Chapter 4: The Costs of Production Objectives of chapter 4: Understand the notion of economic cost The short-run production relationship The short-run production costs The long-run production costs Chapter 4 by TITH Seyla

Introduction Businesses produce goods and services. To produce, those firms need economic resources To use the resource, we need to make monetary payment to resource owners (such as salary for workers). To use the resource we already own, there is an opportunity cost. The monetary payment and the opportunity cost constitutes the cost of production in any given firms. $$$$$$$$$$$$$ Chapter 4 by TITH Seyla

Economic costs Explicit costs: monetary payments or cash expenditure a firm makes to those who supply labor services, materials, fuel, transportation services, etc. Implicit costs: the opportunity costs of using its self-owned, self-employed resources. To a firm, implicit costs are the money payments that self-employed resources could have earned in their best alternative use. Normal profit of a firm is considered as an economic cost. The normal profit is the profit required to attract and retain resources in a specific line of production. Economic profit: pure profit after deducting the economic cost, which include the normal profit. Chapter 4 by TITH Seyla

(including a normal profit) Economic profit Economic profit Implicit costs (including a normal profit) Explicit costs Chapter 4 by TITH Seyla

Short-run and long-run Short-run: Fixed plant A period too brief for a firm to alter its plant capacity. The firm’s plant capacity is fixed in the short-run. However, the firm can vary its output by applying larger or smaller amounts of labor, materials, and other resources to that plant. Long-run: Variable plant A period long enough for a firm to adjust the quantities of all the resources that it employs, including plant capacity. The long-run also includes enough time for existing firm to dissolve and leave the industry or for new firms to be created and enter the industry. The short-run and the long-run are conceptual periods rather than calendar time periods. Chapter 4 by TITH Seyla

Short-run production relationships Total product (TP): The total quantity, or total output, of a particular good produced. Marginal product (MP): The extra output or added product associated with adding a unit of a variable resource, normally labor. MP = ∆ TP / ∆ units of labor Average product (AP): also called labor productivity. AP is the output per unit of labor input. AP= TP / Units of labor Chapter 4 by TITH Seyla

Law of diminishing returns (a) Law of diminishing returns = law of diminishing marginal product The law of diminishing returns: states that as successive units of a variable resource (labor) are added to a fixed resource (capital), the marginal product (extra product), that can be attributed to each additional unit of the variable resource, will decline. Chapter 4 by TITH Seyla

Law of diminishing returns (b) Chapter 4 by TITH Seyla

Law of diminishing returns (c) Chapter 4 by TITH Seyla

Short-run production costs (a) A firm’s total cost (TC) is the cost of all resources used. Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC Chapter 4 by TITH Seyla

Short-run production costs (b) Chapter 4 by TITH Seyla

Short-run production costs (c) Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. Average fixed cost (AFC) is total fixed cost per unit of output. Average variable cost (AVC) is total variable cost per unit of output. Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC Chapter 4 by TITH Seyla

Short-run production costs (d) Chapter 4 by TITH Seyla

Chapter 4 by TITH Seyla

Long-run production costs (a) In the long run, all inputs are variable and all costs are variable. Diminishing Marginal Product of Capital The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labor employed. For each plant, diminishing marginal product of labor creates a set of short run, U-shaped costs curves for MC, AVC, and ATC. The larger the plant, the greater is the output at which ATC is at a minimum. Chapter 4 by TITH Seyla

Chapter 4 by TITH Seyla

Long-run production costs (b) Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases. Chapter 4 by TITH Seyla