2. The Costs of Production 1 22 C H A P T E R

3. Costs exist because resources Are scarce Productive Have alternative uses Use of a resource in a specific use implies an economic or opportunity cost 2

4. Explicit and implicit costs Explicit costs: payments for the use of resources owned by others. Implicit costs: payments that self-employed resources could have earned in their best alternative use. 3

5. Economic costs The payment the firm must make or income it must provide to attract resources away from alternative production opportunities. Normal profit as a cost Implicit costs are a normal profit: Foregone wages Foregone interest Foregone rent Foregone entrepreneurial income 4

6. Example: Your salary: 22000 a year Open your own business: Invest your savings: 20000 The saving earn 1000 per year Rent a store you own: 5000 per year Hire an employee: 18000 a year 5

7. After 1 year: Total sale revenue ………………………..….120,000 costs of t-shirts ………….40,000 worker salary …………….18,000 rent …………………………..5,000 Total (explicit) costs …………63,000 Accounting profits ………………………...57,000 6

8. Accounting profit ……………….………….….57,000 forgone interest ……………...1,000 forgone rent …………………...5,000 forgone wages ………….…….22,000 forgone entrepreneurial income ….5,000 Total implicit costs ………………33,000 Economic Profits ………………………………..24,000 7

9. Economic profit Economic profit is = Total revenue – economic costs Or Total revenue – (explicit + implicit costs) 8

10. Example Hamad is working as a manager for 22000. his talent worth 5000. He decides to open his own business. He invested his 20000 of savings that earn 1000 The new firm will occupy a store he used to let out for 5000. He hired labor for 18000 Cost of raw materials is 40000 and other utilities is 5000. Total revenue is 120000 Calculate the explicit and implicit costs Calculate the accounting and economic profits. 9

11. Economic Profit Implicit costs (including a normal profit) Explicit Costs Accounting costs (explicit costs only) Accounting Profit Economic (opportunity) Costs TOTALREVENUETOTALREVENUE Profits to an Economist Profits to an Accountant ECONOMIC COSTS 10

12. 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 11

13. Average Product (AP) Total Product (TP) Marginal Product (MP) SHORT-RUN PRODUCTION RELATIONSHIPS Marginal Product = Change in Total Product Change in Labor Input Average Product = Total Product Units of Labor 12

14. Variable resource (labor) Total product Marginal product Average product Comments 00- 110 Increasing marginal returns 2251512.5 Increasing marginal returns 3452015 Increasing marginal returns 46015 Diminishing marginal returns 5701014 Diminishing marginal returns 675512.5 Diminishing marginal returns 775010.71 Diminishing marginal returns 870-58.75 Negative marginal returns

15. 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? 14

16. Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and marginal product, MP Quantity of Labor Total Product Marginal Product Average Product Increasing Marginal Returns 15

17. Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and marginal product, MP Quantity of Labor Total Product Marginal Product Average Product Diminishing Marginal Returns 16

18. Law of Diminishing Returns SHORT-RUN PRODUCTION RELATIONSHIPS Total Product, TP Quantity of Labor Average Product, AP, and marginal product, MP Quantity of Labor Total Product Marginal Product Average Product Negative Marginal Returns 17

19. 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 18

20. Total Cost Total Fixed and Variable Costs Average Total Cost = Total Costs Quantity Marginal Cost Total Variable Costs Marginal Cost = Change in Total Costs Change in Quantity SHORT-RUN PRODUCTION COSTS 19

21. Total ProductTotal Fixed CostsTotal Variable CostsTotal Costs 01000 1 90190 2100170270 3100240340 4100300400 5100370470 6100450550 7100540640 8100650750 9100780880 101009301030

22. Total Product Average Fixed CostsAverage Variable Costs Average Total Costs Marginal Costs 0 11009019090 2508513580 333.3380113.3370 4257510060 520749470 616.677591.6780 714.2977.1491.4390 812.5081.2593.75110 911.1186.6797.78130 10 93103150

23. 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 22

24. SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) TC Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost 23

25. SHORT-RUN COSTS GRAPHICALLY Quantity Costs (dollars) AFC AVC ATC MC Plotting Average and Marginal Costs 24

26. PRODUCTIVITY AND COST CURVES Costs (dollars) Average product and marginal product Quantity of labor Quantity of output MP AP MC AVC 25

27. LONG-RUN PRODUCTION COSTS All such plant capacities can be plotted... For every plant capacity size... There is a short-run ATC curve 26

28. LONG-RUN PRODUCTION COSTS Unit Costs Output 27

29. LONG-RUN PRODUCTION COSTS Unit Costs Output 28

30. LONG-RUN PRODUCTION COSTS The Long-run ATC just “envelopes” all of the short-run ATC curves Unit Costs Output 29

31. LONG-RUN PRODUCTION COSTS Unit Costs Output Long-run ATC 30

32. ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output Long-run ATC Economies of scale 31

33. ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output Long-run ATC Economies of scale Constant returns to scale 32

34. ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output Long-run ATC Economies of scale Diseconomies of scale Constant returns to scale 33

35. 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 34

36. 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, 35

37. Diseconomies of scale The main reason is difficulty of efficiently controlling and coordinating a firms operation when it becomes large. 36

38. 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. 37

39. ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output Long-run ATC Where extensive economies of scale exist: Natural Monopolies. 38

40. ECONOMIES AND DISECONOMIES OF SCALE Unit Costs Output Long-run ATC Where economies of scale are quickly exhausted 39

41. Chapter Conclusions Natural Monopoly MINIMUM EFFICIENT SCALE AND INDUSTRY STRUCTURE Minimum Efficient Scale - MES 40

42. 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 natural monopoly 41 ENDBACK Copyright McGraw-Hill/Irwin 2002