2. 20 The Costs of Production

3. Economic Costs Economic Cost / Opportunity Cost –the measure of any resource used to produce a good is the value or worth the resource would have in its best alternative use Explicit Costs –Cash expenditures (i.e. labor costs) Implicit Costs –Opportunity costs; money payments that resources could have earned in their best alternative use (i.e. interest in a savings account) Normal Profit as a Cost –Nick could be earning $30k but is not while he decides to go into being a DJ at parties. Giving up $30k is an opportunity cost. Add this to the start up costs of $5k for DJ equipment, for Nick to get his groove on and not go back to his old job.He needs to make $35k to cover his costs and opportunity cost. so... if revenue < $35k = loss revenue = $35k = normal profit Economic or Pure Profit Economic Profit Total Revenue Economic Cost = -

4. Profits Compared Economic Profit Versus Accounting Profits Economic Profit Accounting Costs (Explicit Costs Only) Accounting Profit Explicit Costs Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Economics Accounting Short Run and Long Run Short Run: too short to alter its plants capacity. However, the firm can vary its output by applying larger or smaller amounts of labor, materials, or other resources. Long Run: Variable Plant – every cost is a variable cost

5. Short-Run Production Relationships Average Product Total Product Units of Labor = Marginal Product Change in Total Product Change in Labor Input = Total Product (TP) – total output Marginal Product (MP) – extra output associated with adding a unit of a variable resource Average product (AP) – also called labor productivity, output per unit of labor

6. Increasing Marginal Returns Law of Diminishing Returns Definition: while one variable factor are increased, and other factor inputs remain constant, ceteris paribus, a point is reached beyond which the addition of one more unit of the variable factor will result in a diminishing rate of return and the marginal physical product will fall. –For example: Part time job? (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

7. Law of Diminishing Returns 0 10 20 30 output 123456789 20 10 output 123456789 TP MP AP Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns

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

9. So what’s the difference between Average vs. Marginal? There are two twins enrolled in econ. Both have a “B” average (3.0).  Twin One gets a “C.” What happens to her GPA?  Twin Two gets an “A.” What happens to her GPA?

10. Average vs. Marginal A “marginal” grade lower than the average pulls down the average. A “marginal” grade higher than the average boosts the average.

11. Average vs. Marginal The same is true of marginal cost and average cost.

12. Average vs. Marginal If marginal cost is less than average cost, the average cost will fall. If marginal cost is more than average cost, the average cost will rise.

13. Short-Run Production Costs AFC = TFC Q AVC = TVC Q ATC = TC Q = AFC + AVC MC = Change in TC Change in Q Graphically…

14. Short-Run Production Costs Total Cost, Fixed and Variable 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

15. Short-Run Production Costs Average and Marginal Costs Costs 123456789 100 Q 50 100 150 $200 AFC MC ATC AVC AFC *Notice that as MC increases, so does ATC and AVC * Notice AFC decreases as the fixed cost is spread out with qty.

16. Short-Run Production Costs Shifts in Cost Curves –Changes in either resources prices or technology will cause costs to change and therefore the cost curves to shift For example, if fixed costs double from $100 to $200, the AFC will shift upward –ATC will also shift upward because AFC is apart of ATC

17. MC and Marginal Product The marginal cost curve, the graphical relation between marginal cost and output, is U-shaped. Marginal cost is relatively high at small quantities of output, then as production increases, it declines, reaches a minimum value, then rises once again. This U shape is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns). –As marginal marginal returns increases for relatively small output quantities, marginal cost declines. Then as marginal returns decreases with the law of diminishing marginal returns for relatively large output quantities, marginal cost increases

18. Average Product and Marginal Product Cost (Dollars) MP AP MC AVC Quantity of Output Quantity of Labor Production Curves Cost Curves So Why are they mirror images of each other?

19. Economies of Scale / Diseconomies of Scale Reduction in long-run average and marginal costs, due to increase in size of an operating unit (a factory or plant, for example). Economics of scale can be internal to a firm (cost reduction due to technological and management factors) or external (cost reduction due to the effect of technology in an industry). In contrast, when production is low in comparison to the input costs, the result is diseconomies of scale. – This anomaly may be caused by factors such as (1) over- crowding where workers and machines get in each other's way, (2) greater wastage due to lack of coordination

20. 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

21. Long-Run Production Costs 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

22. Long-Run Production Costs 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

23. Long-Run Production Costs Alternative 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

24. Long-Run Production Costs Alternative Long-Run ATC Shapes 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

25. Long-Run Production Costs Alternative Long-Run ATC Shapes 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

26. 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

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