Businesses and the Costs of Production 9 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic Costs The payment that must be made to obtain and retain the services of a resource Explicit Costs Monetary payments, often uses check Implicit Costs Value of next best use What the firm gives up Includes normal profit LO1

Economic Costs Normal profit Minimum payment required to remain engaged in current enterprise. Economic profit means firm is earning a normal profit. LO1

Accounting Profit and Normal Profit Accounting profit = Revenue – Explicit Costs Economic profit = Revenue – Explicit - Implicit Costs LO1

Short Run and Long Run Short Run Some variable inputs Fixed plant Long Run All inputs are variable Variable plant Firms enter and exit LO1

Short-Run Production Relationships Total Product (TP) Marginal Product (MP) Average Product (AP) LO2 Marginal Product Change in Total Product Change in Labor Input = Average Product Total Product Units of Labor =

Law of Diminishing Marginal Returns Resources are of equal quality Technology fixed Variable resources are added to fixed resources At some point, marginal product will fall LO2

The Law of Diminishing Returns LO2 Table 7.1 Total, Marginal, and Average Product: The 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) (4) Average Product (AP), (2)/(1) Increasing marginal returns Diminishing marginal returns Negative marginal returns 8.75

Short-Run Production Costs Fixed Costs (TFC) Costs do not vary with output Variable Costs (TVC) Costs vary with output Total Costs (TC) TC = TFC + TVC LO3

Per-Unit, or Average, Costs Average Fixed CostsAFC = TFC/Q Average Variable CostsAVC = TVC/Q Average Total CostsATC = TC/Q Marginal CostsMC = ΔTC/ΔQ LO3

Short-Run Production Costs LO3 Table 7.2 Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run Total Cost DataAverage Cost Data Marginal Cost (1) Total Product (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) TC=TFC+TVC (5) Average Fixed Cost (AFC) AFC = TFC/Q (6) Average Variable Cost (AVC) AVC=TVC/Q (7) Average Total Cost (ATC) ATC = TC/Q (8) Marginal Cost (MC) MC =ΔTC/ΔQ 0 $100 $0$ $100.00$90.00$190.00$

Long-Run Production Costs The firm can change all input amounts, including plant size. All costs are variable in the long run. Long run ATC Each point reflects the lowest possible ATC for that output level LO4

Economies and Diseconomies of Scale Economies of scale: downward sloping portion of LR-ATC Increase in resources, output increases more than proportionately Labor specialization Managerial specialization Efficient capital Other factors LO4

Economies and Diseconomies of Scale Constant returns to scale: horizontal portion of LR-ATC Diseconomies of scale: upslopint portion of LR-ATC Control and coordination problems Communication problems Worker Alienation Shirking LO4

MES and Industry Structure Minimum Efficient Scale (MES) is Lowest level of output where long run average costs are minimized Can determine the structure of the industry. LO4

Applications and Illustrations Rising gasoline prices Successful start-up firms Verson stamping machine The daily newspaper Aircraft and concrete plants LO3