1. Chapter 8 Production and Cost
Introduction to Economics (Combined Version) 5th Edition

2. Introduction to Economics (Combined Version) 5th Edition
Costs and Profits
Microeconomic theory is based on the assumption that firms are in business to maximize profit.
Profit is the difference between the revenue a firm earns by selling its output and the opportunity costs of producing that output.
Introduction to Economics (Combined Version) 5th Edition

3. Introduction to Economics (Combined Version) 5th Edition
Explicit Costs
Explicit costs are opportunity costs that take the form of explicit payments to suppliers of factors of production and intermediate goods.
Examples:
workers’ wages
managers’ salaries
salespeople’s commissions
interest payments to banks and other creditors
fees for legal advice and other services
payments for energy and raw material
Players’ salaries are an explicit cost for a professional football team.
Introduction to Economics (Combined Version) 5th Edition

4. Introduction to Economics (Combined Version) 5th Edition
Implicit Costs
Implicit costs are opportunity costs of using resources contributed by the firm’s owners (or owned by the firm itself as a legal entity) that are not obtained under contracts calling for explicit payments.
Examples:
Labor of a small-business owner
Opportunity cost of small-business owners’ own savings invested in a business
Opportunity cost of capital invested by corporate shareholders
The opportunity cost of the time of a small-business owner who works without a salary is an example of an implicit cost.
Introduction to Economics (Combined Version) 5th Edition

5. Introduction to Economics (Combined Version) 5th Edition
Normal Profit
Table shows the implicit and explicit costs of the imaginary firm Fieldcom, Inc.
Total revenue minus explicit costs equals accounting profit.
Subtracting implicit costs from this quantity yields pure economic profit.
The opportunity cost of capital contributed by the owners can also be called normal profit.
Total Revenue $600,000 Less explicit costs: Wages and salaries 300,000 Materials and other 100,000 _________ Equals accounting profit $200,000 Less implicit costs: Owners’ forgone salary 160,000 80,000 Opportunity cost of capital 20,000 = pure economic profit $ 20,000
Introduction to Economics (Combined Version) 5th Edition

6. Fixed and Variable Costs
Variable costs: Costs of inputs whose quantities can be changed easily in the short run
Fixed costs: Costs of inputs whose quantities can be changed only in the long run by increasing or decreasing the size of the firm’s plant
Sunk costs: One-time costs which, once made, cannot be recovered if the firm goes out of business
The costs of owning a warehouse are a fixed cost for a trucking firm.
Introduction to Economics (Combined Version) 5th Edition

7. Marginal Physical Product
Marginal physical product of labor is the amount by which total output increases or decreases when the quantity of labor increases by one unit.
Introduction to Economics (Combined Version) 5th Edition

8. Law of Diminishing Returns
According to the law of diminishing returns, as the amount of one variable input is increased while the amounts of all other inputs remain fixed, a point will be reached beyond which the marginal physical product of the input will decrease.
Range of Diminishing Returns
Introduction to Economics (Combined Version) 5th Edition

9. Introduction to Economics (Combined Version) 5th Edition
Marginal Cost
Marginal Cost is the amount by which total variable costs (labor costs, in this example) increase or decrease when the quantity of output increases by one unit.
Introduction to Economics (Combined Version) 5th Edition

10. Introduction to Economics (Combined Version) 5th Edition
Family of Cost Curves
TC = TVC + TFC
ATC = TC/Q
AVC = TVC/Q
AFC = TFC/Q
MC = ΔTC/ ΔQ
Introduction to Economics (Combined Version) 5th Edition

11. Marginal-Average Rule
The marginal cost curve intersects the minimum points of the average total cost and average variable cost curves.
Introduction to Economics (Combined Version) 5th Edition

12. Long- and Short-Run Average Cost Curves
The position of the short-run average total cost curve for a firm depends on the size of the plant. Each plant size can be represented by a U-shaped short-run average total cost curve. The firm’s long-run average cost curve is the “envelope” of these and other possible short-run average total cost curves; that is, it is a smooth curve drawn so that it just touches the short-run curves without intersecting any of them.
Introduction to Economics (Combined Version) 5th Edition

13. Economies and Diseconomies of Scale
In any output range in which long-run average cost decreases as output increases, the firm is said to experience economies of scale.
In any output range in which long-run average cost increases, the firm is said to experience diseconomies of scale.
If there is any range of output for which long-run average cost does not change as output varies, the firm is said to experience constant returns to scale in that range.
Introduction to Economics (Combined Version) 5th Edition

14. Appendix to Chapter Eight
Costs and Output with Two Variable Inputs
Introduction to Economics (Combined Version) 5th Edition

15. Introduction to Economics (Combined Version) 5th Edition
An Isoquant
An isoquantity line, or isoquant shows various ways of producing a given quantity of output.
Here, Points P, Q, and R represent various ways of growing the 200 bushels of corn.
A movement downward along the isoquant represents the substitution of fertilizer for land while output is maintained at 200 bushels per year.
As fertilizer is substituted for land, the isoquant becomes flatter because of diminishing returns.
Introduction to Economics (Combined Version) 5th Edition

16. Least-Cost Method of Production
The price of fertilizer is assumed to be $50 a ton and the rental price of land $50 per year.
A set of budget lines is drawn to represent various levels of spending on inputs.
Line A ($400) does not provide enough inputs to produce 200 bushels.
Line C ($625) provides enough inputs to grow 200 bushels of corn using methods P or R.
Line B ($500) permits the 200 bushels to be grown using method Q, which is the least-cost method given these input prices.
Introduction to Economics (Combined Version) 5th Edition

17. Effect of a Change in Input Price
Assume the price of land increases from $50 to $200 and the price of fertilizer remains fixed at $50 a ton. The $500 budget line shifts from position B to position C and now falls short of the 200-bushel isoquant. Increasing the amount spent on variable inputs to $1,000 shifts the budget line up to position D, where it just touches the isoquant at point R. Total variable cost of 200 bushels increases and fertilizer is be substituted for land, which is now relatively more costly.
Introduction to Economics (Combined Version) 5th Edition

18. From Isoquants to Cost Curve
Part (a) of this figure shows 100, 200, and 300 bushels isoquants.
Budget lines are based on input prices of $50 an acre for land and $50 a ton for fertilizer.
As output expands, the firm will move from T to Q and then to W along the expansion path.
Part (b) of the figure plots the amount of output and the total variable cost for each of these points, giving a total variable cost curve.
Introduction to Economics (Combined Version) 5th Edition