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4 Economic Costs
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4 Economic Costs (Students)

Dec 12, 2015

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Page 1: 4 Economic Costs (Students)

4 Economic Costs

Page 2: 4 Economic Costs (Students)

Production Costs

Total production cost =(i.e. the cost of foregoing the opportunity to produce alternative goods & services).

Total production costs =

Page 3: 4 Economic Costs (Students)

Explicit costs

The monetary payments to outside suppliers for supplying factors of production.

E.g. wages & salaries paid for labor services, cost of raw materials, payments for transport services, etc.

Page 4: 4 Economic Costs (Students)

Implicit costs

The cost of using resources owned within the firm. Usually no outright payments are made.

E.g. depreciation (loss in value of buildings & machinery), entrepreneur’s risk-taking & time, normal profit.

Page 5: 4 Economic Costs (Students)

Normal profit

The minimum profit that a firm must earn to stay in the current production.

Note: Normal profit is included in implicit costs.

Page 6: 4 Economic Costs (Students)

Economic profit

Also known as Pure or Abnormal or Supernormal Profit

Economic Profit ==

(where TR = Price x Quantity sold)

Page 7: 4 Economic Costs (Students)

Accounting profit

Accounting Profit =

Accounting profit > Economic Profit

Page 8: 4 Economic Costs (Students)

Exercise:

Franco’s Pizza produces 100 pizzas a day.Price per pizza = $15Costs of tomatoes & pizza ingredients = $550Cost of electricity & water = $75Depreciation of oven = $50Wages = $250Minimum profit = $200

Q. Calculate Franco’s Pizza’s (i) economic profit, and (ii) accounting profit for a day.

Page 9: 4 Economic Costs (Students)

Exercise:

Page 10: 4 Economic Costs (Students)

The Short-Run

• That time period where certain factors of production can easily be varied to alter production, while some factors cannot.

E.g. To increase production, more labour can be hired, more raw materials can be bought, but cannot build another factory.

• Those factors of production that can easily be changed in quantity to alter output are called ________________.

E.g. labour, raw materials, electricity, water.• Factors of production that cannot be varied to alter output

are called _____________. E.g. heavy machinery, factories, land.

Page 11: 4 Economic Costs (Students)

The Long-Run

• That time period long enough for all factors of production to be varied to alter output.

E.g. More labour can be hired, more factories can be built, more machinery can be installed.

• Therefore, in the long-run, there are __________________, only variable factors.

Page 12: 4 Economic Costs (Students)

Note:Different firms in different markets may not have similar short-run or long-run time periods. The actual time period may be different for different firms.As long as there is at least _______ fixed factor, the firm is operating in the short-run.

Page 13: 4 Economic Costs (Students)

Short-run production

We will look at what happens to output in the S/R when more or less of the variable factor are applied to a given fixed factor.

Assumptions:• Only 2 factors of production are used, i.e. labor (L) &

capital (K).• In the S/R, L is the variable factor, K is the fixed factor.

Page 14: 4 Economic Costs (Students)

Total product (TP)

The ____________________ produced in a given time, using all resources employed.

To increase TP in the S/R, L increases, while K is constant.

Page 15: 4 Economic Costs (Students)

Average product (AP)

The total product per unit of the variable factor. (e.g. output per worker)

AP = (where L is the quantity of labour)

Page 16: 4 Economic Costs (Students)

Marginal product (MP)

The change in TP resulting from a one-unit change in the variable factor. (e.g. the additional output produced by an extra worker)

MP = (where is ‘change in’)

When MP falls, the firm is experiencing diminishing marginal returns/productivity.

Page 17: 4 Economic Costs (Students)

Example:

Assume that K is fixed at 2 units.

Qty of Qty of LL

TPTP APAP MPMP

00 00 -- --

11 1515

22 3434

33 1616

44 1515

55 22

Page 18: 4 Economic Costs (Students)

TP, AP, MP

Qty of labour (L)

Page 19: 4 Economic Costs (Students)

The law of diminishing returns

• states that if increasing quantities of a variable factor are applied to a given fixed factor, there will come a point when an extra unit of the variable factor adds less to TP than the variable factor before it. (i.e. MP of the variable factor falls)e.g. as additional workers are hired to work on a fixed number of machines, there will come a time when an extra worker produces less than the previous worker.

Page 20: 4 Economic Costs (Students)

Short-run production costs

We will look at how costs change as more or less of the variable factor are added to a given fixed factor to alter output.

Page 21: 4 Economic Costs (Students)

Total fixed cost (TFC)

(also called overhead or unavoidable cost)• Cost of using the fixed factors.

E.g. rental, depreciation on buildings & machinery, insurance.

• TFC is __________, i.e. it does not change as output changes.

• Even if output is zero, TFC still has to be paid.

Page 22: 4 Economic Costs (Students)

Total variable cost (TVC)

• Cost of using the variable factors. E.g. wages & salaries, payments for raw materials and electricity.

• TVC __________ as output increases (as more variable factors are hired).

• If output is zero; TVC is ______.

Page 23: 4 Economic Costs (Students)

Total cost (TC)

• Cost of producing a certain level of output.

TC =

If output is zero; TC = _____.

Page 24: 4 Economic Costs (Students)

Total costs for a firm

TC, TFC, TVC

Qty of output (Q)

Page 25: 4 Economic Costs (Students)

Average fixed cost (AFC)

• Fixed cost per unit of output.

AFC = (where Q is quantity of output)

• As output (Q) increases; AFC _____ (i.e. spreading the overheads).

Page 26: 4 Economic Costs (Students)

Average variable cost (AVC)

• Variable cost per unit of output.

AVC =

Page 27: 4 Economic Costs (Students)

Average total cost (ATC or AC)

• Total cost per unit of output.

AC =

Page 28: 4 Economic Costs (Students)

Marginal cost (MC)

• The change in TC resulting from a one-unit change in output. (The additional cost of producing one more unit of output.)

MC =

• When MP falls; MC _________ (diminishing returns).

Page 29: 4 Economic Costs (Students)

Average and marginal costs

Cost per unit

Qty of output (Q)

Page 30: 4 Economic Costs (Students)

Long-run production costs

• In the L/R, there are no fixed factors, therefore no fixed cost, only variable cost.

(Only look at AC, i.e. LRAC, and LRMC).

Page 31: 4 Economic Costs (Students)

OutputO

Co

sts

A typical U-shaped long-run average cost curveA typical U-shaped long-run average cost curve

Page 32: 4 Economic Costs (Students)

A typical bowl-shaped long-run average cost curve

OutputO

Co

sts

Page 33: 4 Economic Costs (Students)

Economies of scale

• Where increasing the scale of production leads to ___________________ (falling LRAC).

Types of economies:• ____________ economies (e.g. larger machinery)• ____________ economies (e.g. lower bank interest rate)• ____________ economies (e.g. advertising & promotions)• ____________ economies (e.g. division of labour)• ____________ economies (e.g. product diversification)

Page 34: 4 Economic Costs (Students)

Diseconomies of scale

• Where LRAC _________ as output expands.

Causes:• Problems of coordination & communication.• Increased monotony falling productivity.• Disruptions in long production lines.

Page 35: 4 Economic Costs (Students)

Long-run average cost curve

OutputO

Co

sts

LRACEconomiesof scale

Constantcosts

Diseconomiesof scale

Page 36: 4 Economic Costs (Students)

Revenue

Total Revenue (TR)= i.e. total sales revenue from selling a certain quantity.

Average Revenue (AR)= i.e. revenue per unit sold.

Marginal Revenue (MR)= i.e. the additional revenue gained from selling one more unit.

Page 37: 4 Economic Costs (Students)

Profit-maximising output level

Total economic profit = The profit-maximising firm will produce at that level of output where (TR-TC) is the greatest, i.e. where MC=MR.

2 approaches:Difference between TR-TC is the greatest.MC=MR.

Page 38: 4 Economic Costs (Students)

Profit-maximising output level

1. Using total curves (TR-TC approach)

– maximising difference between TR and TC

Page 39: 4 Economic Costs (Students)

-8

-6

-4

-2

0

2

4

6

8

10

12

14

16

18

20

22

24

1 2 3 4 5 6 7

TR

, TC

, T

)

T

TR

TC

d

e

f

Quantity

Finding maximum profit using total curves

Profit-maximisingoutput

Page 40: 4 Economic Costs (Students)

Profit-maximising output level

2. Using marginal and average curves (MR-MC approach)

– Profit is maximised where MR = MC.

Firms will produce output where MR>MC right up until MR=MC. Further production of output will leave MR<MC & losses will be made on those units above the MR=MC point.

Page 41: 4 Economic Costs (Students)

-4

0

4

8

12

16

1 2 3 4 5 6 7Quantity

Co

sts

and

rev

enu

e (

£)

e

MR

MC

Profit-maximisingoutput

Finding the profit-maximising output using marginal curves