1 Costs of Production

2 COSTS (in Economics) that deal with forgoing the opportunity to produce alternative goods and services. The OPPORTUNITY COST of producing a good is its value or worth in its best alternative use.

3 Explicit costs are those payments a firm must make, or incomes it must provide to resource suppliers to attract these resources away from alternative production opportunities.

4 Examples: payments to hired labor payments to vendors payments for rent or mortgage payments for trucks, etc.

5 Costs of self-owned, self-employed resources Money payments the self-employed resources could have earned in their next best alterative employments. IMPLICIT COSTS

6 Examples:  value lost by investing in business instead of alternative investment  value lost in working for someone else  value lost by not using entrepreneurial skill in another way

7  Amount remaining from revenue less those costs to attract and retain resources in a given line of production.  Minimum return needed by entrepreneur to stay in business  If not realized, entrepreneur will reallocate resources to more attractive pursuits. NORMAL PROFIT

8 Total Revenue minus all Costs Costs will include both explicit and implicit costs Implicit costs will include the normal profit ECONOMIC PROFITS

9 Economic profit is not a cost! … it is a return in excess of the normal profit required to retain the entrepreneur Economic profits = Total revenue —opportunity costs of all inputs ECONOMIC PROFITS

10 ECONOMIC PROFITS Implicit Costs including Normal Profit Explicit Costs ACCOUNTING PROFITS ACCOUNTING COSTS explicit costs only TOTAL REVENUETOTAL REVENUE ECONOMICECONOMIC COSTSCOSTS

11 Gomez runs a small firm which makes pottery. He hires one helper at $12,000 per year, pays annual rent of $5,000 and materials cost $20,000 per year. Gomez has $40,000 of his own funds invested in equipment which could earn $4,000. Gomez has been offered $15,000 to work as a potter for a competitor. He estimates his entrepreneurial skills are worth $3,000 per year. Explicit Costs? Implicit Costs?

12 Explicit costs: $12,000 + $5,000 + $20,000 = $37,000 Implicit Costs: $4,000 + $15,000+ $3,000 = $22,000

13 If Total Revenue is $72,000 If Total Revenue is $72,000 Economic Profits $72,000— $37,000—$22,000 = $13,000 Accounting Profits $72,000— $37,000 = $35,000 Explicit costs: $37,000 Explicit costs:$37,000 Implicit costs:$22,000

14 What is a Fixed Cost? Cost to a firm that does not vary with the quantity of goods produced

15 What are examples of Fixed Costs? rent or mortgagerent or mortgage loan paymentsloan payments certain salariescertain salaries a part of utilitiesa part of utilities property taxesproperty taxes

16 What are some other names for Fixed Cost? Sunk and Historical

17 What is a Variable Cost? Cost that varies with the quantity of goods produced

18 What are examples of Variable Costs? worker’s wagesworker’s wages raw materialsraw materials some utilitiessome utilities

19 Short Run Costs of Production Total costs = Total Fixed costs + Total Variable costs TC = TFC + TVC

20 Total Fixed cost curve Q TFC P/C

21 Total Variable Cost Curve Q TVC 0 P/C

22 Total Costs, Sum of Variable and Fixed Cost Q P/C 0 TVC TFC TC

23 What is Average Fixed Cost? Total fixed cost divided by the quantity of goods produced AFC = TFC/Q AFC = TFC/Q

24 What is Average Variable Cost? Total variable cost divided by the quantity of goods produced AVC = TVC/Q AVC = TVC/Q

25 What is Average Total Cost? Total cost divided by the quantity of goods produced ATC = TC/Q ATC = TC/Q

26 ATC AFC Q P/C AVC

27 ATC AVC Ave. Fixed Costs Q P/C

28 What is Marginal Cost? The change in total cost generated by a change in the quantity of a good produced

29 MC = Q TC = TVC Q So…

30 Q ATC AVC MC Ave. Fixed Costs P/ C

31 Why does MC = ATC at minimum ATC? If the margin is above the average, the average increasesIf the margin is above the average, the average increases If the margin is below the average, the average decreaseIf the margin is below the average, the average decrease