1. 20
The Costs of
Production

2. 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

3. Economic Costs Economic Cost Opportunity Cost Explicit Costs
Implicit Costs
Normal Profit as a Cost
Economic or Pure Profit
Economic
Profit
Total
Revenue
Cost = -
W 20.1

4. Profits Compared Short Run and Long Run Short Run: Fixed Plant
Economic Profit Versus Accounting Profits
Economics
Accounting
Economic
Profit
Accounting
Profit
Implicit Costs
(Including a
Normal Profit)
(Opportunity)
Economic
Costs
Total Revenue
Explicit
Costs
Accounting
Costs (Explicit
Costs Only)
Short Run and Long Run
Short Run: Fixed Plant
Long Run: Variable Plant

5. Short-Run Production Relationships
Total Product (TP)
Marginal Product (MP)
Average Product (AP)
Marginal Product
Change in Total Product
Change in Labor Input =
Average Product
Total Product
Units of Labor =
W 20.2

6. Law of Diminishing Returns
Rationale
Tabular Example
O 20.1
(1)
Units of the
Variable Resource
(Labor)
(2)
Total Product
(TP)
(3)
Marginal Product
(MP),
Change in (2)/
Change in (1)
Average
Product
(AP),
(2)/(1) 1 2 3 4 5 6 7 8 10 25 45 60 70 75 -
10.00
12.50
15.00
14.00
10.71
8.75 ] 10 15 20 5 -5
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns

7. Law of Diminishing Returns
Graphical Portrayal 10 20 30
Total Product, TP 1 2 3 4 5 6 7 8 9 TP 20 10
Marginal Product, MP 1 2 3 4 5 6 7 8 9
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns AP
O 20.2 MP

8. Short-Run Production Costs
Fixed Costs
Variable Costs
Total Cost
TC = TFC + TVC

9. 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
Graphically…
MC =
Change in TC
Change in Q

10. Short-Run Production Costs
Total Cost, Fixed and Variable Costs
Costs 1 2 3 4 5 6 7 8 9 10 Q
100
200
300
400
500
600
700
800
900
1000
$1100 TC
TVC
Fixed
Cost
Total
Cost
Variable
Cost
TFC

11. Short-Run Production Costs
Average and Marginal Costs
Costs 1 2 3 4 5 6 7 8 9 10 Q 50
100
150
$200 MC
AFC
ATC
AVC
AVC
AFC
G 20.1

12. 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 20.3

13. Short-Run Production Costs
Production Curves
Average Product and
Marginal Product
Cost (Dollars) AP MP
Quantity of Labor
Cost Curves MC
AVC
Quantity of Output

14. 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

15. Long-Run Production Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
ATC-3
ATC-4
Average Total Costs
Output
Any Number of Short-Run Optimum
Size Cost Curves Can Be Constructed

16. Long-Run Production Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
Long-Run
ATC
ATC-3
ATC-4
Average Total Costs
Output
The Long-Run ATC Curve Just
“Envelopes” the Short Run ATCs

17. Long-Run Production Costs
Long-Run ATC Curve
ATC-1
ATC-5
ATC-2
Long-Run
ATC
ATC-3
ATC-4
Average Total Costs
Output
The Long-Run ATC Curve Just
“Envelopes” the Short Run ATCs

18. Long-Run Production Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Constant Returns
To Scale
Diseconomies
Of Scale
Average Total Costs
Long-Run
ATC q1 q2
Output
Long-Run ATC Curve Where Economies
Of Scale Exist

19. Long-Run Production Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Diseconomies
Of Scale
Average Total Costs
Long-Run
ATC
Output
Long-Run ATC Curve Where Costs Are
Lowest Only When Large Numbers Are
Participating

20. Long-Run Production Costs
Alternative Long-Run ATC Shapes
Economies
Of Scale
Diseconomies
Of Scale
Long-Run
ATC
Average Total Costs
Output
Long-Run ATC Curve Where Economies
Of Scale Exist, are Exhausted Quickly,
And Turn Back Up Substantially

21. 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 20.3

22. Don’t Cry Over Sunk Costs
Last
Word
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!

23. Key Terms economic (opportunity) cost explicit costs implicit costs
normal profit
economic profit
short run
long run
total product (TP)
marginal product (MP)
average product (AP)
law of diminishing returns
fixed costs
variable costs
total cost
average fixed cost (AFC)
average variable cost (AVC)
average total cost (ATC)
marginal cost (MC)
economies of scale
diseconomies of scale
constant returns to scale
minimum efficient scale (MES)
natural monopoly

24. Next Chapter Preview…
Pure
Competition
Chapter 21!