©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 1 Production and Costs Survey of ECON Robert L. Sexton Chapter 6 © ISIFA/GETTY IMAGES ©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

2 Chapter 6 Sections – Firms and Profits: Total Revenues Minus Total Costs – Production in the Short Run – Costs in the Short Run – The Shape of the Short-Run Cost Curves – Cost Curves: Short-Run versus Long-Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 3 Firms and Profits: Total Revenues Minus Total Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 4 Section 1 SECTION 1 QUESTIONS

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 5 A firm’s costs are a key determinant in pricing and production decisions. But what exactly makes up a firm’s cost of production? Let’s begin by looking at the two distinct components of a firm’s total cost: explicit costs and implicit costs. Firms and Profits

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 6 Explicit costs are input costs that require a monetary payment. They are out-of-pocket expenses, such as wages, which are relatively easy to measure by the money spent on the resources used. Explicit Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 7 Implicit Costs Implicit costs do not represent an explicit outlay of money, but they are still real, representing the implicit opportunity costs of alternatives that must be forgone. © ERLEND KVALSVIK/ISTOCKPHOTO.COM

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 8 Implicit Costs: Example Example: A typical farmer or small business owner may perform work without receiving formal wages, but the value of the alternative earnings forgone represents an implicit opportunity cost to the individual.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 9 Whenever we talk about costs  explicit or implicit  we are talking about opportunity costs. Implicit Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 10 Profits Economists generally assume that the ultimate goal of every firm is to maximize profits. In other words, firms try to maximize the difference between what they receive for their goods and services— their total revenue—and what they give up for their inputs—their total costs (explicit and implicit).

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 11 Accounting Profits and Economic Profits ACCOUNTING PROFITS total revenues minus total explicit costs. ECONOMIC PROFITS total revenues minus all explicit and implicit costs.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 12 Exhibit 6.1: Accounting Profits versus Economic Profits

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 13 A Zero Economic Profit is a Normal Profit Economists consider a zero economic profit a normal profit because it means that the firm is covering both implicit and explicit costs—the total opportunity cost of its resources. This is clearly different from making a zero accounting profit, when revenues would not cover the implicit costs.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 14 Sunk Costs SUNK COSTS costs that have already been incurred and cannot be recovered. Sunk costs are irrelevant for any future action.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 15 Section 1

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 16 Production in the Short Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 17 Section 2 SECTION 2 QUESTIONS

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 18 Since it takes more time to vary some inputs than others, we must distinguish between the short run and the long run. The Short Run Versus the Long Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 19 The Short Run versus the Long Run The short run is defined as a period too brief for some inputs to be varied. In the short run, the inputs that do not change with output are called fixed inputs.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 20 The long run is a period of time in which the firm can adjust all inputs. In the long run, all inputs to the firm are variable and will change as output changes. The long run can vary considerably in length from industry to industry. The Short Run versus the Long Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 21 Production in the Short Run Production function is the relationship between the quantity of inputs and the quantity of outputs. Total output (Q) is the total amount of output of a good produced by the firm.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 22 Total output will start at a low level and increase—perhaps rapidly at first, and then more slowly—as the amount of the variable input increases. It will continue to increase until the quantity of the variable input becomes so large in relation to the quantity of others that further increases in output become more and more difficult or even impossible. Production in the Short Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 23 Exhibit 6.2: Moe’s Production Function with One Variable, Labor

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 24 Rising Marginal Product The marginal product (MP) of any single input is defined as the change in total product resulting from a small change in the amount of that input used. Marginal product first rises as the result of more effective use of fixed inputs, and then falls.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 25 Exhibit 6.3: Total Output and Marginal Product

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 26 Exhibit 6.3: Total Output and Marginal Product

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 27 As the amount of a variable input is increased, the amount of other (fixed) inputs being held constant, a point ultimately will be reached beyond which marginal product will decline. Diminishing marginal product stems from the crowding of the fixed input with more and more of the variable input. Diminishing Marginal Product

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 28 A firm never knowingly allows itself to reach the point at which the marginal product becomes negative, the situation in which the use of additional variable input units actually reduces total output. In such a situation, there are so many units of the variable input (inputs with positive opportunity costs) that efficient use of the fixed input units is impaired. Diminishing Marginal Product

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 29 Section 2

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 30 Costs in the Short Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 31 Section 3 SECTION 3 QUESTIONS

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 32 The short-run total costs of a business fall into two distinct categories: –Fixed costs –Variable costs Costs in the Short Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 33 Fixed Costs, Variable Costs, and Total Costs Fixed costs are costs that do not vary with the level of output. –Examples: the rent on buildings or equipment that is fixed for some period of time, as well as insurance premiums and property taxes. Fixed costs have to be paid even if no output is produced. In the short run, fixed costs cannot be avoided.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 34 The sum of the firm’s fixed costs is called its total fixed cost (TFC). Costs that are not fixed are called variable costs. Variable costs vary with the level of output. –Examples: the expenditures on wages and raw materials Fixed Costs, Variable Costs, and Total Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 35 The sum of the firm’s variable costs is called its total variable cost (TVC). The sum of the firm’s total fixed costs and total variable costs is called its total cost (TC). Fixed Costs, Variable Costs, and Total Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 36 Average Total Costs Sometimes we find it convenient to discuss costs on a per-unit-of-output, or average, basis. AVERAGE TOTAL COST (ATC) a per-unit cost of operation; total cost divided by output

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 37 Average fixed cost (AFC) equals total fixed cost divided by the level of output produced. Average variable cost (AVC) equals total variable cost divided by the level of output produced. Average Fixed Cost and Average Total Cost

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 38 Marginal Cost The most important single cost concept is marginal cost. Marginal cost (MC) shows the change in total costs associated with a change in output by one unit, or the costs of producing one more unit of output.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 39 Marginal costs are really just a very useful way to view variable costs (costs that vary as output varies). Marginal costs are the additional, or incremental, costs associated with the “last” unit of output produced. Marginal Cost

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 40 How Are These Costs Related? Exhibit 6.4 summarizes the definitions of the seven different short-run cost concepts. Exhibit 6.5 presents the costs incurred by Pizza Shack at various levels of output.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 Exhibit 6.4: A Summary of the Short-Run Cost Concept

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 42 Exhibit 6.5: Cost Calculations for Pizza Shack Company

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 43 The various cost concepts are illustrated graphically. A total fixed cost (TFC) curve is always a horizontal line because fixed costs are the same at all output levels. The total cost (TC) curve is the summation of the total variable cost (TVC) and total fixed cost (TFC) curves. How Are These Costs Related?

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 44 Because the total fixed cost curve is horizontal, the total cost curve lies above the total variable cost curve by a fixed (vertical) amount. How Are These Costs Related?

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 45 Exhibit 6.6: Total and Fixed Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 46 The average fixed cost (AFC) curve constantly declines, approaching—but never reaching—zero. The marginal cost (MC) curve crosses the average variable cost (AVC) and average total cost (ATC) curves at those curves’ lowest points. How Are These Costs Related?

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 47 At higher output levels, high marginal costs pull up the average variable cost and average total cost curves, while at low output levels, low marginal costs pull the curves down. How Are These Costs Related?

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 48 Exhibit 6.7: Average and Marginal Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 49 Section 3

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 50 The Shape of the Short- Run Cost Curves

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 51 Section 4 SECTION 4 QUESTIONS

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 52 Marginal Costs and Marginal Product The behavior of marginal costs bears a definite relationship to marginal product (MP). For example, the variable input is labor. Initially, as the firm adds more workers, the marginal product of labor tends to rise. © AGE FOOTSTOCK/SUPERSTOCK

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 53 When the marginal product of labor is rising, marginal costs are falling, because each additional worker adds more to the total product than the previous worker. Thus, the increase in total cost resulting from the production of another unit of output—marginal costs—falls. Marginal Costs and Marginal Product

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 54 Exhibit 6.8: Marginal Product and Marginal Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 55 The Relationship Between Marginal and Average Amounts The relationship between the marginal and the average is simply a matter of arithmetic. When a number (the marginal cost) being added into a series is smaller than the previous average, the new average will be lower than the previous one.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 56 When a number (the marginal cost) being added into a series is larger than the previous average, the new average will be higher. The Relationship Between Marginal and Average Amounts

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 57 The average total cost (ATC) curve is usually U ‑ shaped. The average cost per unit declines as output expands, but then starts increasing again as output expands still further beyond a certain point. The U-Shaped Average Total Cost Curve

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 58 The reason for high average total costs when the firm is producing a very small amount of output is the high average fixed costs. It is the declining AFC that is primarily responsible for the falling ATC. The U-Shaped Average Total Cost Curve

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 59 The average total cost curve rises at high levels of output because of diminishing marginal product. Diminishing marginal product sets in at the very bottom of the marginal cost curve. The U-Shaped Average Total Cost Curve

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 60 Diminishing marginal product causes MC to increase, eventually causing the AVC and ATC curves to rise. At very large levels of output, where the plant approaches full capacity, the fixed plant is overutilized, and this leads to a high MC that causes a high ATC. The U-Shaped Average Total Cost Curve

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 61 Exhibit 6.9: U-Shaped Average Total Cost Curve

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 62 Marginal Costs, Average Variable Costs, and Average Total Costs When AVC is falling, MC must be less than AVC. When AVC is rising, MC must be greater than AVC.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 63 MC is equal to AVC at the lowest point on the AVC curve. The same is true for the ATC curve  MC is equal to ATC at the lowest point on the ATC curve. Marginal Costs, Average Variable Costs, and Average Total Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 64 Exhibit 6.10: Marginal Cost and Average Variable Cost

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 65 Exhibit 6.11: Marginal Cost and Average Total Cost

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 66 Section 4

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 67 Cost Curves: Short- Run versus Long-Run

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 68 Section 5 SECTION 5 QUESTIONS

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 69 Cost Curves: Short Run versus Long Run Over long enough time periods, firms can vary all of their productive inputs. However, in the short run a firm cannot alter its plant size and equipment, so the firm can only expand output by employing more variable inputs (e.g., workers and raw materials).

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 70 Why Are Long-Run Cost Curves Different From Short-Run Cost Curves? If a company has to pay many workers overtime wages in order to expand output in the short run, over the long run firms may opt to invest in new equipment to conserve on expensive labor. In the long run, the firm can expand its factories, build new ones, or shut down unproductive ones.

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 71 The time it takes for a firm to get to the long run varies from firm to firm. In Exhibit 6.12, we see that the long-run average total cost (LRATC) curve lies equal to or below the short-run average total cost (SRATC) curves. It presents three short-run average total cost curves, representing small, medium, and large plant sizes. Long-Run Cost Curves versus Short-Run Cost Curves

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 72 Exhibit 6.12: Short- and Long-Run Average Total Costs

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 73 It also shows the long-run average total cost curve. In the short run, the firm is restricted to the current plant size, but in the long run it can choose the short-run cost curve for the level of production it is planning on producing. Long-Run Cost Curves versus Short-Run Cost Curves

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 74 As we move along the LRATC, the factory size changes with the quantity of output. The reason for the difference between the firm’s long-run total cost curve and the short-run total cost curve is that in the long run, costs are lower because firms have greater flexibility in changing inputs that are fixed in the short run. Long-Run Cost Curves versus Short-Run Cost Curves

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 75 Economies of Scale ECONOMIES OF SCALE occur in an output range where LRATC falls as output increases MINIMUM EFFICIENT SCALE the output level where economies of scale are exhausted and constant returns to scale begin

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 76 Economies of Scale (cont.) DISECONOMIES OF SCALE occur in an output range where LRATC rises as output expands CONSTANT RETURNS TO SCALE occur in an output range where LRATC does not change as output varies

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 77 Economies of scale may exist because a firm can use mass production techniques or capture gains from further labor specialization not possible at lower levels of output. Diseconomies of scale may occur as a firm finds it increasingly difficult to handle the complexities of large-scale management. Why Do Economies and Diseconomies of Scale Occur?

©2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 78 Section 5