1. McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. The Costs of Production Chapter 8

2. Chapter Objectives Explicit and implicit costs Law of diminishing returns Fixed and variable costs Total, average, and marginal costs The firm’s size in the long run 8-2

3. Economic Costs Equal to opportunity costs Explicit + implicit costs Explicit costs –Monetary payments Implicit costs –Value of next best use –Self-owned resources (rent) –Self-employed resources (labor) 8-3

4. Profit Accounting profit –Total revenue less explicit cost Normal profit –Equal to implicit cost Economic or pure profit –Total revenue less economic cost 8-4

5. Profits Compared Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Economic Accounting 8-5

6. Short and Long Run The short run –Fixed plant capacity –Variable intensity of plant use –Variable output The long run –Variable plant capacity –Firms enter and exit 8-6

7. Production Relationships Total product (TP) Marginal product (MP) Average product (AP) Average Product Total Product Units of Labor = Marginal Product Change in Total Product Change in Labor Input = 8-7 **AP = Productivity

8. Law of Diminishing Returns Fixed technology Add variable resource to fixed resource Marginal product will decline –Beyond some point Rationale - farming, factory examples 8-8

9. Increasing Marginal Returns Law of Diminishing Returns (1) Units of the Variable Resource (Labor) (2) Total Product (TP) (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) 012345678012345678 0 10 25 45 60 70 75 70 10 15 20 15 10 5 0 -5 - 10.00 12.50 15.00 14.00 12.50 10.71 8.75 ] ] ] ] ] ] ] ] Diminishing Marginal Returns Negative Marginal Returns 8-9

10. 0 10 20 30 Total Product, TP 123456789 20 10 Marginal Product, MP 123456789 TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns Law of Diminishing Returns 8-10

11. Short-Run Production Costs Fixed Costs –Do not vary with output –What are some fixed costs of production? Variable Costs –Materials, most labor Total Cost –TC = TFC + TVC 8-11

12. Per-Unit Production Costs Why are per-unit costs important? Important when comparing to price Average fixed cost AFC = TFC/Q Average variable cost AVC = TVC/Q Average total cost ATC = TC/Q = TFC/Q + TVC/Q ATC = AFC+AVC Marginal cost MC = change in TC/change in Q 8-12

13. Individual Firm in Short Run – Pg. 161

14. Short-Run Production Costs Costs 123456789 100 Q 100 200 300 400 500 600 700 800 900 1000 $1100 TFC TC TVC Total Cost Variable Cost Fixed Cost 8-14

15. Short-Run Production Costs Costs 123456789 100 Q 50 100 150 $200 AFC MC ATC AVC AFC 8-15

16. Average Product and Marginal Product Cost (Dollars) Graphical Relationships MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves 8-16

17. Production Relationships Marginal cost and diminishing returns Marginal cost and marginal product Marginal cost and average variable cost Marginal cost and average total cost Production curves and cost curves 8-17

18. Shifts in Cost Curves Shifts in cost curves – Which curves shift and where? –Change in cost of variable inputs? –Change in cost of fixed inputs? Examples –Decrease in union wage requirements? AVC, ATC, MC shift DOWN –Increase in rent? AFC, ATC, shift UP –Increase in cost of materials? AVC, ATC, MC shift UP –More efficient production technology is discovered? AVC, ATC, MC shift DOWN

19. Long-Run Production Costs Choose your plant size –What would generally happen to cost curves if we open a larger plant? Minimize ATC Different ATC curves –Short run Long run ATC –Envelope of short run ATC 8-19

20. Long-Run ATC Curve Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output Any number of short-run optimum size cost curves can be constructed 8-20

21. Long-Run ATC Curve Long-Run ATC Average Total Costs ATC-1 ATC-2 ATC-3 ATC-4 ATC-5 Output The long-run ATC curve just “envelopes” the short run ATCs 8-21

22. Long Run Production Cost Economies of Scale –Labor specialization –Managerial specialization –Efficient capital Diseconomies of Scale –Difficulty in communicating and coordinating –Workers can feel less attached/motivated Constant Returns to Scale 8-22

23. Long-Run ATC Shapes Output Long-run ATC curve where economies of scale exist Average Total Costs Long-Run ATC Economies Of Scale Constant Returns To Scale Diseconomies Of Scale q1q1 q2q2 8-23

24. Output Long-run ATC curve where costs are lowest only when large numbers are participating Average Total Costs Economies Of Scale Diseconomies Of Scale Long-Run ATC Long-Run ATC Shapes 8-24

25. Output Long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially Average Total Costs Long-Run ATC Economies Of Scale Diseconomies Of Scale Long-Run ATC Shapes 8-25

26. Industry Structure Minimum efficient scale (MES) –Minimum level of output necessary to minimize LRATC Natural monopoly –One large firm Pure Competition –Many small firms Monopolistic Competition –Some small, some large firms 8-26

27. Sunk Costs Irrelevant in decision making Cannot be recovered Do not affect marginal benefit and marginal cost Firm example: –R&D costs 8-27

28. 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 8-28

29. Next Chapter Preview… Pure Competition 8-29