Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–15–1 Chapter 5 The Costs of Production

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–25–2 Learning Objectives Define economic and other categories of costs. Examine how various cost concepts vary in the short and long run. Develop cost-analysis tools that will be useful in later chapters.

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–35–3 Economics Costs Economic costs are opportunity costs Explicit costs – monetary payments Implicit costs – income foregone for the use of owned resources Normal profit is a cost – minimum payment for entrepreneurship

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–45–4 Economic, or Pure, Profits Economic profit – the difference between total revenue and opportunity cost of all inputs – Accounting vs economic profit Accounting profit includes economic profit and all implicit costs EconomicprofitTotalrevenue Opportunity cost of all inputs = –

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–55–5 Economic Profits Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profits Economic (Opportunity) Costs Total Revenue Profits to an Economist Profits to an Accountant Summary of Costs and Profits

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–65–6 Short Run and Long Run Variable Resources – Factors of production whose quantity can be increased or decreased during a particular period Fixed Resources – Factors of production whose quantity cannot be increased or decreased during a particular period

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–75–7 Short Run and Long Run (cont.) Short run – a period of time where at least one factor is variable and all others fixed Long run – a time period where all factors can be varied

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–85–8 Short-Run Production Costs Law of Diminishing Returns – as successive units of a variable resource (say, labour) are added to a fixed resource (say, capital) beyond some point the extra, or marginal product attributable to each additional unit of the variable resource will decline

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–95– ] ] ] ] ] ] ] ] ] Inputs of thevariableresource Extra or marginalproduct Averageproduct Totalproduct –1

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–10 Short-Run Production Costs (cont.) Marginal Product (MP) – additional output resulting from the addition of an extra unit of a resource Average Product (AP) – the total output per unit of resource employed – total product divided by number of workers Total Product (TP) – the total output of a good produced by a firm

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–11 Law of Diminishing Returns Total Product, TP Quantity of Labour Average Product, AP, and Marginal Product, MP Quantity of Labour Marginal Product Average Product Total Output

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–12 The Least-Cost Rule The cost of any output is minimised when the marginal product per dollar’s worth of each resource is used Given two resources, labour and raw materials, cost is minimised when: MP of labour Price of labour = Price of materials MP of materials

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–13 Fixed, Variable & Total Costs Fixed costs – do not vary with changes in output Variable costs – vary with changes in output Total costs – the sum of fixed and variable costs at each level of output

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–14 Total Cost Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–15 Average Costs Average Fixed Cost Average Variable Cost AFC = TFC Q AVC = TVC Q

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–16 Average Costs (cont.) Average Total Cost ATC = Quantity Total Cost = AFC + AVC

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–17 Marginal Cost Marginal Cost (MC) – the extra, or additional cost of producing one more unit of output Marginal Cost = Change in Total Costs Change in Quantity

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–18 Marginal Cost (cont.) Quantity Short-run average costs (dollars) AFC AVC ATC MC

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–19 Marginal Cost & Marginal Product Given the price of the variable resource, increasing returns (marginal product) will be reflected in a declining marginal cost, and diminishing returns (marginal product) in a rising marginal cost

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–20 Marginal Cost Relationships When MC > ATC – ATC increases When MC < AC – ATC falls When ATC = MC – ATC is at its minimum

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–21 Long-Run Production Costs All factors variable – all costs are variable Long-run cost curve – shape depends on economies of scale – scale is defined as different levels of plant utilisation

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–22 Long-Run Production Costs (cont.) Unit Costs Output For every plant capacity size... there is a short-run ATC curve, and every ATC has a minimum cost

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–23 Long-Run Production Costs (cont.) Unit Costs Output An infinite number of such cost curves can be constructed

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–24 Long-Run Production Costs (cont.) Unit Costs Output The long-run ATC just ‘envelops’ all the short-run ATC curves

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–25 Long-Run Production Costs (cont.) Long-run ATC Unit Costs Output

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–26 Economies & Diseconomies of Scale Economies of scale – ATC falls as plant size increases Diseconomies of scale – ATC increases as plant size increases Constant returns of scale – ATC constant as plant size increases

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–27 Economies & Diseconomies of Scale (cont.) Economies of scale arise from: – Labour specialisation – Managerial specialisation – Efficient capital – By-products – Other factors

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–28 Shape of Long-Run Costs May take on many shapes U-shaped curve would initially involve falling ATC then increasing ATC as diseconomies of scale set in Other shapes are possible

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–29 Diseconomies of scale Constant returns to scale Economies of scale Long-Run ATC Curves Unit Costs Output Long-run ATC

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–30 Long-Run ATC Curves (cont.) Unit Costs Output Where extensive economies of scale exist Long-run ATC

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–31 Long-Run ATC Curves (cont.) Unit Costs Output Where economies of scale are quickly exhausted Long-run ATC

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–32 Minimum Efficiency Scale (MES) & Industry Structure MES is the smallest level of output at which a firm can minimise long-run average costs Natural monopoly

Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University of Canberra and Jay Bandaralage, Griffith University 5–33 Next Chapter: Pure Competition