Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited A Firm’s Production and Costs in the Short Run CHAPTER SIX

© 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: Understand how and why economists measure costs differently from accountants Understand the crucial relationship between productivity and costs Understand the important difference between fixed costs and variable costs List and graph the seven specific cost definitions used by economists Explain the meaning of increasing productivity and cutting costs

© 2004 McGraw–Hill Ryerson Limited Explicit and Implicit Costs Explicit costs –A cost that is actually paid out in money Implicit costs –A cost that does not require an actual expenditure of money Depreciation –The annual cost of any asset that is expected to be in use for more than one year Sunk costs –The historical costs of buying plant, machinery and equipment that are unrecoverable

© 2004 McGraw–Hill Ryerson Limited Normal Profits and Economic Profits Total accounting profit Total revenue – total explicit costs Total economic profit Total revenue – total costs (implicit and explicit) Normal profit –The minimum profit that must be earned to keep the entrepreneur in that type of business

© 2004 McGraw–Hill Ryerson Limited Total, Average and Marginal Product (I) Short run –Any period of time in which at least one input in the production process is fixed Total product –The total output of any production process Division of labour –The dividing of the production process into series of specialized tasks, each done by a different worker

© 2004 McGraw–Hill Ryerson Limited Total, Average And Marginal Product (II) Marginal product –The increase in total product as a result of adding one more unit of input Average product –Total product (or total output) divided by the quantity of inputs used to produce that total MP L =  total product /  labour AP L = total product / labour

© 2004 McGraw–Hill Ryerson Limited Table 6.3 Units of LabourTotal ProductMarginal Product Average Product Marginal and Average Product Data

© 2004 McGraw–Hill Ryerson Limited Division of Labour Division of labour –The dividing of the production process into a series of specialized tasks, each done by a different worker –It leads to specialization of processes and activities

© 2004 McGraw–Hill Ryerson Limited The Law of Diminishing Returns As more of a variable input is added to a fixed input in the production process, the resulting increase in output will, at some point, begin to diminish

© 2004 McGraw–Hill Ryerson Limited TP, AP and MP Curves At first, the total product curve increases at an increasing rate, then it continues to increase at a decreasing rate. As long as MP is above AP, AP is rising. If MP is below AP, AP is falling. At first, the total product curve increases at an increasing rate, then it continues to increase at a decreasing rate. As long as MP is above AP, AP is rising. If MP is below AP, AP is falling. TP AP MPL TP AP, MP Diminishing returns begin Max. AP Figure 6.1

© 2004 McGraw–Hill Ryerson Limited Marginal and Variable Costs Total variable costs The total of all costs that vary with the level of output –Marginal cost The increase in total variable costs as a result of producing one more unit of output –Average variable costs Total variable cost divided by total output MC =  TVC /  output (or  TVC /  MP)

© 2004 McGraw–Hill Ryerson Limited Relationship Between Product and Costs The maximum of the marginal product curve corresponds with the minimum of the marginal cost curve The maximum of the average product curve corresponds with the minimum of the average variable cost curve Law of production –As long as at least one input is fixed, an increase in output eventually means an increase in both marginal and average costs

© 2004 McGraw–Hill Ryerson Limited Total Costs and Average Total Costs Total fixed costs (TFC) –Costs that do not vary with the level of output Average fixed costs (AFC) –Total fixed cost divided by the quantity of output Total cost (TC) –The sum of both total variable cost and total fixed cost TC = TVC + TFC Average total cost (ATC) –Total cost divided by quantity of output ATC = TC / output

© 2004 McGraw–Hill Ryerson Limited The MC, ATC, AVC, and AFC Curves (I) MC ATC AVC Q AVC and ATC both decrease, reach a minimum when crossed by MC, and then increase. AFC constantly decreases. AVC and ATC both decrease, reach a minimum when crossed by MC, and then increase. AFC constantly decreases. Costs AFC Figure 6.3

© 2004 McGraw–Hill Ryerson Limited The MC, ATC, AVC, and AFC Curves (II) The U-shaped marginal cost curve reflects the advantages of the division of labour as it declines, and then, as it rises, the law of diminishing returns Marginal cost is initially below the average variable cost curve and the average total cost curve but then rises above each of these, which explains their basic U shape

© 2004 McGraw–Hill Ryerson Limited The MC, ATC, AVC, and AFC Curves (III) The marginal cost curve intersects –the average variable cost (AVC) curve at its minimum point and –the average total cost (ATC)curve at its minimum The average fixed cost curve continuously declines

© 2004 McGraw–Hill Ryerson Limited The TC, TVC, and TFC Curves Costs Output TC TVC TFC TC and TVC both first increase at a decreasing rate and then continue to increase at an increasing rate. TFC remains constant. The difference between TC and TVC is TFC TC and TVC both first increase at a decreasing rate and then continue to increase at an increasing rate. TFC remains constant. The difference between TC and TVC is TFC Figure 6.5

© 2004 McGraw–Hill Ryerson Limited A Shift in MC and ATC curves MC 1 MC 2 ATC 1 ATC 2 Costs Output Figure 6.6

© 2004 McGraw–Hill Ryerson Limited Economic and Excess Capacity Economic capacity –That output at which average total cost is at a minimum Excess capacity –The situation in which a firm’s output is below economic capacity

© 2004 McGraw–Hill Ryerson Limited A Firm’s Excess Capacity ATC Costs Output Figure 6.7 ATC 2 ATC 1 Q1Q1 Q2Q2 Q3Q3 Economic capacity Output both above and below economic capacity results in higher ATC. Output both above and below economic capacity results in higher ATC.

© 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember how and why economists measure costs differently from accountants the crucial relationship between productivity and costs the important difference between fixed costs and variable costs the seven specific cost definitions used by economists the meaning of increasing productivity and cutting costs