1. Businesses and the Cost of Production
Chapter 9
This chapter develops a number of crucial cost concepts that will be employed in the succeeding three chapters to analyze the four basic market models. A firm’s implicit and explicit costs are explained for both short and long run periods. The explanation of short run costs includes arithmetic and graphic analyses of both the total, average, and marginal-cost concepts. These concepts prepare students for both the total-revenue minus total-cost and marginal-revenue = marginal-cost approaches to profit maximization, which are presented in the next few chapters.
The law of diminishing returns is explained as an essential concept for understanding average and marginal cost curves. The general shape of each cost curve and the relationship they bear to one another are analyzed with special care.
The final part of the chapter develops the long run average cost curve and analyzes the characteristics and factors involved in economies and diseconomies of scale. In the Last Word, there is a discussion about 3-D printers, a new technology that may revolutionize manufacturing.
Businesses and the Cost of Production
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2. Economic Costs
The payment that must be made to obtain and retain the services of a resource
Explicit costs
Monetary outlay
Implicit costs
Opportunity cost of using self-owned resources
Value of next-best use
Includes a normal profit
Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those resources away from their best alternative production opportunities. Payments may be explicit or implicit. (Recall the opportunity-cost concept)
Explicit costs are payments to non-owners for resources they supply. In the textbook’s T-shirt example, this would include the cost of the T-shirts, clerk’s salary, and utilities, for a total of $63,000.
Implicit costs are the money payments the self‑employed resources could have earned in their best alternative employment. In the textbook’s T-shirt example, this would include forgone interest, forgone rent, forgone wages, and forgone entrepreneurial income, for a total of $33,000.
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3. Accounting Profit and Normal Profit
= Total revenue – explicit costs
Economic profit
= Accounting profit – implicit costs
Economic profit (to summarize)
= Revenue – economic cost
= Revenue – explicit costs – implicit costs
Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit). Economic profit will always be smaller than an accounting profit, which excludes implicit costs. The normal profit is the return to the entrepreneur and is the amount of money required by the entrepreneur to stay in that market.
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4. Short Run and Long Run Short run Some variable inputs Fixed plant
All inputs are variable
Firms can adjust plant size as well as enter and exit industry
The short run is a period of time that is too brief for a firm to alter its plant capacity, but can change output somewhat by increasing or decreasing its variable inputs. The long run is a period of time that is long enough for the firm to adjust the plant size as well as enter or leave the industry. All inputs are variable in the long run. One of the primary characteristics of the long run is that it is enough time for firms to enter and exit the industry. Notice that the actual time associated with the short and long run will differ among industries. Light industry and retailing (small t-shirt manufacturer) can adjust quickly compared to heavy industry (an oil company) which may take years to change capacity.
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5. Short Run Production Relationships
Total product (TP)
Marginal product (MP)
Average product (AP)
Marginal product
change in total product
change in labor input =
The production relationships reflect how labor and output are related in the short run. The total product is the total quantity that is produced. Marginal product (MP) is the amount that total product changes when labor changes by one unit. It reflects the change in output when one more unit of labor is hired. Average product is the output that is produced per unit of labor.
Average product
total product
units of labor =
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6. Law of Diminishing Returns
Resources are of equal quality
Technology is fixed
Variable resources are added to fixed resources
At some point, marginal product will fall
Rationale
As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will decrease. Essentially the fixed plant gets overcrowded with variable resources. If we focus on labor being the variable resource, when there isn’t any labor, then the plant is underused because none of the machinery is being used, etc. When hiring one unit of labor, the machinery is still underused – there is machinery that is often idle as that one unit of labor has to perform all of the tasks. As the firm continues to hire more and more labor, the TP is rising by increasing amounts because the machinery is being used more and more to its capacity. However, at some point there will be so much labor that the fixed resources are overutilized and the individuals will have to wait to use the necessary equipment. This is where we might see diminishing marginal returns – where the TP is still increasing when hiring one more unit of labor, but it doesn’t increase as much as it did with the previous unit of labor.
The table on the next slide presents a numerical example of the law of diminishing returns.
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7. Short Run Production Costs
Fixed costs (TFC)
Costs that do not vary with output
Variable costs (TVC)
Costs that do vary with output
Total cost (TC)
Sum of TFC and TVC
TC = TFC + TVC
Fixed, variable and total costs are the short‑run classifications of costs. In the short run, costs can be variable or fixed. Fixed cost examples: rental payments, insurance premiums, interest payments. Variable cost examples: payments for materials, fuel, power, transportation services, labor. Total cost is the sum of total fixed and total variable costs at each level of output.
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8. Per-Unit, or Average, Costs
Average fixed cost AFC = TFC/Q
Average variable cost AVC = TVC/Q
Average total cost ATC = TC/Q
Marginal cost MC = ΔTC/ΔQ
These per-unit costs are useful in making comparisons to price. Average fixed costs reflect the fixed costs per unit produced whereas the average variable costs reflect the variable costs per unit produced. The average total costs can also be found by adding the AFC and AVC. Marginal costs play an extremely important role in the firm’s decision-making about how much they will produce. Marginal costs reflect the additional cost associated with producing one more unit of output. MC tells a firm how much it will cost to increase output by 1 more unit. Marginal cost essentially measures the rate of the change of the total costs.
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9. Long Run Production Costs
The firm can change all input amounts, including plant size
All costs are variable in the long run
Long run ATC
Different short run ATCs
An industry and the individual firms that are in it can make all desired resource adjustments in the long run. All resources are variable, therefore all costs are variable in this time period.
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10. Economies of Scale Economies of scale Labor specialization
Managerial specialization
Efficient capital
Other factors
Constant returns to scale
Economies of scale refers to the idea that, for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there are economies of scale will lead to a more than proportionate increase in output. Labor specialization leads to economies of scale because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. Managerial Specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can specialize in their respective area of expertise. Efficient Capital leads to economies of scale because high volume production warrants the expensive large scale equipment. Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities.
Constant returns to scale will occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output.
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11. Diseconomies of Scale Diseconomies of scale
Control and coordination problems
Communication problems
Worker alienation
Shirking
Diseconomies of scale may occur if a firm becomes too large, as illustrated by the rising part of the long run ATC curve. As the firm expands over time, the expansion may lead to higher average total costs. With diseconomies of scale, an increase in inputs will cause a less than proportionate increase in output.
Reasons that diseconomies of scale may occur: 1) difficulty in controlling and coordinating large scale operations, 2) a large bureaucracy leads to communication problems, 3) workers may feel alienated and therefore may not work efficiently and 4) shirking, or work avoidance, may be easier in a larger firm.
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12. MES and Industry Structure
Minimum efficient scale (MES)
Lowest level of output at which long run average costs are minimized
Can determine the structure of the industry
Natural monopoly
Long run costs are minimized when one firm produces the product
Where MES occurs on an industry’s long-run ATC determines if there will be many or few producers and whether they will be large, small, or different sizes. A natural monopoly is a rare situation where economies of scale extend beyond the market size. Therefore, one large firm can provide the product more cheaply than a multi-firm market.
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