implicit Costs: Total Explicit and Implicit Costs: Economic Profit or (Loss): (2 000)

Implicit Costs Assume a rate of return of 10% per year: $96,000 x 0.10 = $9,600 per year $9,600 / 12 = $800 per month *They are working for themselves at the new business. If they didn’t they would be able to earn $4,000 elsewhere. *This gives them total implicit costs of $4,800 per month. © McGraw Hill Publishing Co,

Accounting v Economic Profit 6-5© 2012 McGraw-Hill Ryerson Limited LO1 Accounting profit  total revenue  total explicit costs Economic profit  total revenue  total costs (including implicit and explicit costs)

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Accounting v Economic Profit 6-7© 2012 McGraw-Hill Ryerson Limited LO1 Normal Profit the minimum profit that must be earned to keep the entrepreneur in that type of business Economic Profit revenue over and above all costs, including normal profits Sunk Cost the historical costs of an asset that are unrecoverable

Theory of Production 6-8© 2012 McGraw-Hill Ryerson Limited LO2 Short Run any period of time in which at least one input in the production process is fixed Total Product the total output of any productive process

Theory of Production 6-9© 2012 McGraw-Hill Ryerson Limited LO2 Marginal Product the increase in total product as a result of adding one more unit of input Average Product total product (or total output) divided by the quantity of inputs used to produce that total

Theory of Production 6-10© 2012 McGraw-Hill Ryerson Limited LO2 Marginal and Average Product Units of Labour TPMPAP 00—— –513

Theory of Production Law of Diminishing Returns as more of a variable input is added to a fixed input in the production process, the resulting increase in output will, at some point, begin to diminish. Division of Labour Dividing the production process into a series of specialized tasks, each done by a different worker 6-11© 2012 McGraw-Hill Ryerson Limited LO2

Benefits of Division of Labour 1.ability to fit the best person to the right job 2.increased dexterity achieved when one worker focuses on a single operation 3.time savings from not having to change tools 4.time savings gained by not moving from one operation to another 5.machine specialization can be developed around specific, discrete operations 6-12© 2012 McGraw-Hill Ryerson Limited LO2

6-13© 2012 McGraw-Hill Ryerson Limited LO2 Average product will rise if marginal product exceeds it and will fall if marginal product is less than it.

Marginal and Variable Costs 6-14© 2012 McGraw-Hill Ryerson Limited LO3 Production relates the number of units produced to the amount of labour used Costs relate the number of units produced to dollars Costs depend on the level of production, i.e. how many workers and the level of total product

Marginal and Variable Costs Total Variable Cost the total of all costs that vary with the level of output Marginal Cost the increase in total variable costs as a result of producing one more unit of output 6-15© 2012 McGraw-Hill Ryerson Limited LO3

Marginal and Variable Costs Average Variable Cost total variable cost divided by total output 6-16© 2012 McGraw-Hill Ryerson Limited LO3

Cost Data for a Firm 6-17© 2012 McGraw-Hill Ryerson Limited LO3 Units of LabourTPMPAPTVCMCAVC 00//0/ / 1888$100$ —— – ——7.69

MP = TP = 20 – 8 = 12 = 12 L 2 – 1 1 AP = TP = 20 = 10 L 2 MC = TVC = 200 – 100 = 100 = 8.33 output 20 – 8 12 AVC = TVC = 300 = 6.67 output 45 © McGraw Hill Publishing Co,

© McGraw Hill Publishing Col, Variable costs of production are a reflection of productivity

Total and Average Total Costs Total Fixed Costs costs that do not vary with the level of output Average Fixed Cost total fixed cost divided by the quantity of output 6-20© 2012 McGraw-Hill Ryerson Limited LO4

Total and Average Total Costs Total Cost the sum of both total variable cost and total fixed cost Average Total Cost total cost divided by quantity of output 6-21© 2012 McGraw-Hill Ryerson Limited LO4 TC  TVC  TFC

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6-23© 2012 McGraw-Hill Ryerson Limited LO4 Both MC and AVC curves reflect the division of labour as they decline and the law of diminishing returns as they rise. MC is initially below AVC and ATC but then rises above each of these. MC intersects AVC and ATC at their minimum points. AFC continuously declines.

6-24© 2012 McGraw-Hill Ryerson Limited LO4 *Please disregard an incorrect statement made in the lecture on this slide regarding AP being at a maximum when ATC is at a minimum. This is incorrect. The correct statement is that AP is at a maximum when AVC is at a minimum.

6-25© 2012 McGraw-Hill Ryerson Limited LO4

Cutting Costs 6-26© 2012 McGraw-Hill Ryerson Limited LO5 Cutting costs involves a reduction in average costs rather than total costs The firm is assumed to be producing at the lowest possible cost for each output level Costs will decrease if: the price of either fixed or variable inputs decreases the marginal product of a productive process increases a firm is operating at excess capacity, and then increases output

6-27© 2012 McGraw-Hill Ryerson Limited LO5