Businesses and the Costs of Production 07 McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Copyright 2008 The McGraw-Hill Companies 8-2 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show 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

Copyright 2008 The McGraw-Hill Companies 8-3 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Economic Costs Economic Cost Opportunity Cost Explicit Costs Implicit Costs Normal Profit as a Cost Economic or Pure Profit Economic Profit Total Revenue Economic Cost = - W 8.1

Copyright 2008 The McGraw-Hill Companies 8-4 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Economic Costs Equal to opportunity costs Explicit + implicit costs Explicit costs –Monetary payments Implicit costs –Value of next best use –Self-owned resources –Self-employed resources 8-4

Copyright 2008 The McGraw-Hill Companies 8-5 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Profit Accounting profit –Total revenue less explicit cost Normal profit –Equal to implicit cost Economic or pure profit –Total revenue less economic cost 8-5

Copyright 2008 The McGraw-Hill Companies 8-6 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Profits Compared Economic Profit Versus Accounting Profits Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Economics Accounting Short Run and Long Run Short Run: Fixed Plant Long Run: Variable Plant

Copyright 2008 The McGraw-Hill Companies 8-7 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show SHORT RUN AND LONG RUN Accounting: Short and long run is based upon annual chronology Economics: Short run has fixed plant capacity size Long run has variable plant capacity size

Copyright 2008 The McGraw-Hill Companies 8-8 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Short and Long Run The short run –Fixed plant capacity –Variable intensity of plant use –Variable output The long run –Variable plant capacity –Firms enter and exit 8-8

Copyright 2008 The McGraw-Hill Companies 8-9 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Short-Run Production Relationships Total Product (TP) Marginal Product (MP) Average Product (AP) Average Product Total Product Units of Labor = Marginal Product Change in Total Product Change in Labor Input = W 8.2

Copyright 2008 The McGraw-Hill Companies 8-10 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Law of Diminishing Returns Fixed technology Add variable resource to fixed resource Marginal product will decline –Beyond some point Rationale 8-10

Copyright 2008 The McGraw-Hill Companies 8-11 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Increasing Marginal Returns Law of Diminishing Returns Rationale Tabular Example (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns O 8.1

Copyright 2008 The McGraw-Hill Companies 8-12 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Law of Diminishing Returns Graphical Portrayal Total Product, TP Marginal Product, MP TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns O 8.2

Copyright 2008 The McGraw-Hill Companies 8-13 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Fixed Costs Total Fixed Costs Average Fixed Costs = Total Fixed Costs Quantity Variable Costs Total Variable Costs Average Variable Costs = Total Variable Costs Quantity SHORT-RUN PRODUCTION COSTS

Copyright 2008 The McGraw-Hill Companies 8-14 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Short-Run Production Costs Fixed Costs Variable Costs Total Cost TC = TFC + TVC

Copyright 2008 The McGraw-Hill Companies 8-15 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show 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 MC = Change in TC Change in Q Graphically…

Copyright 2008 The McGraw-Hill Companies 8-16 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Marginal Cost = MC Total Fixed Costs = TFC Total Variable Costs = TVC Average Variable Costs = AVC Total Costs = TC Average Total Costs = ATC Average Fixed Costs = AFC Summary of Definitions SHORT-RUN PRODUCTION COSTS

Copyright 2008 The McGraw-Hill Companies 8-17 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Short-Run Production Costs Total Cost, Fixed and Variable Costs Costs Q $1100 TFC TC TVC Total Cost Variable Cost Fixed Cost

Copyright 2008 The McGraw-Hill Companies 8-18 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Short-Run Production Costs Average and Marginal Costs Costs Q $200 AFC MC ATC AVC AFC G 8.1

Copyright 2008 The McGraw-Hill Companies 8-19 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show 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 8.3

Copyright 2008 The McGraw-Hill Companies 8-20 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Average Product and Marginal Product Cost (Dollars) Short-Run Production Costs MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves

Copyright 2008 The McGraw-Hill Companies 8-21 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show 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

Copyright 2008 The McGraw-Hill Companies 8-22 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Choose your plant size Minimize ATC Different ATC curves –Short run Long run ATC –Envelope of short run ATC 8-22

Copyright 2008 The McGraw-Hill Companies 8-23 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Long-Run ATC Curve Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed

Copyright 2008 The McGraw-Hill Companies 8-24 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The Long-Run ATC Curve Just “Envelopes” the Short Run ATCs

Copyright 2008 The McGraw-Hill Companies 8-25 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The Long-Run ATC Curve Just “Envelopes” the Short Run ATCs

Copyright 2008 The McGraw-Hill Companies 8-26 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Alternative Long-Run ATC Shapes Output Long-Run ATC Curve Where Economies Of Scale Exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1q1 q2q2

Economies and Diseconomies of Scale Economies of scale Labor specialization Managerial specialization Efficient capital Other factors Constant returns to scale LO4 7-27

Economies and Diseconomies of Scale Diseconomies of scale Control and coordination problems Communication problems Worker Alienation Shirking LO4 7-28

MES and Industry Structure Minimum Efficient Scale (MES): Lowest level of output where long- run average costs are minimized Can determine the structure of the industry LO4 7-29

Copyright 2008 The McGraw-Hill Companies 8-30 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Alternative Long-Run ATC Shapes Output Long-Run ATC Curve Where Costs Are Lowest Only When Large Numbers Are Participating Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC

Copyright 2008 The McGraw-Hill Companies 8-31 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Long-Run Production Costs Alternative Long-Run ATC Shapes Output Long-Run ATC Curve Where Economies Of Scale Exist, are Exhausted Quickly, And Turn Back Up Substantially Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale

Copyright 2008 The McGraw-Hill Companies 8-32 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show 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 8.3

Copyright 2008 The McGraw-Hill Companies 8-33 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Don’t Cry Over Sunk Costs 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!

Copyright 2008 The McGraw-Hill Companies 8-34 Economic Costs Profits Compared Short-Run Production Relationships Law of Diminishing Returns Short-Run Production Costs Long-Run Production Costs Minimum Efficient Scale and Industry Structure Last Word Key Terms End Show Key Terms economic (opportunity) costeconomic (opportunity) cost explicit costs implicit costs normal profit economic profit short run long run total product (TP) marginal product (MP)marginal product (MP) average product (AP) law of diminishing returnslaw of diminishing returns fixed costs variable costs total cost average fixed cost (AFC)average fixed cost (AFC) average variable cost (AVC)average variable cost (AVC) average total cost (ATC)average total cost (ATC) marginal cost (MC) economies of scale diseconomies of scale constant returns to scaleconstant returns to scale minimum efficient scale (MES)minimum efficient scale (MES) natural monopoly