Chapter 6 Production Costs Lecture Slides Survey of Economics Irvin B. Tucker 1 © 2016 south-Western, a part of Cengage Learning

What is the purpose of this chapter? The purpose of this chapter is to study production and its relationship to various types of costs 2 © 2016 south-Western, a part of Cengage Learning

What is a basic assumption in economics? The motivation for business decisions is profit maximization 3 © 2016 south-Western, a part of Cengage Learning

To understand profit, what is necessary? To distinguish between the way economists measure costs and the way accountants measure costs 4 © 2016 south-Western, a part of Cengage Learning

What are explicit costs? Payments to nonowners of a firm for their resources 5 © 2016 south-Western, a part of Cengage Learning

What are implicit costs? The opportunity costs of using resources owned by the firm 6 © 2016 south-Western, a part of Cengage Learning

What is an example of implicit costs? When a firm uses its own resources, such as the owner’s labor, land, building, or savings, the firm gives up the opportunity of earning a return on its resources. 7 © 2016 south-Western, a part of Cengage Learning

What are total opportunity costs? Explicit costs + Implicit costs 8 © 2016 south-Western, a part of Cengage Learning

What is economic profit? Total revenue minus explicit and implicit costs, or total revenue minus total opportunity costs 9 © 2016 south-Western, a part of Cengage Learning

What is normal profit? The minimum profit necessary to keep a firm in operation 10 © 2016 south-Western, a part of Cengage Learning

What about opportunity cost? A firm that earns normal profits earns total revenue equal to its total opportunity cost 11 © 2016 south-Western, a part of Cengage Learning

How is accounting profit defined? Total revenue minus total explicit costs 12 © 2016 south-Western, a part of Cengage Learning

6.1 13 © 2016 south-Western, a part of Cengage Learning

What conclusion can we make? Since business decision making is based on economic profit, rather than accounting profit, the word profit in this text always means economic profit 14 © 2016 south-Western, a part of Cengage Learning

What is a fixed input? Any resource for which the quantity cannot change during the period of time under consideration 15 © 2016 south-Western, a part of Cengage Learning

What is a variable input? Any resource for which the quantity can change during the period of time under consideration 16 © 2016 south-Western, a part of Cengage Learning

A period of time so short that there is at least one fixed input What is the short run? A period of time so short that there is at least one fixed input 17 © 2016 south-Western, a part of Cengage Learning

What is the long run? A period of time so long that all inputs are variable 18 © 2016 south-Western, a part of Cengage Learning

What is the production function? The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs 19 © 2016 south-Western, a part of Cengage Learning

What do technological advances make possible? More output is possible from a given quantity of inputs 20 © 2016 south-Western, a part of Cengage Learning

What is marginal product? The change in total output produced by adding one unit of a variable input, with all other inputs used held constant 21 © 2016 south-Western, a part of Cengage Learning

What is the law of diminishing returns? The principle that beyond some point the marginal product decreases as additional units of a variable resource are added to a fixed factor 22 © 2016 south-Western, a part of Cengage Learning

What does the law of diminishing returns assume? Fixed inputs; it is therefore a short-run concept 23 © 2016 south-Western, a part of Cengage Learning

24 © 2016 south-Western, a part of Cengage Learning

Exhibit 6-2 (a) Total Output Curve Curve 60 50 40 Total Product (bushels of grapes per day) 30 Total Output 20 10 1 2 3 4 5 6 Quantity of labor 25 25 © 2016 south-Western, a part of Cengage Learning (number of workers per day)

Exhibit 6-2(b) Marginal Product Curve 12 10 8 Marginal Product 6 (bushels of grapes per day) Marginal Product Law of Diminishing Returns 4 2 1 2 3 4 5 6 Quantity of labor © 2016 south-Western, a part of Cengage Learning 26 26 (number of workers per day)

What is total fixed cost? Costs that do not vary as output varies and that must be paid even if output is zero. For example, rent, interest on loans, and property taxes. 27 © 2016 south-Western, a part of Cengage Learning

What is total variable cost? Costs that are zero when output is zero and vary as output varies. Examples are wages, electricity, fuel, and materials. 28 © 2016 south-Western, a part of Cengage Learning

What is total cost? TC = TFC + TVC The sum of total fixed cost and total variable cost at each level of output TC = TFC + TVC 29 © 2016 south-Western, a part of Cengage Learning

What is average fixed cost? Total fixed cost divided by the quantity of output produced AFC = TFC / Q 30 © 2016 south-Western, a part of Cengage Learning

What is average variable cost? Total variable cost divided by the quantity of output produced AVC = TVC / Q 31 © 2016 south-Western, a part of Cengage Learning

What is average total cost? Total cost divided by the quantity of output produced. Also called per-unit cost. ATC = TC/Q OR ATC=AFC +AVC 32 © 2016 south-Western, a part of Cengage Learning

The change in total cost when one unit of output is produced What is marginal cost? The change in total cost when one unit of output is produced MC = TC/Q 33 © 2016 south-Western, a part of Cengage Learning

6.3 34 © 2016 south-Western, a part of Cengage Learning

TC TVC TFC TFC 2 4 6 8 10 12 800 700 600 Total Costs (dollars) 500 400 Exhibit 6-4(a) Short-Run Cost Curves 800 TC 700 TVC 600 500 Total Costs (dollars) TFC 400 300 200 TFC 100 2 4 6 8 10 12 Quantity of output (units per hour) 35 35 © 2016 south-Western, a part of Cengage Learning

Exhibit 6-4(b) Short-Run Cost Curves 160 140 MC 120 100 Cost per unit (dollars) 80 ATC 60 AVC AFC 40 20 AFC 2 4 6 8 10 12 Quantity of output (units per hour) 36 36 © 2016 south-Western, a part of Cengage Learning

6.5 37 © 2016 south-Western, a part of Cengage Learning

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 38 © 2016 south-Western, a part of Cengage Learning

Cost per unit (dollars) Quantity of output (units per hour) Exhibit 6-6 The Relationship Between Three Factory Sizes and the Long-Run Average Cost Curves SRATCs SRATCm SRATCl 50 Cost per unit (dollars) B D 40 LRAC 30 C A 20 10 2 4 6 8 10 12 14 16 Quantity of output (units per hour) 39 39 © 2016 south-Western, a part of Cengage Learning

Short-run average total cost curves Exhibit 6-7 Long-run Average Cost Curves Short-run average total cost curves 12 10 Cost per unit (dollars) 8 6 4 2 Long-run average cost curve 2 4 6 8 10 12 14 16 Quantity of output (units per hour) 40 4040 © 2016 south-Western, a part of Cengage Learning

What are economies of scale? A situation in which the long-run average cost curve declines as the firm increases output 41 © 2016 south-Western, a part of Cengage Learning

What are constant returns to scale? A situation in which the long-run average cost curve does not change as the firm increases output 42 © 2016 south-Western, a part of Cengage Learning

What are diseconomies of scale? A situation in which the long-run average cost curve rises as the firm increases output 43 © 2016 south-Western, a part of Cengage Learning

Exhibit 6-8 Long-run Average Cost Curve Cost per unit (dollars) LRAC Cost per unit (dollars) Constant returns to scale Diseconomies of scale Economies of scale Q1 Q2 Quantity of output 44 44 © 2016 south-Western, a part of Cengage Learning

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