1. Chapter 6: Production and Costs
economic costs & profits
short run
long run

2. big picture understand behavior of firm understand & measure
production
costs

3. I. economic costs & profits
firm’s goal:
maximize profit
look at factors that affect firm’s decision

4. economic costs opportunity cost of resources used explicit costs
paid in money
wages, rent, material, etc.
implicit costs

5. example: smoothie shop
explicit costs:
wages
interest on loan
rent on store
fruit, blenders

6. implicit costs
forgone interest on funds used to buy capital
owner’s forgone wages
owner’s forgone profit from other venture

7. accounting profit total revenue – explicit costs
ignores opportunity cost

8. economic profit includes opp. costs = total revenue - total costs
= (price)(quantity)
- (explicit + implicit costs)

9. normal profit occurs when amount of accounting profit
= opportunity costs of resources
if earning a normal profit,
economic profit = 0

11. Short Run vs. Long Run Short Run (SR)
time frame where some resources are fixed
-- plants, equipment
some inputs variable
-- labor
SR decisions are reversible

12. Long Run (LR)
time frame where all inputs are variable
--build a bigger plant
LR decisions are hard to reverse
-- cannot easily get rid of capital
-- sunk cost

13. II. SR Production measures of output total product marginal product
average product

14. total product (TP) total quantity of good produced in a given period
at first, increases with labor,
then falls

15. TP: gal. of smoothies per hour
# workers TP 1 2 3 4 5 6 7 1 3 6 8 9

16. TP
5 6 9
# workers

17. marginal product (MP) change in TP due to one more worker change in TP=
change in labor

18. At first MP rises with workers
add more workers
greater specialization
MP of each worker added is larger
than previous worker
increasing marginal returns

19. then, MP falls with more workers
keep adding workers
but same amount of capital
so eventually get in the way
MP of more workers smaller than
MP of previous workers
decreasing marginal returns

20. TP, MP: gal. of smoothies 1 2 3 4 5 6 7 1 3 6 8 9 # workers TP MP 1 21 2 3 4 5 6 7 1 3 6 8 9 1 2 3 2 1 -1

21. MP 3
Q = # workers

22. law of decreasing returns
As firm uses more labor
with capital fixed,
MP of labor will eventually fall

23. Average Product (AP) TP =
labor
= productivity

24. AP
# workers TP MP 1 2 3 4 5 6 7 1 3 6 8 9 1 2 3 -1 1
1.5 2
1.8
1.1

25. MP 3 AP
# workers

26. MP & AP MP intersects AP at max of AP why? MP > AP AP is rising
AP is falling

27. III. SR cost measure cost 3 ways: total cost marginal cost
average cost

28. Total Cost (TC) cost of all factors used total fixed cost (TFC)
cost of land, capital, etc.
does not change in SR
total variable cost (TVC)
cost of labor
changes in SR
TC = TFC + TVC

29. example : yogurt
labor = $6/ hour
TFC = $10/ hour

30. workers TP
TFC
TVC TC 4 5 8 9 10 24 30 34 40

31. Q = output TC TC
TVC
TFC 10

32. Marginal Cost change in TC due to one-unit increase in output (Q)=
change in Q

33. TP
TFC
TVC TC MC 6
3.6
2.4 8 9 10 24 30 34 40 6

34. Average Cost (ATC) = TC/Q average fixed cost (AFC) (TFC/Q)
average variable cost (AVC)
(TVC/Q)
ATC = AFC + AVC

35. TP
TFC
TVC TC
AFC AVC AC 8 9 10 24 30 34 40

36. Q = output
AC, MC
AFC
ATC
AVC MC

37. MC & AC MC intersects AC at its minimum MC < AC AC is falling
AC is rising

38. AC is U-shaped why? AFC falls with Q AVC falls then rises
decreasing marginal returns
so ATC falls, then rises

39. cost & product curves when MP is at maximum, MC is at minimum
when AP is at maximum,
AVC is at minimum

40. what shifts cost curves?
technology
make more with same inputs
shifts TP, MP, AP up
changes ATC curve

41. changes in factor prices
increase fixed costs
-- TFC, AFC shift up
-- TC shift up
increase wages (variable)
-- TVC, AVC, MC shift up

42. IV. LR costs all inputs (and costs) are variable
what happens if increase plant
AND labor by 10%?
ATC fall?
ATC rise?
ATC stay same?

43. Economies of scale increase inputs 10% output increase > 10%
ATC falls
why?
gains from specialization
-- labor
-- capital

44. Diseconomies of scale increase inputs 10% output increase < 10%
ATC rises
why?
too hard to control large firm

45. Constant returns to scale
increase inputs 10%
output increase = 10%
ATC stays same

46. LR Average Cost (LRAC)
lowest average cost when all inputs are variable
SRAC curves from different plant sizes

47. Q = output AC
ATC1
ATC2
ATC3
ATC4
LRAC

48. Q = output AC
ATC1
ATC2
ATC3
ATC4
diseconomies
of scale
economies
of scale
constant
returns to
scale

49. summary: costs = implicit + explicit SR, only labor variable
LR, all inputs variable
Production & costs
total, marginal, average
fixed, variable