1. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. Understanding Economics 6 th edition by Mark Lovewell

2. Chapter 4 Costs of Production Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

3. Learning Objectives After this chapter you will be able to: 1. identify economic costs (explicit and implicit) of production and economic profit 2. recognize short-run (total, average, and marginal) products, and the law of diminishing marginal returns 3. derive short-run (total, average, and marginal) costs 4. explain long-run results of production (increasing returns to scale, constant returns to scale, and decreasing returns to scale) and long-run costs Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

4. Types of Production There are three main sectors in the economy: the primary sector, which consists of industries that extract or cultivate natural resources the secondary sector, which consists of industries that fabricate or process goods the service sector, which consists of trade and information industries Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

5. Productive Efficiency Businesses can 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. The lowest-cost process provides productive efficiency. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

6. Economic Costs Economic costs include: explicit costs, which are payments to resource supplies outside a business implicit costs, which are what owners give up by being involved in a business Economic profit is found by subtracting economic costs (both explicit and implicit) from total revenue. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

7. Accounting versus Economic Profit Accounting profit is total revenue minus explicit costs. Because accountants consider only explicit costs, accounting profit always exceeds economic profit by the amount of the business’s implicit costs. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

8. Production in the Short Run (a) In the short run: some inputs (such as capital) are fixed other inputs (such as labour) are variable Inputs are combined to make total product. Other product measures include: average product, which is total product divided by the number of workers marginal product, which is the extra total product associated with an additional worker Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

9. The Law of Diminishing Marginal Returns Short-run production is determined by the law of diminishing marginal returns. According to this law: the addition of more variable input causes marginal product to fall after some point average product also falls after some point Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

10. Relating Average and Marginal Values Average and marginal values are related using three rules: If an average value is rising, then the marginal value must be above the average value. If an average value is falling, 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. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

11. Total, Marginal, and Average Products Figure 4.2, Page 95 and Figure 4.3, Page 97 Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. 01234 5 6 Number of Workers Employed per Day T-Shirts Produced per Day 50 100 150 200 250 300 0 123 4 56 Number of Workers Employed per Day T-Shirts Produced per Day 40 60 80 100 120 -20 20 Labour (L) (workers per day) Total Product (q) (T-shirts per day) Marginal Product (Δq/ΔL) (T-shirts per day) Average Product (q/L) (T-shirts per day) 01234560123456 0 80 200 250 270 280 270 -- 80 100 83.3 67.5 56 45 80 120 50 20 10 -10 TP MP AP Diminishing returns set in

12. Costs in the Short Run Short-run costs include: fixed costs (costs of all fixed inputs) variable costs (costs of all variable inputs) total cost (fixed costs + variable costs) Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

13. Marginal Cost (a) Marginal cost is the extra cost of producing another 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. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

14. Marginal Cost (b) Figure 4.6, Page 100 Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. 050100150200 250 300 Quantity of T-Shirts Produced Per Day $ per T-Shirt 2 4 6 8 10 12 MC Diminishing returns set in

15. Per-Unit Costs Per-unit costs include: average fixed cost (fixed costs divided by total product) average variable cost (variable costs divided by total product) average cost either total cost divided by total product or average fixed cost + average variable cost Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

16. Short-Run Costs for Pure ‘n’ Simple T-Shirts Figure 4.5, Page 99 Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. 012345012345 0 80 200 250 270 280 $825 825 $0 140 300 425 535 640 $825 965 1125 1250 1360 1465 $1.75 1.33 2.50 5.50 10.50 140 160 125 110 105 80 120 50 20 10 $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 Labour (L) Total Product (q) Fixed Costs (FC) Variable Costs (VC) Total Cost (TC) (FC + VC) Marginal Cost (MC) (ΔTC/Δq) Average Fixed Costs (AFV) (FC/q) Average Variable Costs (AVC) (VC/q) Average Cost (AC) (AFC + AVC) Marginal Product (MP)

17. The Family of Short-Run Cost Curves Figure 4.7, page 102 Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. 0 50100150200 250 300 Quantity of T-Shirts Produced Per Day $ per T-Shirt 2 4 6 8 10 12 AVC AFC MC AC b a

18. 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. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

19. Returns to Scale (b) Increasing returns to scale are caused by the division of labour, specialized capital, or specialized management. 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. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

20. 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: an initial range of increasing returns to scale a middle range of constant returns to scale a final range of decreasing returns to scale Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

21. Costs in the Long Run (b) Figure 4.8, page 105 Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. Quantity of Magazines per Week $ per Magazine Range ARange BRange C Long-Run Average Costs AC 1 AC 2 AC 3 AC 4 Long-Run AC

22. Costs in the Long Run (b) Figure 4.9, page 107 Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. 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 Long-Run AC

23. Critic of the Modern Corporation John Kenneth Galbraith: suggested that ownership and control are separated in large corporations argued that shareholders (the owners) give up control to managers held out the possibility that managers are more interested in maximizing sales than in maximizing profit Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

24. The Profit Game (OLC) Economists and accountants differ in the way they measure business performance. For accountants, there are two main business records: a balance sheet shows a business’s assets, or items that it owns. It also lists a business’s liabilities, or items that it owes, as well as owner’s equity, which is the owner’s stake in the business Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

25. The Profit Game (OLC) (b) An income statement shows a business’s activities in a given time period, incorporating total sales (or revenue) and total expenses, which are its explicit costs. One important explicit cost is depreciation, or the reduction in the value of a business’s durable assets. For these assets (excluding land), an annual depreciation charge is included in the income statement as an expense. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

26. The Profit Game (OLC) Income Statement Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. Total Sales Expenses Food Fuel Depreciation Interest on loan Total explicit costs Total profit $50 000 $ 15 000 3 500 1 000 500 $20 000 $ 30 000 Income Statement (for the year)

27. The Profit Game (OLC) Calculating Economic Profit Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved. Total Revenue Explicit Costs Food Fuel Depreciation Interest on loan Total explicit costs Implicit Costs Owner’s wage Normal profit Total implicit costs Economic Profit $50 000 $ 15 000 3 500 1 000 500 $20 000 $28 000 $ 2 000 $ 25 000 3 000

28. Markets in Motion (OLC) (a) While bonds are a form of marketable form of interest- bearing debt, stocks provide their holders with the opportunity for dividends and stock price appreciation. Stocks have a book value and market value, which often differ widely. Participants in stock markets look at P/E ratios, which relate a stock’s market price to the company’s latest reported earnings. Stocks with high P/E ratios are considered to be expensive. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

29. Markets in Motion (OLC) (b) The Toronto Stock Exchange (the TSX) is the third largest in North America, behind the New York Stock Exchange (NYSE) and NASDAQ (originally the National Association of Securities Dealers Automated Quotations system). The TSX concentrates on shares of relatively large companies in Canada. All junior equities (i.e. shares of smaller companies) in Canada trade on the TSX Venture Exchange, with headquarters in Calgary, Alberta, and with offices in Toronto, Vancouver, Winnipeg, and Montreal. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

30. Markets in Motion (OLC) (c) All derivatives in Canada trade on the Montreal Exchange. There are two main types of derivatives: Future contracts represent agreements to exchange an underlying at some future time. So-called hedgers and speculators participate in the futures market, the first group in order to protect themselves from changes in the price of the underlying item and the second to make a profit. Price variations in futures markets can be significant. Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

31. Markets in Motion (OLC) (d) Options allow their holders to buy or sell an underlying item during a given time period. There are two types of options. Call options allow the holder to buy, and put options to sell, the underlying item. Both are traded by hedgers and speculators for the same reasons as futures contracts. Option premiums contain two elements: an intrinsic value and a time value Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

32. Chapter 4 The End Copyright © 2012 by McGraw-Hill Ryerson Limited. All rights reserved.