The Costs of Production 22 C H A P T E R The Costs of Production

COSTs Accounting Costs Explicit costs 2) Economic Costs Explicit costs + Implicit costs

Definitions: Explicit costs Implicit costs Economic costs Profit The monetary payments a firm must make to those who supply it. Implicit costs Are the opportunity costs, or are the money payments the self‑employed resources could have earned in their best alternative employments ( foregone wage, interest, rent, and entrepreneurial income ) Economic costs The payment the firm must make or income it must provide to attract resources away from alternative production opportunities Profit Total Revenue –Total Cost=Accounting Profit or Economic Profit Accounting Profit= TR-Explicit Costs Economic Profit=TR- (Explicit Costs+ Implicit Costs)

Numerical Example Calculate the explicit and implicit costs? Ali runs a small firm. He hires one labor at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipments that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a manager for a competitor. He also estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from his firm sales is $72,000. Calculate the explicit and implicit costs? Calculate the accounting and economic profits?

Profits to an Economist Profits to an Accountant ECONOMIC COSTS Profits to an Economist Profits to an Accountant T O A L R E V N U Economic Profit Accounting Profit Implicit costs (including a normal profit) Economic (opportunity) Costs Explicit Costs Accounting costs (explicit costs only)

-Accounting: -Economics: Short and long run Short run Long run SHORT RUN AND LONG RUN -Accounting: Short and long run is based upon annual fiscal year -Economics: Short run has fixed plant capacity size Long run has variable plant capacity size

II. SHORT-RUN PRODUCTION RELATIONSHIPS Definitions: -Total Product (TP) Total quantity or total output of a particular good or service produced -Marginal Product (MP) Once one more labor added, what will happen to the TP MP can be measured as the following: Marginal Product = Change in Total Product Change in Labor Input -Average Product (AP) AP can be measured as : Average Product = Total Product Units of Labor

Variable resource (labor) Numerical Example: suppose a fixed amount of capital, the firm can produce chairs according to the following costs: Variable resource (labor) Total product Marginal product Average product Comments - 1 10 Increasing marginal returns 2 25 15 12.5 3 45 20 4 60 Diminishing marginal returns 5 70 14 6 75 7 10.71 8 -5 8.75 Negative marginal returns

Law of diminishing marginal returns As successive units of a variable resource are added to a fixed resource, beyond some point, the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline WHY?

Law of Diminishing Returns Short Run Production and the law of Diminishing Marginal Returns-Graphically Law of Diminishing Returns Total Product Total Product, TP Increasing Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Law of Diminishing Returns Short Run Production and the law of Diminishing Marginal Returns-Graphically Law of Diminishing Returns Total Product Total Product, TP Diminishing Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Law of Diminishing Returns Short Run Production and the law of Diminishing Marginal Returns-Graphically Law of Diminishing Returns Total Product Total Product, TP Negative Marginal Returns Quantity of Labor Average Product, AP, and marginal product, MP Average Product Marginal Product Quantity of Labor

Definitions: III. SHORT RUN PRODUCTION COSTS -Total Fixed Costs: Costs that do not vary with changes in output -Average Fixed Costs: Average Fixed Costs = Total Fixed Costs Quantity -Total Variable Costs: Costs that vary with changes in output -Average Variable Costs: Average Variable Costs = Total Variable Costs Quantity

-Total Marginal Costs: -Total Costs: Total Fixed and Variable Costs - Average Total Costs Average Total Cost = Total Costs Quantity -Total Marginal Costs: Marginal Cost = Change in Total Costs Change in Quantity

Numerical Example: suppose a fixed amount of capital, the firm can produce chairs according to the following costs: Total Product Total Fixed Costs Total Variable Costs Total Costs 100 1 90 190 2 170 270 3 240 340 4 300 400 5 370 470 6 450 550 7 540 640 8 650 750 9 780 880 10 930 1030

Average Variable Costs Total Product Average Fixed Costs Average Variable Costs Average Total Costs Marginal Costs 1 100 90 190 2 50 85 135 80 3 33.33 113.33 70 4 25 75 60 5 20 74 94 6 16.67 91.67 7 14.29 77.14 91.43 8 12.50 81.25 93.75 110 9 11.11 86.67 97.78 130 10 93 103 150

Summary of Definitions Total Fixed Costs = TFC Total Variable Costs = TVC Total Costs = TC Average Fixed Costs = AFC Average Variable Costs = AVC Average Total Costs = ATC Marginal Cost = MC

Combining TVC With TFC to get Total Cost SHORT-RUN COSTS GRAPHICALLY TC Combining TVC With TFC to get Total Cost TVC Fixed Cost Costs (dollars) Total Cost Variable Cost TFC Quantity

Plotting Average and Marginal Costs SHORT-RUN COSTS GRAPHICALLY MC Plotting Average and Marginal Costs ATC AVC Costs (dollars) AFC Quantity

PRODUCTIVITY AND COST CURVES Costs (dollars) Average product and marginal product AP MP Quantity of labor Quantity of output MC AVC

IV. LONG-RUN PRODUCTION COSTS For every plant capacity size... There is a short-run ATC curve All such plant capacities can be plotted...

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Output

LONG-RUN PRODUCTION COSTS The Long-run ATC just “envelopes” all of the short-run ATC curves Unit Costs Output

LONG-RUN PRODUCTION COSTS Unit Costs Long-run ATC Output

Long-run ATC ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output

Long-run ATC Unit Costs Output Economies Constant returns of scale to scale Unit Costs Long-run ATC Output

Long-run ATC Unit Costs Output Economies of scale Constant returns to scale Diseconomies of scale Unit Costs Long-run ATC Output

Economies of scale Labor specialization: working at fewer tasks workers become efficient in them. Greater labor specialization eliminates the loss of time that accompanies each shift of a worker from one task to another Managerial specialization: small firms can’t use management specialists to best advantages. Large companies can use specialists full time, which means greater efficiency and lower costs

Economies of scale Efficient capital. Large firms can afford the most efficient equipments, these requires high volume of production and large scale producers, e.g., car robots. Other factors: design and development and other startup costs,

Diseconomies of scale The main reason is difficulty of efficiently controlling and coordinating a firms operation when it becomes large.

Constant returns of scale Effect of factors of economies and factors of diseconomies is equal. Minimum efficient size: The lowest level of output at which a firm can minimize long run average costs.

Where extensive economies of scale exist: Natural Monopolies. ECONOMIES AND DISECONOMIES OF SCALE Where extensive economies of scale exist: Natural Monopolies. Unit Costs Long-run ATC Output

Where economies of scale are quickly exhausted ECONOMIES AND DISECONOMIES OF SCALE Where economies of scale are quickly exhausted Unit Costs Long-run ATC Output