1. Costs of Production
Microeconomics

2. Economic versus Accounting Costs
Are tangible measurements of what it costs to produce a good or service
EX: Rent, Utilities, Wages
Economic costs
Are the opportunity costs of any resource used to produce a good or service (or the value or worth the resource would have if used in its next best alternative use.

3. Explicit versus Implicit Costs
Explicit Costs
Similar to Accounting Costs
Monetary payments to suppliers of resources = accounting costs
Implicit Costs
Similar to Economic Costs
Opportunity costs of self-owned resources
Money payments of self-employed resources that could have been earned in their next best alternative use = economic costs

4. Self-Owned Resources EXAMPLE You work at a job at a large company
Your salary is $75,000 per year
If you gave up your job to go into business for yourself, your economic costs would equal $75,000.

5. Explicit costs + (Implicit costs + normal profits)
Total Costs
Total costs =
Explicit costs + (Implicit costs + normal profits)
Normal profits are what you would pay yourself (over and above your foregone wages) for your entrepreneurial skills and your entrepreneurial risks.

6. Total Revenue – Explicit Costs =
Accounting Profit
The amount left over from Total Revenue after you subtract EXPLICIT COSTS
Total Revenue – Explicit Costs =
Accounting Profit

7. Total Revenue (TR) – Total Costs (TC) =
Economic Profit
The amount left over from Total Revenue after you subtract Total Cost (explicit costs +implicit costs + normal profits):
Total Revenue (TR) – Total Costs (TC) =
Economic Profits

8. Let’s see if it is a good idea for us to open a music shop
Music Shop Example
Let’s see if it is a good idea for us to open a music shop
We need to calculate our costs, both explicit and implicit.

9. Music Shop Example Total Revenue = $200,000 Explicit Costs
Cost of inventory = $50,000
Payroll = $35,000
Rent = $25,000
Utilities = $5,000
= Total (explicit) costs = $115,000
Accounting profits = $85,000

10. Music Shop Example BUT…
We still need to see if it is worth for us to leave our current job to open this music store.
We need to calculate implicit costs and normal profits too!

11. Music Shop Example Implicit Costs Normal Profit
Foregone wage = $40,000
Foregone interest = $5,000
on the $75,000 investment needed to start the business
Normal Profit
Entrepreneurial income = $10,000
Total (implicit) cost = $55,000

12. Remember! Economic Profits
Total Revenue – Total Costs = Economic Profits
$200,000 – ($115,000 + $55,000) = $30,000
Economic Profits should equal or exceed normal profits for a person to open/start this business
$30,000 > $10,000 (entrepreneurial income/normal profits)

13. Problem Solving Yearly costs One part-time worker = $12,000
Rent = $5,000
Inventory = $20,000
Financial Capital = $4,000 (if invested elsewhere)
Potential salary = $15,000 (if employed elsewhere)
Entrepreneurial talents = $3,000

14. Problem Solving Yearly Revenue $72,000
1. Calculate the accounting profit
2. Calculate the economic profit

15. Short Run Production Terms
Total Production (TP) = Total quantity produced or total output of a good or service
Marginal Product (MP) = Extra output or quantity produced by adding one more unit of a variable resource (EX: labor)
Average Product (AP) = Output per unit of a variable resource (EX: labor)
AP = TP ÷ units of variable labor

16. Short Run Production Terms
Law of Diminishing Returns – As successive units of a variable resource (EX: labor) are added to production, marginal production will decline as each successive unit of the variable resource is added.

17. Short Run Cost Terms Fixed Costs (FC) Variable Costs (VC)
Costs associated with production that do not change regardless of the amount produced
Rent, mortgage, start-up costs, payments on machinery, etc.
Variable Costs (VC)
Costs associated with production that change as the amount produced changes
Labor, raw materials, utilities, etc.

18. Short Run Cost Terms Average Total Costs (ATC)
Total costs divided by the number of units produced (i.e. output or “Q”)
Average Fixed Costs (AFC)
Total fixed costs divided by the number of units produced (i.e. output or “Q”)
Average Variable Costs (AVC)
Total variable costs divided by the number of units produced (i.e. output or “Q”)

19. Short Run Cost Terms
Marginal Cost (MC)
The increase in Total Cost of producing ONE MORE (i.e. “marginal”) unit of a good or service
Or the Change in Total Cost divided by the change in Quantity

20. Short Run Cost Terms Economies of Scale Diseconomies of Scale
As total output increases, average total cost decreases
Diseconomies of Scale
As total output increases, average total cost increases

21. Short Run versus the Long Run
Costs differ in the short run vs. the long run
Firms cannot adjust costs as quickly in the short run
Short run
Plant capacity is fixed
Difficult for businesses to enter or leave the industry
Long run
Plant capacity is variable
Business can leave or enter the industry

22. Short Run and Long Run Adjustments
Short Run adjustment
EX: Hire more workers
Long Run adjustment
EX: Build a new production facility

23. Costs of Production Review

24. Calculate Production Costs
Total Product
Total Fixed Cost
Total Variable Cost
Total
Cost
Avg
Fixed Cost
Avg Variable Cost
Avg Total Cost
Marginal Cost
$60 1 45 2 85 3
120 4
150 5
185 6
225 7
270 8
325 9
390 10
465

25. Graph and Label the Following:
Total fixed cost
Total variable cost
Total cost
Economies and Diseconomies of Scale
Average fixed cost
Average variable cost
Average total cost
Marginal cost