1. Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.
Understanding Economics 3rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson
Chapter 4
Costs of Production
Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

2. Learning Objectives In this chapter you will:
learn about economic costs (explicit and implicit) of production and economic profit
analyze short-run (total, average, and marginal) products, and the law of diminishing marginal returns
derive short-run (total, average, and marginal) costs
examine long-run results of production (increasing returns to scale, constant to scale, and decreasing to scale) and long-run costs

3. T 1, Production,costs, and profit
Define:”business”,”production”,”inputs”,”output”, See page 85.
Types of Production
There are three main sectors in the economy
the primary sector consists of industries that extract or cultivate natural resources
the secondary sector consists of industries that fabricate or process goods
the service sector consists of trade and information industries

4. Productive Efficiency
Productive efficiency: making a given quantity of output at the lowest cost
Businesses choose from different production processes
a labour-intensive process employs more labour and less capital
a capital-intensive process employs more capital and less labour

5. Economic Costs & Economic profit
Economic costs include
explicit costs: payments made by a business to business or people outside of it
implicit costs:the owner’s opportunity costs of being involved with a business.
Economic costs = explicit costs + implicit costs
Economic profit: the excess of a business’s total revenue over its economic costs
Accounting profit: the excess of a business’s total revenue over its explicit costs
Economic profit = total revenue – economic costs

6. Accounting Vs. Economic Profit
Accounting profit is total revenue minus explicit costs
Because accountants only consider explicit costs, accounting profit always exceeds economic profit by the amount of the business’s implicit costs.

7. T 2, Production in the Short Run (a)
some inputs (such as capital) are fixed
other inputs (such as labour) are variable
Inputs are combined to make a business’s total product
Total product: the overall quantity of output produced with a given workforce
average product is total product divided by the number of workers
marginal product is the extra total product with an additional worker

8. Average product = total product (q)
number of workers (L)
Marginal product
= change in total product (Δ q)
change in workforce (Δ L)

9. The Law of Diminishing Marginal Returns
Short-run production is determined by the law of diminishing marginal returns
the law of diminishing marginal returns:
At some point, as more units of a variable input are added to a fixed input, the marginal product will start to decrease
average product also falls after some point

10. Relating Average and Marginal Values
Average and marginal values are related using three rules
if an average value rises then the marginal value must be above the average value
if an average value falls then the marginal value must be below the average value
if an average value stays constant then the marginal value must equal the average value

11. Total, Marginal, and Average Products Figure 4.2, Page 89 and Figure 4.3, Page 911 2 3 4 5 6
Number of Workers Employed per Day
T-Shirts Produced per Day 50
100
150
200
250
300
Labour
(L)
(workers
per day)
Total
Product
(q)
(T-shirts
Marginal
(Δq/ΔL)
Average
(q/L) 1 2 3 4 5 6 TP 80
200
250
270
280 -- 80
100
83.3
67.5 56 45 80
120 50 20 10
-10 1 2 3 4 5 6
Number of Workers Employed per Day
T-Shirts Produced per Day 40 60 80
100
120
-20 20
Diminishing
returns set in AP MP

12. T 3, Costs in the Short Run Short-run costs include Marginal Cost (a)
fixed costs (costs of all fixed inputs)
variable costs (costs of all variable inputs)
total cost (fixed costs + variable costs)
Marginal Cost (a)
Marginal cost is the extra cost of producing an extra unit of output
it equals the change in total cost divided by the change in total product
The marginal cost curve is shaped like a “J” because of the law of diminishing marginal returns

13. Marginal Cost (b) Figure 4.6, Page 9350
100
150
200
250
300
Quantity of T-Shirts Produced Per Day
$ per T-Shirt 2 4 6 8 10 12 MC
Diminishing
returns set in

14. Per-Unit Costs Per-unit costs include
average fixed cost (fixed costs divided by total product)
AFC = FC/Q
average variable cost (variable costs divided by total product)
AVC = VC/Q
average cost
either total cost divided by total product
or average fixed cost + average variable cost
AC= AFC + AVC

15. Short-Run Costs for Pure ‘n’ Simple T-Shirts Figure 4.5, Page 93
Marginal Product (MP)
Labour
(L)
Total
Product
(q)
Fixed
Costs
(FC)
Variable
(VC)
Cost
(TC)
(FC + VC)
Marginal
(MC)
(ΔTC/Δq)
Average
Fixed Costs
(AFV)
(FC/q)
(AVC)
(VC/q)
(AC)
(AFC + AVC) 1 2 3 4 5 80
200
250
270
280
$825
825 $0
140
300
425
535
640
$825
965
1125
1250
1360
1465 80
120 50 20 10
140
160
125
110
105
$1.75
1.33
2.50
5.50
10.50
$10.31
4.13
3.30
3.06
2.95
$1.75
1.50
1.70
1.98
2.29
$12.06
5.63
5.00
5.04
5.24

16. The Family of Short-Run Cost Curves Figure 4.7, page 9512 MC 10 8
$ per T-Shirt 6 AC b 4
AFC 2
AVC a 50
100
150
200
250
300
Quantity of T-Shirts Produced Per Day

17. T 4, Returns to Scale (a)
All inputs can be changed by the same proportion in the long run
increasing returns to scale means the % change in output > the % change in inputs
constant returns to scale means the % change in output = the % change in inputs
decreasing returns to scale means the % change in output < the % change in inputs

18. Returns to Scale (b)
Increasing returns to scale are caused by the division of labour or specialized capital or specialized management (see page 97)
Constant returns to scale arise whenever making more of a product means repeating exactly the same tasks
Decreasing returns to scale are caused by management difficulties or limited natural resources (see page 98)

19. Costs in the Long Run (a)
Long-run average cost is the minimum short-run average cost at every output
The long-run average cost curve is saucer-shaped because of various ranges of returns to scale
initial range of increasing returns to scale
middle range of constant returns to scale
final range of decreasing returns to scale

20. Costs in the Long Run (b) Figure 4.8, page 99
Quantity of Magazines per Week
$ per Magazine
Range A
Range B
Range C
Long-Run Average Costs
AC1
AC4
Long-Run AC
AC2
AC3

21. Costs in the Long Run (b) Figure 4.9, page 100
Possible Long-Run Average Costs
Quantity of Output
$ per Unit
Extended Range of
Increasing Returns
to Scale
Quantity of Output
$ per Unit
Extended Range of
Constant Returns
to Scale
Quantity of Output
$ per Unit
Extended Range of
Decrease Returns
to Scale