Principles of Economics

1. Principles of Economics Session 5

2. Topics To Be Covered • Categories of Costs • Costs in the Short Run • Costs in the Long Run • Economies of Scope

3. The Firm’s Objective The economic goal of the firm is to maximize profits. Maximum Profits

4. A Firm’s Profit Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost

5. Costs as Opportunity Costs A firm’s cost of production includes all the opportunity costs of making its output of goods and services.

6. Opportunity Cost The value of the next best use for an economic good, or the value of the sacrificed alternative.

7. Explicit and Implicit Costs A firm’s cost of production include explicit costs and implicit costs. Explicit costs involve a direct money outlay for factors of production. Implicit costs, also called normal profit, refer to the opportunity cost of using the owner’s own resources.

8. Economic Profit versus Accounting Profit • Economists measure a firm’s economic profit as total revenue minus all the opportunity costs (explicit and implicit). • Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. In other words, they ignore the implicit costs.

9. Economic Profit versus Accounting Profit • When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. • Economic profit is smaller than accounting profit.

10. How an Economist How an Accountant Views a Firm Views a Firm Economic profit Accounting profit Implicit costs Revenue Revenue Total opportunity costs Explicit Explicit costs costs Economic Profit versus Accounting Profit

11. Total Cost of Production Total cost of production may be divided into fixed costs and variable costs.

12. Fixed and Variable Costs • Fixed costs are those costs that do not vary with the quantity of output produced. • Variable costs are those costs that do change as the firm alters the quantity of output produced.

13. Family of Total Costs TC = Total Costs TFC=Total Fixed Costs TVC=Total Variable Costs

14. Fixed Cost vs. Sunk Cost • Fixed CostCost paid by a firm that is in business regardless of the level of output • Sunk CostCost that have been incurred and cannot be recoverede.g. advertising expenditure

15. Variable Cost and Sunk Cost • Personal Computers: most costs are variablee.g. components, labor • Software: most costs are sunke.g. cost of developing the software

16. Total Cost

17. TC Cost ($ per year) 400 Total cost is the vertical sum of FC and VC. TVC Variable cost increases with production and the rate varies with increasing & decreasing returns. 300 200 Fixed cost does not vary with output 100 50 TFC Output 0 1 2 3 4 5 6 7 8 9 10 11 12 13 Total Cost Curves

18. Average Costs • The average cost is the cost of each typical unit of product. • Average costs can be determined by dividing the firm’s costs by the quantity of output produced.

19. Family of Average Costs ATC=Average Total Costs AFC=Average Fixed Costs AVC=Average Variable Costs

20. Family of Average Costs

21. Average Costs

22. ATC AVC AFC Average Cost Curves Cost ($ per unit) 100 75 50 25 Output (units/yr.) 1 0 2 3 4 5 6 7 8 9 10 11

23. U-Shaped ATC and AVC Curves • The ATC curve is U-shaped. • At very low levels of output average total cost is high because fixed cost is spread over only a few units. • Average total cost declines as output increases. • Average total cost starts rising because average variable cost rises substantially. • The AVC curve is also U-shaped for its relationship with the ATC curve.

24. Marginal Cost Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:

25. Marginal Cost

26. MC Marginal Cost Curve Cost ($ per unit) 100 75 50 25 Output (units/yr.) 1 0 2 3 4 5 6 7 8 9 10 11

27. Cost Curves for a Firm Cost ($ per unit) 100 MC 75 50 ATC AVC 25 AFC Output (units/yr.) 1 0 2 3 4 5 6 7 8 9 10 11

28. From TC to AC and MC AFC= slope of line from origin to a point on TFC AVC = slope of line from origin to a point on TVC ATC = slope of line from origin to a point on TC MC = slope of tangent to a point on TC or TVC P P TC 100 400 TVC MC 75 300 B 50 ATC 200 B' AVC A A' 25 100 TFC AFC Q Q 13 1 11 12 0 2 3 4 5 6 7 8 9 10 11 0 1 2 4 5 6 7 8 9 10 3

29. AFC falls continuously When MC < AVC or MC < ATC, AVC and ATC decrease When MC > AVC or MC > ATC, AVC and ATC increase Cost ($ per unit) 100 MC 75 50 ATC AVC 25 AFC 1 0 2 3 4 5 6 7 8 9 10 11 Output (units/yr.) Properties of Cost Curves

30. MC crosses AVC and ATC at the minimums of AVC and ATC, respectively. Minimum AVC occurs at a lower output than minimum ATC Cost ($ per unit) 100 MC 75 50 ATC AVC 25 AFC 1 0 2 3 4 5 6 7 8 9 10 11 Output (units/yr.) Properties of Cost Curves

31. Costs in the Long Run For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. • In the short run some costs are fixed. • In the long run fixed costs become variable costs.

32. Costs in the Long Run Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

33. Long-Run Average and Marginal Cost • If LMC < LAC, LAC will fall • If LMC > LAC, LAC will rise • LMC = LAC at the minimum of LAC

34. LMC LAC A Long-Run Average and Marginal Cost Cost ($ per unit of output Output

35. ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Average Total Cost in the Short and Long Runs Average Total Cost 0 Quantity of Cars per Day

36. Long-Run Costs andReturns to Scale • The optimal plant size will depend on the anticipated output. • Firms can change scale to change output in the long-run. • The long-run average cost curve is the envelope of the firm’s short-run average cost curves.

37. SAC1 LAC SAC3 SAC2 A $10 $8 B SMC1 SMC3 LMC SMC2 If the output is Q1 a manager would choose the small plant SAC1 and SAC $8. Q1 Long-Run Cost with Economiesand Diseconomies of Scale Cost ($ per unit of output Output

38. Economies and Diseconomies of Scale • Economies of scale occur when long-run average total cost declines as output increases. • Diseconomies of scale occur when long-run average total cost rises as output increases. • Constant returns to scale occur when long-run average total cost does not vary as output increases.

39. ATC in long run Economies of scale Constant Returns to scale Diseconomies of scale Economies and Diseconomies of Scale Average Total Cost 0 Quantity of Cars per Day

40. Economies of Scope Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output. • Chicken farm—poultry and eggs • Automobile company—cars and trucks • University—Teaching and research

41. Advantages of Economiesof Scope • Both use similar, relative, and even the same capital and labor. • The firms share management resources. • The production of one good results in the production of another good at little or no extra cost.

42. Measuring Degree of Economies of Scope C(Q1)= cost of producing Q1 C(Q2)=cost of producing Q2 C(Q1Q2)=joint cost of producing both products If SC > 0 —Economies of scope If SC < 0 —Diseconomies of scope

43. Economies of Scope vs.Economies of Scale • There is no direct relationship between economies of scope and economies of scale. • A firm may experience economies of scope and diseconomies of scale • A firm may have economies of scale and not have economies of scope

44. Assignment • Review Chapter 7 • Answer questions on P130 • Preview Chapter 8

45. Thanks