20 The Costs of Production

Chapter Objectives Why Do Economic Costs Include Both Explicit Costs and Implicit Costs How Does the Law of Diminishing Returns Relate to a Firm’s Short-Run Production Costs Learn the Distinctions Between Fixed and Variable Costs and Among Total, Average, and Marginal Costs Learn the Link Between a Firm’s Size and Its Average Costs in the Long Run

Economic Costs Economic Cost Opportunity Cost Explicit Costs Implicit Costs Normal Profit as a Cost Economic or Pure Profit Economic Profit Total Revenue Cost = - W 20.1

Profits Compared Short Run and Long Run Short Run: Fixed Plant Economic Profit Versus Accounting Profits Economics Accounting Economic Profit Accounting Profit Implicit Costs (Including a Normal Profit) (Opportunity) Economic Costs Total Revenue Explicit Costs Accounting Costs (Explicit Costs Only) Short Run and Long Run Short Run: Fixed Plant Long Run: Variable Plant

Short-Run Production Relationships Total Product (TP) Marginal Product (MP) Average Product (AP) Marginal Product Change in Total Product Change in Labor Input = Average Product Total Product Units of Labor = W 20.2

Law of Diminishing Returns Rationale Tabular Example O 20.1 (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) Average Product (AP), (2)/(1) 1 2 3 4 5 6 7 8 10 25 45 60 70 75 - 10.00 12.50 15.00 14.00 10.71 8.75 ] 10 15 20 5 -5 Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns

Law of Diminishing Returns Graphical Portrayal 10 20 30 Total Product, TP 1 2 3 4 5 6 7 8 9 TP 20 10 Marginal Product, MP 1 2 3 4 5 6 7 8 9 Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns AP O 20.2 MP

Short-Run Production Costs Fixed Costs Variable Costs Total Cost TC = TFC + TVC

Short-Run Production Costs Per-Unit or Average Costs Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC) Marginal Cost (MC) AFC = TFC Q AVC = TVC Q ATC = TC Q = AFC + AVC Graphically… MC = Change in TC Change in Q

Short-Run Production Costs Total Cost, Fixed and Variable Costs Costs 1 2 3 4 5 6 7 8 9 10 Q 100 200 300 400 500 600 700 800 900 1000 $1100 TC TVC Fixed Cost Total Cost Variable Cost TFC

Short-Run Production Costs Average and Marginal Costs Costs 1 2 3 4 5 6 7 8 9 10 Q 50 100 150 $200 MC AFC ATC AVC AVC AFC G 20.1

Short-Run Production Costs MC and Marginal Product Marginal Decisions Relation of MC to AVC and ATC Relationship Between Productivity Curves and Cost Curves Shifts in Cost Curves Graphically… W 20.3

Short-Run Production Costs Production Curves Average Product and Marginal Product Cost (Dollars) AP MP Quantity of Labor Cost Curves MC AVC Quantity of Output

Long-Run Production Costs Firm Size and Costs Long-Run Cost Curve Economies of Scale Labor Specialization Managerial Specialization Efficient Capital Diseconomies of Scale Constant Returns to Scale

Long-Run Production Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-3 ATC-4 Average Total Costs Output Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed

Long-Run Production Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 Long-Run ATC ATC-3 ATC-4 Average Total Costs Output The Long-Run ATC Curve Just “Envelopes” the Short Run ATCs

Long-Run Production Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 Long-Run ATC ATC-3 ATC-4 Average Total Costs Output The Long-Run ATC Curve Just “Envelopes” the Short Run ATCs

Long-Run Production Costs Alternative Long-Run ATC Shapes Economies Of Scale Constant Returns To Scale Diseconomies Of Scale Average Total Costs Long-Run ATC q1 q2 Output Long-Run ATC Curve Where Economies Of Scale Exist

Long-Run Production Costs Alternative Long-Run ATC Shapes Economies Of Scale Diseconomies Of Scale Average Total Costs Long-Run ATC Output Long-Run ATC Curve Where Costs Are Lowest Only When Large Numbers Are Participating

Long-Run Production Costs Alternative Long-Run ATC Shapes Economies Of Scale Diseconomies Of Scale Long-Run ATC Average Total Costs Output Long-Run ATC Curve Where Economies Of Scale Exist, are Exhausted Quickly, And Turn Back Up Substantially

Minimum Efficient Scale and Industry Structure Minimum Efficient Scale (MES) Natural Monopoly Applications and Illustrations Rising Cost of Insurance and Security Successful Start-Up Firms The Verson Stamping Machine The Daily Newspaper Aircraft and Concrete Plants O 20.3

Don’t Cry Over Sunk Costs Last Word Sunk Costs Irrelevant in Decision Making Once Incurred, They Cannot Be Recovered Compare Marginal Analysis to Find MC and MB Previously Incurred Costs Do Not Impact the MB=MC Decision Sunk Costs Are Irrelevant!

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

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