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

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

3. Explicit and implicit costs
Explicit costs
The monetary payments a firm must make to those who supply it.
Implicit costs
The opportunity costs of using self-employed resources.

4. 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

5. Total revenue – (explicit + implicit costs)
Economic profit
Economic profit is:
Total revenue – economic costs Or
Total revenue – (explicit + implicit costs)

6. Example
Hamad is working as a manager for his entrepreneurial talent worth He decides to open his own business.
He invested his 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 and other utilities is 5000.
Total revenue is
Calculate the explicit and implicit costs
Calculate the accounting and economic profits.

7. ECONOMIC COSTS Profits to an Economist Profits to an AccountantL 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)

8. Accounting: Economics:
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

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

10. 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

11. 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?

12. Law of Diminishing Returns
SHORT-RUN PRODUCTION
RELATIONSHIPS
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

13. Law of Diminishing Returns
SHORT-RUN PRODUCTION
RELATIONSHIPS
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

14. Law of Diminishing Returns
SHORT-RUN PRODUCTION
RELATIONSHIPS
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

15. SHORT-RUN PRODUCTION COSTS
Fixed Costs
Total Fixed Costs
Average Fixed Costs =
Total Fixed Costs
Quantity
Variable Costs
Total Variable Costs
Average Variable Costs =
Total Variable Costs
Quantity

16. SHORT-RUN PRODUCTION COSTS
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

17. 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

18. 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

19. SHORT-RUN PRODUCTION COSTS 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

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

21. SHORT-RUN COSTS GRAPHICALLYMC
Plotting Average and
Marginal Costs
ATC
AVC
Costs (dollars)
AFC
Quantity

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

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

24. LONG-RUN PRODUCTION COSTS
Unit Costs
Output

25. LONG-RUN PRODUCTION COSTS
Unit Costs
Output

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

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

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

29. ECONOMIES AND DISECONOMIES OF SCALE
Constant returns
to scale
Unit Costs
Long-run ATC
Output

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

31. 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

32. 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,

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

34. 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.

35. 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

36. 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

37. 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
natural monopoly
Copyright McGraw-Hill/Irwin 2002
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