1. The Costs of Production22
C H A P T E R
The Costs of Production

2. COSTs Accounting Costs Explicit costs 2) Economic Costs
Explicit costs + Implicit costs

3. Definitions: Explicit costs Implicit costs Economic costs Profit
The monetary payments a firm must make to those who supply it.
Implicit costs
Are the opportunity costs, or are the money payments the self‑employed resources could have earned in their best alternative employments ( foregone wage, interest, rent, and entrepreneurial income )
Economic costs
The payment the firm must make or income it must provide to attract resources away from alternative production opportunities
Profit
Total Revenue –Total Cost=Accounting Profit or Economic Profit
Accounting Profit= TR-Explicit Costs
Economic Profit=TR- (Explicit Costs+ Implicit Costs)

4. Numerical Example Calculate the explicit and implicit costs?
Ali runs a small firm. He hires one labor at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials.
He has $40,000 of his own funds invested in equipments that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a manager for a competitor. He also estimates his entrepreneurial talents are worth $3,000 per year.
Total annual revenue from his firm sales is $72,000.
Calculate the explicit and implicit costs?
Calculate the accounting and economic profits?

5. Profits to an Economist Profits to an Accountant
ECONOMIC COSTS
Profits to an
Economist
Profits to an
Accountant T O A L R E V N U
Economic
Profit
Accounting
Profit
Implicit costs
(including a
normal profit)
Economic (opportunity) Costs
Explicit
Costs
Accounting
costs (explicit
costs only)

6. -Accounting: -Economics: Short and long run Short run Long run
SHORT RUN AND LONG RUN
-Accounting:
Short and long run
is based upon annual fiscal year
-Economics:
Short run
has fixed plant capacity size
Long run
has variable plant capacity size

7. II. SHORT-RUN PRODUCTION RELATIONSHIPS
Definitions:
-Total Product (TP)
Total quantity or total output of a particular good or service produced
-Marginal Product (MP)
Once one more labor added, what will happen to the TP
MP can be measured as the following:
Marginal Product =
Change in Total Product
Change in Labor Input
-Average Product (AP)
AP can be measured as :
Average Product =
Total Product
Units of Labor

8. Variable resource (labor)
Numerical Example: suppose a fixed amount of capital, the firm can
produce chairs according to the following costs:
Variable resource (labor)
Total product
Marginal product
Average product
Comments - 1 10
Increasing marginal returns 2 25 15
12.5 3 45 20 4 60
Diminishing marginal returns 5 70 14 6 75 7
10.71 8 -5
8.75
Negative marginal returns

9. Law of diminishing marginal returns
As successive units of a variable resource are added to a fixed resource, beyond some point, the extra, or marginal product that can be attributed to each additional unit of the variable resource will decline
WHY?

10. Law of Diminishing Returns
Short Run Production and the law of Diminishing Marginal Returns-Graphically
Law of Diminishing Returns
Total Product
Total Product, TP
Increasing
Marginal
Returns
Quantity of Labor
Average Product, AP, and
marginal product, MP
Average
Product
Marginal
Product
Quantity of Labor

11. Law of Diminishing Returns
Short Run Production and the law of Diminishing Marginal Returns-Graphically
Law of Diminishing Returns
Total Product
Total Product, TP
Diminishing
Marginal
Returns
Quantity of Labor
Average Product, AP, and
marginal product, MP
Average
Product
Marginal
Product
Quantity of Labor

12. Law of Diminishing Returns
Short Run Production and the law of Diminishing Marginal Returns-Graphically
Law of Diminishing Returns
Total Product
Total Product, TP
Negative
Marginal
Returns
Quantity of Labor
Average Product, AP, and
marginal product, MP
Average
Product
Marginal
Product
Quantity of Labor

13. Definitions: III. SHORT RUN PRODUCTION COSTS -Total Fixed Costs:
Costs that do not vary with changes in output
-Average Fixed Costs:
Average Fixed Costs =
Total Fixed Costs
Quantity
-Total Variable Costs:
Costs that vary with changes in output
-Average Variable Costs:
Average Variable Costs =
Total Variable Costs
Quantity

14. -Total Marginal Costs:
-Total Costs:
Total Fixed and Variable Costs
- Average Total Costs
Average Total Cost =
Total Costs
Quantity
-Total Marginal Costs:
Marginal Cost =
Change in Total Costs
Change in Quantity

15. Numerical Example: suppose a fixed amount of capital, the
firm can produce chairs according to the following costs:
Total Product
Total Fixed Costs
Total Variable Costs
Total Costs
100 1 90
190 2
170
270 3
240
340 4
300
400 5
370
470 6
450
550 7
540
640 8
650
750 9
780
880 10
930
1030

16. Average Variable Costs
Total Product
Average Fixed Costs
Average Variable Costs
Average Total Costs
Marginal Costs 1
100 90
190 2 50 85
135 80 3
33.33
113.33 70 4 25 75 60 5 20 74 94 6
16.67
91.67 7
14.29
77.14
91.43 8
12.50
81.25
93.75
110 9
11.11
86.67
97.78
130 10 93
103
150

17. Summary of Definitions
Total Fixed Costs = TFC
Total Variable Costs = TVC
Total Costs = TC
Average Fixed Costs = AFC
Average Variable Costs = AVC
Average Total Costs = ATC
Marginal Cost = MC

18. Combining TVC With TFC to get Total Cost
SHORT-RUN COSTS GRAPHICALLY TC
Combining TVC
With TFC to get
Total Cost
TVC
Fixed Cost
Costs (dollars)
Total
Cost
Variable Cost
TFC
Quantity

19. Plotting Average and Marginal Costs
SHORT-RUN COSTS GRAPHICALLY MC
Plotting Average and
Marginal Costs
ATC
AVC
Costs (dollars)
AFC
Quantity

20. PRODUCTIVITY AND COST CURVES
Costs (dollars)
Average product and
marginal product AP MP
Quantity of labor
Quantity of output MC
AVC

21. IV. LONG-RUN PRODUCTION COSTS
For every plant capacity size...
There is a short-run ATC curve
All such plant capacities
can be plotted...

22. LONG-RUN PRODUCTION COSTS
Unit Costs
Output

23. LONG-RUN PRODUCTION COSTS
Unit Costs
Output

24. LONG-RUN PRODUCTION COSTS
The Long-run ATC just “envelopes”
all of the short-run ATC curves
Unit Costs
Output

25. LONG-RUN PRODUCTION COSTS
Unit Costs
Long-run ATC
Output

26. Long-run ATC ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output

27. Long-run ATC Unit Costs Output Economies Constant returns of scale
to scale
Unit Costs
Long-run ATC
Output

28. Long-run ATC Unit Costs Output Economies of scale Constant returns
to scale
Diseconomies
of scale
Unit Costs
Long-run ATC
Output

29. Economies of scale
Labor specialization: working at fewer tasks workers become efficient in them. Greater labor specialization eliminates the loss of time that accompanies each shift of a worker from one task to another
Managerial specialization: small firms can’t use management specialists to best advantages. Large companies can use specialists full time, which means greater efficiency and lower costs

30. Economies of scale
Efficient capital. Large firms can afford the most efficient equipments, these requires high volume of production and large scale producers, e.g., car robots.
Other factors: design and development and other startup costs,

31. Diseconomies of scale
The main reason is difficulty of efficiently controlling and coordinating a firms operation when it becomes large.

32. Constant returns of scale
Effect of factors of economies and factors of diseconomies is equal.
Minimum efficient size:
The lowest level of output at which a firm can minimize long run average costs.

33. Where extensive economies of scale exist: Natural Monopolies.
ECONOMIES AND
DISECONOMIES OF SCALE
Where extensive economies of
scale exist: Natural Monopolies.
Unit Costs
Long-run ATC
Output

34. Where economies of scale are quickly exhausted
ECONOMIES AND
DISECONOMIES OF SCALE
Where economies of scale are quickly exhausted
Unit Costs
Long-run ATC
Output