Principles of Microeconomics : Ch.13 Second Canadian Edition Chapter 13 The Costs of Production © 2002 by Nelson, a division of Thomson Canada Limited

Principles of Microeconomics : Ch.13 Second Canadian Edition Overview  Types of Costs and Profit  Short-Run Cost Behaviour  Long-Run Cost Behaviour

Principles of Microeconomics : Ch.13 Second Canadian Edition Supply The Costs of Production The Law of Supply: Firms are willing to produce and sell a greater quantity of a good when the price of a good is high, due to typical productivity and cost behaviour. P Q

Principles of Microeconomics : Ch.13 Second Canadian Edition Why Study Behaviour of Firms?  Gain a better understanding of the decisions made by producers.  Study how the behaviour of a firm depends on the structure of the market.

Principles of Microeconomics : Ch.13 Second Canadian Edition Purpose Facing The Typical Firm The economic purpose of the firm is to maximize profit! Profit = Total Revenue - Total Cost.

Principles of Microeconomics : Ch.13 Second Canadian Edition An Individual Firm’s Profit: Revenue minus Cost  Revenue: The amount that the firm receives for the sale of its product. (Market Price x Amount Sold)= Revenue  Cost: The amount that the firm sacrifices to buy inputs.  Profit: Total revenue minus total costs.

Principles of Microeconomics : Ch.13 Second Canadian Edition Costs of Production  In general, three costs are often considered when making business supply decisions. Explicit Costs Implicit Costs Sunk Costs

Principles of Microeconomics : Ch.13 Second Canadian Edition Costs as Opportunity Costs  The firm’s costs include Explicit Costs and Implicit Costs: –Explicit Costs: costs that involve a direct money outlay for factors of production. –Implicit Costs: costs that do not involve a direct money outlay (e.g. opportunity costs of the owner’s own inputs used - implicit wages, implicit rent, cost of capital).

Principles of Microeconomics : Ch.13 Second Canadian Edition Costs as Opportunity Costs  Accountants measure the explicit costs but often ignore the implicit costs.  Economists include all opportunity costs when measuring costs.  Accounting Profit = TR - Explicit Costs  Economic Profit = TR - Explicit Costs - Implicit Costs

Principles of Microeconomics : Ch.13 Second Canadian Edition Costs as Opportunity Costs  A third, not so obvious implicit cost includes sunk costs.  Sunk costs are costs that have already been committed and cannot be recovered. Sunk Costs are... –an opportunity cost –often ignored when making decisions about supplying a product

Principles of Microeconomics : Ch.13 Second Canadian Edition Quick Quiz “A farmer has planted corn seeds but has not yet fertilized the field.”  Is the cost of seed an opportunity cost or a sunk cost?  Is the cost of fertilizer an opportunity cost or a sunk cost?  Which of these two costs is more likely to affect the decision to continue farming?

Principles of Microeconomics : Ch.13 Second Canadian Edition Overview Types of Costs and Profit  Short-Run Cost Behaviour  Long-Run Cost Behaviour

Principles of Microeconomics : Ch.13 Second Canadian Edition Short-Run vs. Long-Run Two different time horizons are important when analyzing costs.  Short-Run: Time period over which some inputs are variable (labour, materials) and some inputs are fixed (plant size).  Long-Run: Time period over which all inputs are variable, including plant size.

Principles of Microeconomics : Ch.13 Second Canadian Edition Short-Run Costs Costs of production may be divided into two categories in the short-run:  Fixed Costs: –Those costs that do not vary with the amount of output produced.  Variable Costs: –Those costs that do vary with the amount of output produced.

Principles of Microeconomics : Ch.13 Second Canadian Edition Family of Total Costs...  Total Fixed Costs (TFC)  Total Variable Costs (TVC)  Total Costs (TC) where: TC = TFC + TVC

Principles of Microeconomics : Ch.13 Second Canadian Edition Family of Average Costs...  Average Costs:  Specific Cost / Output Level  Average Fixed Costs (AFC) = TFC / Q  Average Variable Costs (AVC) = TVC / Q  Average Total Costs (ATC) = TC / Q

Principles of Microeconomics : Ch.13 Second Canadian Edition Marginal Cost: “How much does it cost to produce an additional unit of output?”  Marginal Cost (MC): “The extra or additional cost of producing one more unit of output.”  MC is the addition to the cost of production that must be covered by additional revenue for profit maximization.  MC = TC ÷ Q

Principles of Microeconomics : Ch.13 Second Canadian Edition Quick Quiz!  If Ford’s total cost of producing 4 cars is $225,000 and its total cost of producing 5 cars is $250, what is the average total cost and marginal cost of producing the fifth car?

Principles of Microeconomics : Ch.13 Second Canadian Edition The Shape of Short-Run Cost Curves  Short-run cost behaviour is based on the productivity of the inputs (resources).  As the firm continues to expand output, in a fixed plant-size situation, eventually the marginal product of each successive worker hired will decrease.  The diminishing marginal product causes the marginal cost to increase in the short- run. This in turn affects the behaviour of average total cost.

Principles of Microeconomics : Ch.13 Second Canadian Edition The Shape of Typical Cost Curves Cost ($’s) Quantity of output MC

Principles of Microeconomics : Ch.13 Second Canadian Edition The Shape of Typical Cost Curves Cost ($’s) Quantity of output MC ATC

Principles of Microeconomics : Ch.13 Second Canadian Edition The Shape of Typical Cost Curves Cost ($’s) Quantity of output MC ATC AVC

Principles of Microeconomics : Ch.13 Second Canadian Edition The Shape of Typical Cost Curves Cost ($’s) Quantity of output MC ATC AVC AFC

Principles of Microeconomics : Ch.13 Second Canadian Edition The Shape of Typical Cost Curves U-Shaped Average Total Cost (ATC): –At low levels of output, as the firm expands production, ATC declines. –At higher production levels, as output is increased, ATC increases. –The bottom of the U-Shape occurs at the quantity that minimizes average total cost. –This is called the Efficient Size of the firm.

Principles of Microeconomics : Ch.13 Second Canadian Edition The Relationship Between Marginal Cost and Average Total Cost  Why is ATC U - shaped?  When marginal cost is less than average total cost, average total cost is falling. MC < ATC ATC  When marginal cost is greater than average total cost, average total cost is rising. MC > ATC ATC

Principles of Microeconomics : Ch.13 Second Canadian Edition The Relationship Between Marginal Cost and Average Total Cost The marginal-cost curve crosses the average-total-cost at minimum ATC. Why?

Principles of Microeconomics : Ch.13 Second Canadian Edition The Relationship Between Marginal Cost and Average Total Cost Cost ($’s) Quantity MC ATC The marginal cost curve always crosses the average total cost curve at the minimum average total cost!

Principles of Microeconomics : Ch.13 Second Canadian Edition Overview Types of Costs and Profit Short-Run Cost Behaviour  Long-Run Cost Behaviour

Principles of Microeconomics : Ch.13 Second Canadian Edition Long-Run Costs  How do per unit costs behave as the firm expands all inputs, even plant size or scale of operation?  The Long-Run Average Total Cost (LRATC) reflects the lowest possible unit cost related to different plant sizes and/or scales of operation.  The LRATC Curve is U-shaped as shown in the next slide.

Principles of Microeconomics : Ch.13 Second Canadian Edition Long-Run Costs Econ. of Scale Disecon. of Scale Constant Returns to Scale LRATC Curve $ Per Unit Scale of Operation (Q)

Principles of Microeconomics : Ch.13 Second Canadian Edition Long-Run Costs There are three typical long-run cost situations:  Economies of Scale: LRATC decreases as the scale of operation increases.  Diseconomies of Scale: LRATC increases with the scale of operation.  Constant Returns to Scale: LRATC stays constant as the scale of operation increases.

Principles of Microeconomics : Ch.13 Second Canadian Edition Long-Run Costs  Possible causes of Economies of Scale: –volume discounts on purchases –manufacturing, warehousing, transportation, and promotional economies –larger firm can borrow at lower interest rates  Possible causes of Diseconomies of Scale –management diseconomies...

Principles of Microeconomics : Ch.13 Second Canadian Edition Overview Types of Costs and Profit Short-Run Cost Behaviour Long-Run Cost Behaviour