1. COSTS OF THE CONSTRUCTION FIRM
CHAPTER 7
COSTS OF THE CONSTRUCTION FIRM

2. Cost of Owner’s Resources
Firm: A firm is an organization that brings together different factors of production, such as labour, land and capital, to produce a product or service which it is hoped can be sold for a profit.
Cost of Owner’s Resources
The income that the owner could have earned in the best alternative job.
Normal profit is the expected return for supplying entrepreneurial ability.

3. Economic Profit A firm’s total revenue minus its opportunity costs.
The firm’s opportunity cost is the sum of its explicit costs and implicit costs.
Not the same as accounting profit.

4. The Objective: Profit Maximization
All of the firm’s decisions are aimed at one overriding objective: maximum attainable profit.
To study the relationship between a firm’s output decision and its costs, we distinguish two decision time frames:
The short-run
The long-run

5. The Short-Run and the Long-Run
The short-run is a time frame in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.
The long-run is a time frame in which the quantities of all inputs can be varied.

6. Production Function: The relationship between physical output and the quantity of capital and labour used in the production process is sometimes called a production function.
To increase output in the short-run, a firm must increase the quantity of labor employed.
Total product is the total output produced.
Marginal product is the increase in total product that result from a one-unit increase in an input.
Average product is the total product divided by the quantity of inputs.

7. Total Product Curve Read the schedule page 102
Table: 7.1 Diminishing returns: a hypothetical case in construction

8. Total Product Curve TP 15 f e Unattainable d 10 c Attainable 5 b a
Output (sweaters per day) 10
Attainable 5
Instructor Notes:
1) The total product curve, TP, is based on these data.
2) Points a through f on the curve correspond to the rows of the table.
30 The total product curve separates the attainable output from the unattainable.
Labor (workers per day) 17

9. Marginal product is also measured by the slope of the total product curve.
Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.

10. Diminishing marginal returns
Occur when the marginal product of an additional worker is less than the marginal product of the previous worker
Law of diminishing returns
As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes

11. Marginal Product TP d c MP 6 Output (sweaters per day)15 TP 6 d 13
Output (sweaters per day)
Marginal product
(sweaters per day per worker) 10 4 c 3
Instructor Notes:
1) Marginal product is illustrated by the orange bars. For example, when labor increases from 2 to 3, marginal product is the orange bar whose height is 3 sweaters.
2) Marginal product is shown midway between the labor input to emphasize that it is the result of changing inputs.
3) The steeper the slope of the total product curve (TP) in the first graph, the larger is marginal product (MP) in the second graph.
4) Marginal product increases to a maximum (when 1 worker is employed in this example) and then declines--diminishing marginal product. 5 2 4 MP
Labor (workers per day)
Labor (workers per day) 26

12. Short-Run Cost
Total cost (TC) is the cost of all productive resources used by a firm.
Total fixed cost (TFC) is the cost of all the firm’s fixed inputs.
Total variable cost (TVC) is the cost of all the firm’s variable inputs.

13. Total cost (TC) is the cost of all productive resources used by a firm.
TC = TFC + TVC

14. Total Cost Curves TC TVC TFC 0 5 10 15 TC = TFC + TVC 150
Cost (dollars per day)
100
Instructor Notes:
1) The graph shows Swanky’s total cost curves.
2) Total fixed cost (TFC) is constant--it graphs as a horizontal line--and total variable cost (TVC) increases as output increases.
3) Total cost (TC) also increases as output increases.
4) The vertical distance between the total cost curve and the total variable cost curve is total fixed cost, as illustrated by the two green arrows. 50
TFC
Output (sweaters per day) 42

15. Marginal Cost
Marginal cost is the increase in total cost that results from a one-unit increase in output.
It equals the increase in total cost divided by the increase in output.
Marginal costs decrease at low outputs because of the gains from specialization, but it eventually increases due to the law of diminishing returns.

16. Average Cost
Average fixed cost (AFC) is total fixed cost per unit of output.
Average variable cost (AVC) is total variable cost per unit of output.
Average total cost (ATC) is total cost per unit of output. 44

17. Average Cost
TC = TFC + TVC
TC TFC TVC
Q Q Q = + OR
ATC = AFC + AVC

18. Marginal Cost and Average Costs
ATC = AFC + AVC 15
AVC
ATC MC
Cost (dollars per sweater) 10
AFC 5
Instructor Notes:
1) Average fixed cost (AFC) decreases as output increases.
2) The average total cost curve (ATC) and average variable cost curve (AVC) are U-shaped.
3) The vertical distance between these two curves is equal to average fixed cost, as illustrated by the two arrows.
4) The marginal cost curve (MC) is also U-shaped.
5) MC intersects the average variable cost curve and average total cost curve at their minimum points.
Output (sweaters per day) 55

19. Product Curves and Cost CurvesMP 6 AP 4
Average product and marginal product
Instructor Notes:
1) A firm’s cost curves are linked to its product curves.
2) Over the range of rising marginal product, marginal cost is falling.
3) When marginal product is a maximum, marginal cost is a minimum.
4) Over the range of rising average product, average variable cost is falling.
5) When average product is a maximum, average variable cost is a minimum.
6) Over the range of diminishing marginal product, marginal cost is rising.
7) Over the range of falling average product, average variable cost is rising. 2 2
Rising MP and
falling MC:
rising AP and
falling AVC
Falling MP and
rising MC:
rising AP and
falling AVC
Falling MP and
rising MC:
falling AP and
rising AVC
Labor 59

20. Product Curves and Cost Curves12
AVC 9 MC
Average product and marginal product
Maximum MP and
minimum MC
Maximum AP and
minimum AVC 6
Instructor Notes:
1) A firm’s cost curves are linked to its product curves.
2) Over the range of rising marginal product, marginal cost is falling.
3) When marginal product is a maximum, marginal cost is a minimum.
4) Over the range of rising average product, average variable cost is falling.
5) When average product is a maximum, average variable cost is a minimum.
6) Over the range of diminishing marginal product, marginal cost is rising.
7) Over the range of falling average product, average variable cost is rising. 3
Labor 62

21. Long-Run Cost Long-run cost Production function
The cost of production when a firm uses the economically efficient quantities of labor and capital.Long-run costs are affected by the production function.
Production function
The relationship between the maximum output attainable and the quantities of both labor an capital. 64

22. The Long-Run Average Cost Curve
The long-run average total cost curve is derived from the short-run average total cost curves.
The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve. 67

23. Short-Run Costs of Four Different Plants
Instructor Notes:
1) The graph shows short-run average total cost curves for four different quantities of capital.
2) Swanky can produce 13 sweaters a day with 1 knitting machine on ATC1 or with 3 knitting machines on ATC3 for and average cost of $7.69 per sweater.
30 Swanky can produce the same number of sweaters by using 2 knitting machines on ATC2 for $6.80 per sweater or with 4 machines on ATC4 for $9.50 per sweater.
4) If Swanky produces 13 sweaters a day, the least-cost method of production--the long-run method--is with 2 machines on ATC2 .. 68

24. Long-Run Average Cost Curve
Instructor Notes:
1) In the long run, Swanky can vary both capital and labor inputs.
2) The long-run average cost curve, LRAC, traces the lowest attainable average total cost of production.
3) Swanky produces on its long-run average cost curve if it uses 1 machine to produce up to 10 sweaters a day, 2 machines to produce between 10 and 18 sweaters a day, 3 machines to produce between 18 and 24 sweaters a day, and 4 machines to produce more than 24 sweaters a day.
5) Within these ranges, Swanky varies its output by varying its labor input. 69

25. Returns to Scale
Returns to scale are the increases in output that result from increasing all inputs by the same percentage.
Three possibilities:
Constant returns to scale
Increasing returns to scale
Decreasing returns to scale 70

26. Returns to Scale Constant returns to scale
Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by the same percentage 71

27. Returns to Scale Increasing returns to scale
Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a larger percentage 72

28. Returns to Scale Decreasing returns to scale
Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a smaller percentage 73

29. Minimum Efficient Scale
A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level.

30. The End