1. 1 Production Costs ©2006 South-Western College Publishing

2. The Firm’s Objective The economic goal of the firm is to maximize profits.

3. A Firm’s Total Revenue and Total Cost uTotal Revenue u The amount that the firm receives for the sale of its output. uTotal Cost u The amount that the firm pays to buy inputs.

4. A Firm’s Profit Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost

5. 5 To understand profit, what is necessary? To distinguish between the way economists measure costs and the way accountants measure costs

6. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. u Explicit costs involve a direct money outlay for factors of production. (Labor and Raw Materials) u Implicit costs do not involve a direct money outlay.

7. 7 What are implicit costs? The opportunity costs of using resources owned by the firm

8. 8 What is an example of implicit costs? When you invest your nest egg in your own enterprise, you give up earning interest on that money

9. Economic Profit versus Accounting Profit Revenue Total opportunity costs How an Economist Views a Firm Explicit costs Economic profit Implicit costs Explicit costs Accounting profit How an Accountant Views a Firm Revenue

10. 10 What are total opportunity costs? Explicit costs + Implicit costs

11. 11 What is economic profit? Total revenue minus total opportunity costs

12. 12 What is normal profit? The minimum profit necessary to keep a firm in operation

13. The Various Measures of Cost Costs of production may be divided into fixed costs and variable costs.

14. Fixed and Variable Costs uFixed costs are those costs that do not vary with the quantity of output produced. uVariable costs are those costs that do change as the firm alters the quantity of output produced.

15. 15 What is the short run? A period of time so short that there is at least one fixed input

16. 16 What is the long run? A period of time so long that all inputs are variable

17. 17 What is total fixed cost? Costs that do not vary as output varies and that must be paid even if output is zero

18. 18 What is total variable cost? Costs that are zero when output is zero and vary as output varies

19. 19 What is total cost? The sum of total fixed cost and total variable cost at each level of output

20. 20 TC = TFC + TVC

21. Average Costs uAverage costs can be determined by dividing the firm’s costs by the quantity of output produced. uThe average cost is the cost of each typical unit of product.

22. 22 AFC = TFC / Q

23. 23 AVC = TVC / Q

24. 24 ATC = AFC + AVC = TC/Q

25. Cost Curves and Their Shapes The average total-cost curve is U-shaped. uAt very low levels of output average total cost is high because fixed cost is spread over only a few units. uAverage total cost declines as output increases. uAverage total cost starts rising because average variable cost rises substantially.

26. 26 What is the long-run average cost curve? The curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size

27. 27 What are economies of scale? A situation in which the long-run average cost curve declines as the firm increases output

28. 28 What are diseconomies of scale? A situation in which the long-run average cost curve rises as the firm increases output

29. Marginal Cost uMarginal cost (MC) measures the amount total cost rises when the firm increases production by one unit.  Marginal cost helps answer the following question: u How much does it cost to produce an additional unit of output?

30. Cost Curves and Their Shapes Marginal cost rises with the amount of output produced. u This reflects the property of diminishing marginal product.

31. Relationship Between Marginal Cost and Average Total Cost The marginal-cost curve crosses the average-total-cost curve at the efficient scale. u Efficient scale is the quantity that minimizes average total cost.