1 Production Costs Economics for Today by Irvin Tucker, 6 th edition ©2009 South-Western College Publishing

2 What is the purpose of this chapter? The purpose of this chapter is to study production and its relationship to various types of costs

3 What economic puzzles will I learn to solve? Why would an accountant say a firm is making a profit and an economists say it’s losing money? What is the difference between the short run and the long run? Why have multiscreen movie theatres replaced single screen theatres?

4 What is a basic assumption in economics? The motivation for business decisions is profit maximization

5 To understand profit, what is necessary? To distinguish between the way economists measure costs and the way accountants measure costs

6 What are explicit costs? Payments to nonowners of a firm for their resources

7 What are implicit costs? The opportunity costs of using resources owned by the firm

8 What is an example of implicit costs? When you invest your nest egg in your own enterprise, you give up earning interest on that money

9 What are total opportunity costs? Explicit costs + Implicit costs

10 What is economic profit? Total revenue minus explicit and implicit costs, or total revenue minus total opportunity costs

11 What is normal profit? The minimum profit necessary to keep a firm in operation

12 What about opportunity cost? A firm that earns normal profits earns total revenue equal to its total opportunity cost

13 How is accounting profit defined? Total revenue minus total explicit costs

14 What conclusion can we make? Since business decision making is based on economic profit, rather than accounting profit, the word profit in this text always means economic profit

15 What is a fixed input? Any resource for which the quantity cannot change during the period of time under consideration

16 What is a variable input? Any resource for which the quantity can change during the period of time under consideration

17 What is the short run? A period of time so short that there is at least one fixed input

18 What is a variable input? Any resource for which the quantity can change during the period of time under consideration

19 What is the long run? A period of time so long that all inputs are variable

20 What is the production function? The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs

21 What do technological advances make possible? More output is possible from a given quantity of inputs

22 What is marginal product? The change in total output produced by adding one unit of a variable input, with all other inputs used held constant

23 What is the law of diminishing returns? The principle that beyond some point the marginal product decreases as additional units of a variable resource are added to a fixed factor

24 What does the law of diminishing returns assume? Fixed inputs; it is therefore a short-run concept

Production Function Total Output Quantity of Labor Total Output

Marginal Product Curve Marginal Product Law of Diminishing Returns Quantity of Labor

27 What is total fixed cost? Costs that do not vary as output varies and that must be paid even if output is zero

28 What is total variable cost? Costs that are zero when output is zero and vary as output varies

29 What is total cost? The sum of total fixed cost and total variable cost at each level of output

30 TC = TFC + TVC

31 What is average fixed cost? Total fixed cost divided by the quantity of output produced

32 AFC = TFC / Q

33 What is average variable cost? Total variable cost divided by the quantity of output produced

34 AVC = TVC / Q

35 What is average total cost? Total cost divided by the quantity of output produced

36 ATC = AFC + AVC = TC/Q

37 What is marginal cost? The change in total cost when one unit of output is produced

38 MC =  TC/  Q =  TVC/  Q

39 $400 $300 $200 $ $500 $600 $700 $ Short-Run Cost Curves TC TVC TFC Cost per unit

40 $40 $30 $20 $ $50 $60 $ Short-Run Cost Curves ATC AVC MC AFC Cost per unit

41 What is the marginal-average rule? When MC < AC, AC falls When MC > AC, AC rises If MC = AC, AC at minimum

42 What is the relationship between slopes of the MC and MP curves? The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa

43 What is the relationship between the minimum and maximum points of the MR and MP curves? The maximum point of the MP curve corresponds to the minimum point of the MC curve

Marginal Product Curve Total Output Quantity of Labor Maximum

45 $40 $30 $20 $ $50 $60 $ Short-Run Cost Curves ATC AVC MC Cost per unit Minimum

46 What is the long-run average cost curve? The curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size

47 $40 $30 $20 $ $50 $60 $ Short and Long-run Average Cost Curves Short-run average total cost curves Long-run average cost curve

48 What are economies of scale? A situation in which the long-run average cost curve declines as the firm increases output

49 What are constant returns to scale? A situation in which the long-run average cost curve does not change as the firm increases output

50 What are diseconomies of scale? A situation in which the long-run average cost curve rises as the firm increases output

51 $40 $30 $20 $ $50 $60 $ Long-run Average Cost Curve Constant returns to scale Economies of scale Diseconomies of scale

52 END