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Costs Curves Diminishing Returns

Costs Curves Diminishing Returns. Accounting Costs Economic Costs Supply. ACCOUNTING COSTS. Accounting costs are monetary (usually explicit). Accounting profit = Revenue – Accounting costs. ECONOMIC COSTS. Economic costs = accounting costs + opportunity costs.

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Costs Curves Diminishing Returns

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  1. CostsCurvesDiminishing Returns Accounting Costs Economic Costs Supply

  2. ACCOUNTING COSTS • Accounting costs are monetary (usually explicit). • Accounting profit = Revenue – Accounting costs.

  3. ECONOMIC COSTS • Economic costs = accounting costs + opportunity costs. • Economic profit = revenue – economic costs. • Economic profit = revenue – (accounting costs + opportunity costs).

  4. ECONOMIC COSTS • Economic costs = accounting costs + opportunity costs. • In economic analysis we use economic costs. • To make a wise decision we need to consider all costs and not only monetary costs. • Opportunity costs should be considered as they have an important bearing on our decision making. These include opportunity cost for resources owned by the firm itself.

  5. OPPORTUNITY COSTS • Bill owns a farm worth $1m. His yearly revenue is $100,000 and his expenses are $60,000. The current interest rate is 5% for savings. What is Bill’s accounting profit and what is his economic profit? Accounting profit $$40,000 Economic profit -($10,000)

  6. OPPORTUNITY COSTS • Chen runs her own business. She receives no wage or salary. She could work full-time for $25,000pa. Her business revenue for last year was $30,000 and her expenses $10,000. What is her accounting profit and her economic profit? Economic profit -($5000) Accounting profit $20000

  7. OPPORTUNITY COSTS • Tao must travel from Wellington to Auckland for business. Tao is paid $20 per hour and he must travel in work time. Prices and times are: Plane is cheapest. If we consider opportunity costs, total cost for plane travel is $170 – much cheaper than the other options. Which is cheapest?

  8. Economic costs in more detail • Rent- Economic return to land (return to any factor that is in fixed supply) • Wages- Economic return to labour. It includes all ways people a compensated for providing their time, efforts and skills. (except for enterprise) • Interest- Economic return on capital. • Profit- Economic return to enterprise for taking risk. It is the reward to those who run the risk of failure when they bring together all the other factors of production

  9. Do this Now • Last year Mona had a job as a manager for a fishing company, which paid her $65,000 a year, • She had $80,000 in savings, which gave her a rate of return of 10%. • She thought she could do better by going fishing herself, so gave up her job and invested $80,000 of her own money in buying a fishing boat and quota. • By the end of the first year she had sold $140,000 worth of fish and her costs of running the business had been $70,000. She expected the costs to be quite high in the first year, because she was getting the business established, but though these would fall in future years. • 1. Calculate her accounting profit • 2. Calculate her economic profit • 3. Which are always greater? Economic or accounting profits? Explain

  10. Answers! • 1. Calculate her accounting profit Revenue - Accounting costs 140,000 – 70,000 = 70,000 • 2. Calculate her economic profit Revenue – Economic Costs (accounting costs + opportunity costs) 140,000 – 70,000 – 65,000- (80,000 x0.10) = -3000 • 3. Which are always greater? Economic or accounting profits? Explain • Accounting profits are equal to Revenue minus accounting costs. Economic profits are equal to revenue minus accounting costs and opportunity costs. Thus Accounting profits will always be greater than Economic profits due to economic profits taking into account an extra cost, opportunity costs.

  11. Fixed costs are costs that do not vary with output

  12. Fixed costs are costs that do not vary with output Variable costs are costs that increase as output increases

  13. Fixed costs are costs that do not vary with output Variable costs are costs that increase as output increases Total costs = Fixed + Variable costs

  14. Fixed costs are costs that do not vary with output TC Variable costs are costs that increase as output increases VC FC Total costs = Fixed + Variable costs FC, VC & TC Costs($) Quantity

  15. Average and Marginal Cost AC = TC/Q

  16. Average and Marginal Cost AC = TC/Q MC = TC2 - TC1

  17. Starter Activity We will assume all groups are equally skilled, so the marginal product is the difference between group one’s total and group two’s total product. Graph the number of workers on the horizontal axis against the number of blocks sorted on the vertical axis. What do you notice?

  18. Short-run costs In economics we distinguish between various time periods - ie short and long run. The short run, which our particular concern, is a period when at least one input to the production process is fixed. This means that in the short run all production will be subject to the law of diminishing return. fig

  19. Diminishing Returns The law of diminishing returns states that where additional units of a variable input are added to a fixed amount of another input, the additional output, or marginal product, will eventually fall.

  20. Fixed Input Variable input The additional output(MP) eventually falls Diminishing Returns

  21. MC decreases initially because of increasing returns MC increases because of diminishing returns The Shape of the MC curve MC Costs($) Note: always plot the MC curve at the mid-point! Quantity

  22. AFC The Shape of Average Cost Curves Costs($) FC are constant so AFC will continually decline as FC are spread over increasing output FC Quantity

  23. AC decreases because of short run economies: • Technical • Marketing • Managerial • Financial The Shape of Average Cost Curves Costs($) AC AFC Quantity

  24. AC increases as short run diseconomies set in. The Shape of Average Cost Curves Costs($) AC AFC Quantity

  25. The Shape of Average Cost Curves Costs($) AC The difference between AC and AVC is equal to AFC AVC AFC Quantity

  26. If MC<AC then AC will be decreasing Marginal Cost & Average Cost MC Costs($) AC Quantity

  27. If MC>AC then AC will be increasing Marginal Cost & Average Cost MC Costs($) AC Quantity

  28. Marginal Cost & Average Cost MC Costs($) AC MC cuts AC at its minimum point - this is the technical optimum Quantity

  29. Marginal Cost & Average Variable Cost MC Costs($) AC MC also cuts AVC at its minimum point AVC Quantity

  30. This is the break even point Break Even & Shut Down MC Costs($) AC A firm must cover AC if it is to break even AVC Break even point is where AR=AC. Where the price is enough to cover all costs and the firms make normal profits. Quantity

  31. This is the shut down point Break Even & Shut Down MC Costs($) AC In the SR a firm can survive if P > AVC AVC Quantity

  32. A firm’s Supply curve is derived from the MC curve above the shut-down point The Supply Curve MC =S Why do you think the supply curve is upwards sloping? Costs($) AC AVC Because of diminishing returns! Producing higher levels of output results in progressively less efficient resource combinations. Because of this the firm will only supply a larger quantity at higher prices. Quantity

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