The Costs of Production Chapter 8 McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

The Costs ofProduction

Chapter 8

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter Objectives

• Explicit and implicit costs• Law of diminishing returns• Fixed and variable costs• Total, average, and marginal

costs• The firm’s size in the long run

8-2

Economic Costs

• Equal to opportunity costs• Explicit + implicit costs• Explicit costs

–Monetary payments

• Implicit costs–Value of next best use–Self-owned resources–Self-employed resources

8-3

Profit

• Accounting profit–Total revenue less explicit cost

• Normal profit–Equal to implicit cost

• Economic or pure profit–Total revenue less economic cost

8-4

Profits Compared

EconomicProfit

AccountingCosts (Explicit

Costs Only)

AccountingProfit

ExplicitCosts

Implicit Costs(Including a

Normal Profit)

Eco

no

mic

(Op

po

rtu

nit

y)C

ost

s

To

tal

Rev

enu

e

Economic Accounting

8-5

Short and Long Run

• The short run–Fixed plant capacity

–Variable intensity of plant use

–Variable output

• The long run –Variable plant capacity

–Firms enter and exit

8-6

Production Relationships

• Total product (TP)• Marginal product (MP)

• Average product (AP)

Average Product Total Product

Units of Labor=

Marginal ProductChange in Total Product

Change in Labor Input=

8-7

Law of Diminishing Returns

• Fixed technology

• Add variable resource to fixed resource

• Marginal product will decline–Beyond some point

• Rationale

8-8

IncreasingMarginalReturns

Law of Diminishing Returns

(1)Units of the

Variable Resource(Labor)

(2)Total Product

(TP)

(3)Marginal Product

(MP),Change in (2)/Change in (1)

(3)AverageProduct

(AP),(2)/(1)

012345678

01025456070757570

1015201510

50

-5

-10.0012.5015.0015.0014.0012.5010.71 8.75

]]]]]]]]

DiminishingMarginalReturns

NegativeMarginalReturns

8-9

0

10

20

30

To

tal P

rod

uct

, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

gin

al P

rod

uct

, MP

1 2 3 4 5 6 7 8 9

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

Law of Diminishing Returns

8-10

Short-Run Production Costs

• Fixed Costs–Do not vary with output

• Variable Costs–Materials, most labor

• Total Cost–TC = TFC + TVC

8-11

Per-Unit Production Costs

• Average fixed cost AFC = TFC/Q

• Average variable costAVC = TVC/Q

• Average total cost ATC = TC/Q = TFC/Q + TVC/QATC = AFC+AVC

• Marginal costMC = change in TC/change in Q

8-12

Short-Run Production Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

100

200

300

400

500

600

700

800

900

1000

$1100

TFC

TC

TVC

TotalCost

VariableCost

FixedCost

8-13

Short-Run Production Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

8-14

Production Relationships

• Marginal cost and diminishing returns• Marginal cost and marginal product• Marginal cost and average variable

cost• Marginal cost and average total cost• Production curves and cost curves• Shifts in cost curves

8-15

Ave

rag

e P

rod

uct

an

dM

arg

inal

Pro

du

ctC

ost

(D

olla

rs)

Graphical Relationships

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves

8-16

Long-Run Production Costs

• Choose your plant size

• Minimize ATC

• Different ATC curves–Short run

• Long run ATC–Envelope of short run ATC

8-17

Long-Run ATC Curve

Ave

rag

e T

ota

l C

ost

sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

Any number of short-run optimum size cost curves can be constructed

8-18

Long-Run ATC Curve

Long-RunATC

Ave

rag

e T

ota

l C

ost

sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

The long-run ATC curve just“envelopes” the short run ATCs

8-19

Long Run Production Cost

• Economies of Scale–Labor specialization

–Managerial specialization

–Efficient capital

• Diseconomies of Scale

• Constant Returns to Scale

8-20

Long-Run ATC Shapes

Output

Long-run ATC curve where economiesof scale exist

Ave

rag

e T

ota

l C

ost

s

Long-RunATC

EconomiesOf Scale

Constant ReturnsTo Scale

DiseconomiesOf Scale

q1 q2

8-21

Output

Long-run ATC curve where costs arelowest only when large numbers areparticipating

Ave

rag

e T

ota

l C

ost

sEconomies

Of ScaleDiseconomies

Of Scale

Long-RunATC

Long-Run ATC Shapes

8-22

Output

Long-run ATC curve where economiesof scale exist, are exhausted quickly,and turn back up substantially

Ave

rag

e T

ota

l C

ost

s

Long-RunATC

EconomiesOf Scale

DiseconomiesOf Scale

Long-Run ATC Shapes

8-23

Industry Structure

• Minimum efficient scale (MES)• Natural monopoly• Applications and illustrations

–Price of corn–Successful start-up firms–The Verson stamping machine–The daily newspaper–Aircraft and concrete plants

8-24

Sunk Costs

• Irrelevant in decision making• Cannot be recovered• Do not affect marginal

benefit and marginal cost• Firm example:

–R&D costs

8-25

Key Terms

• economic (opportunity) cost

• explicit costs• implicit costs• normal profit• economic profit• short run• long run• total product (TP)• marginal product (MP)• average product (AP)• law of diminishing returns• fixed costs

• variable costs• total cost• average fixed cost (AFC)• average variable cost (AVC)• average total cost (ATC)• marginal cost (MC)• economies of scale• diseconomies of scale• constant returns to scale• minimum efficient scale

(MES)• natural monopoly

8-26

Next Chapter Preview…

PureCompetition

8-27