The Costs of Production 22 C H A P T E R The Costs of Production

Costs exist because resources Are scarce Productive Have alternative uses Use of a resource in a specific use implies an economic or opportunity cost

Explicit and implicit costs Explicit costs The monetary payments a firm must make to those who supply it. Implicit costs The opportunity costs of using self-employed resources.

Economic costs The payment the firm must make or income it must provide to attract resources away from alternative production opportunities Normal profit as a cost Implicit costs are a normal profit: Foregone wages Foregone interest Foregone rent Foregone entrepreneurial income

Total revenue – (explicit + implicit costs) Economic profit Economic profit is: Total revenue – economic costs Or Total revenue – (explicit + implicit costs)

Example Hamad is working as a manager for 22000. his entrepreneurial talent worth 5000. He decides to open his own business. He invested his 20000 of savings that earn 1000 The new firm will occupy a store he used to let out for 5000. He hired labor for 18000 Cost of raw materials is 40000 and other utilities is 5000. Total revenue is 120000 Calculate the explicit and implicit costs Calculate the accounting and economic profits.

ECONOMIC COSTS Profits to an Economist Profits to an Accountant L R E V N U Economic Profit Accounting Profit Implicit costs (including a normal profit) Economic (opportunity) Costs Explicit Costs Accounting costs (explicit costs only)

Accounting: Economics: SHORT RUN AND LONG RUN Accounting: Short and long run is based upon annual chronology Economics: Short run has fixed plant capacity size Long run has variable plant capacity size

Total Product (TP) Marginal Product (MP) Average Product (AP) SHORT-RUN PRODUCTION RELATIONSHIPS Total Product (TP) Marginal Product (MP) Marginal Product = Change in Total Product Change in Labor Input Average Product (AP) Average Product = Total Product Units of Labor

Variable resource (labor) Total product Marginal product Average product Comments - 1 10 Increasing marginal returns 2 25 15 12.5 3 45 20 4 60 Diminishing marginal returns 5 70 14 6 75 7 10.71 8 -5 8.75 Negative marginal returns

Law of diminishing marginal returns As successive units of a variable resource are added to a fixed resource, beyond some point, the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline WHY?

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Total Product, TP Increasing Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Total Product, TP Diminishing Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns Total Product Total Product, TP Negative Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

SHORT-RUN PRODUCTION COSTS Fixed Costs Total Fixed Costs Average Fixed Costs = Total Fixed Costs Quantity Variable Costs Total Variable Costs Average Variable Costs = Total Variable Costs Quantity

SHORT-RUN PRODUCTION COSTS Total Cost Total Fixed and Variable Costs Average Total Cost = Total Costs Quantity Marginal Cost Total Variable Costs Marginal Cost = Change in Total Costs Change in Quantity

Total Product Total Fixed Costs Total Variable Costs Total Costs 100 1 90 190 2 170 270 3 240 340 4 300 400 5 370 470 6 450 550 7 540 640 8 650 750 9 780 880 10 930 1030

Average Variable Costs Total Product Average Fixed Costs Average Variable Costs Average Total Costs Marginal Costs 1 100 90 190 2 50 85 135 80 3 33.33 113.33 70 4 25 75 60 5 20 74 94 6 16.67 91.67 7 14.29 77.14 91.43 8 12.50 81.25 93.75 110 9 11.11 86.67 97.78 130 10 93 103 150

SHORT-RUN PRODUCTION COSTS Summary of Definitions Total Fixed Costs = TFC Total Variable Costs = TVC Total Costs = TC Average Fixed Costs = AFC Average Variable Costs = AVC Average Total Costs = ATC Marginal Cost = MC

SHORT-RUN COSTS GRAPHICALLY TC Combining TVC With TFC to get Total Cost TVC Fixed Cost Costs (dollars) Total Cost Variable Cost TFC Quantity

SHORT-RUN COSTS GRAPHICALLY MC Plotting Average and Marginal Costs ATC AVC Costs (dollars) AFC Quantity

PRODUCTIVITY AND COST CURVES Costs (dollars) Average product and marginal product AP MP Quantity of labor Quantity of output MC AVC

LONG-RUN PRODUCTION COSTS For every plant capacity size... There is a short-run ATC curve All such plant capacities can be plotted...

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS The Long-run ATC just “envelopes” all of the short-run ATC curves Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Long-run ATC Output

ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Long-run ATC Output

ECONOMIES AND DISECONOMIES OF SCALE Constant returns to scale Unit Costs Long-run ATC Output

ECONOMIES AND DISECONOMIES OF SCALE Constant returns to scale Diseconomies of scale Unit Costs Long-run ATC Output

Economies of scale Labor specialization: working at fewer tasks workers become efficient in them. Greater labor specialization eliminates the loss of time that accompanies each shift of a worker from one task to another Managerial specialization: small firms can’t use management specialists to best advantages. Large companies can use specialists full time, which means greater efficiency and lower costs

Economies of scale Efficient capital. Large firms can afford the most efficient equipments, these requires high volume of production and large scale producers, e.g., car robots. Other factors: design and development and other startup costs,

Diseconomies of scale The main reason is difficulty of efficiently controlling and coordinating a firms operation when it becomes large.

Constant returns of scale Effect of factors of economies and factors of diseconomies is equal. Minimum efficient size: The lowest level of output at which a firm can minimize long run average costs.

Where extensive economies of scale exist: Natural Monopolies. ECONOMIES AND DISECONOMIES OF SCALE Where extensive economies of scale exist: Natural Monopolies. Unit Costs Long-run ATC Output

Where economies of scale are quickly exhausted ECONOMIES AND DISECONOMIES OF SCALE Where economies of scale are quickly exhausted Unit Costs Long-run ATC Output

KEY TERMS economic (opportunity) cost explicit costs implicit costs normal profit economic profit short run long run total product (TP) marginal product (MP) average product (AP) law of diminishing returns fixed costs variable costs total cost average fixed cost (AFC) average variable cost (AVC) average total cost (ATC) marginal cost (MC) economies of scale diseconomies of scale constant returns to scale minimum efficient scale natural monopoly Copyright McGraw-Hill/Irwin 2002 BACK END