Objectives of chapter 4: Understand the notion of economic cost

1. Chapter 4: The Costs of Production Objectives of chapter 4: Understand the notion of economic cost The short-run production relationship The short-run production costs The long-run production costs Chapter 4 by TITH Seyla

2. Introduction • Businesses produce goods and services. To produce, those firms need economic resources • To use the resource, we need to make monetary payment to resource owners (such as salary for workers). • To use the resource we already own, there is an opportunity cost. • The monetary payment and the opportunity cost constitutes the cost of production in any given firms. $$$$$$$$$$$$$ Chapter 4 by TITH Seyla

3. Economic costs • Explicit costs: monetary payments or cash expenditure a firm makes to those who supply labor services, materials, fuel, transportation services, etc. • Implicit costs: the opportunity costs of using its self-owned, self-employed resources. • To a firm, implicit costs are the money payments that self-employed resources could have earned in their best alternative use. • Normal profit of a firm is considered as an economic cost. The normal profit is the profit required to attract and retain resources in a specific line of production. • Economic profit: pure profit after deducting the economic cost, which include the normal profit. Chapter 4 by TITH Seyla

4. Economic profit Chapter 4 by TITH Seyla

5. Short-run and long-run • Short-run: Fixed plant • A period too brief for a firm to alter its plant capacity. • The firm’s plant capacity is fixed in the short-run. • However, the firm can vary its output by applying larger or smaller amounts of labor, materials, and other resources to that plant. • Long-run: Variable plant • A period long enough for a firm to adjust the quantities of all the resources that it employs, including plant capacity. • The long-run also includes enough time for existing firm to dissolve and leave the industry or for new firms to be created and enter the industry. • The short-run and the long-run are conceptual periods rather than calendar time periods. Chapter 4 by TITH Seyla

6. Short-run production relationships • Total product (TP): The total quantity, or total output, of a particular good produced. • Marginal product (MP): The extra output or added product associated with adding a unit of a variable resource, normally labor. MP = ∆ TP / ∆ units of labor • Average product (AP): also called labor productivity. AP is the output per unit of labor input. AP= TP / Units of labor Chapter 4 by TITH Seyla

7. Law of diminishing returns (a) • Law of diminishing returns = law of diminishing marginal product • The law of diminishing returns: states that as successive units of a variable resource (labor) are added to a fixed resource (capital), the marginal product (extra product), that can be attributed to each additional unit of the variable resource, will decline. Chapter 4 by TITH Seyla

8. Law of diminishing returns (b) Chapter 4 by TITH Seyla

9. Law of diminishing returns (c) Chapter 4 by TITH Seyla

10. Short-run production costs (a) • A firm’s total cost (TC) is the cost of all resources used. • Total fixed cost (TFC) is the cost of the firm’s fixed inputs. Fixed costs do not change with output. • Total variable cost (TVC) is the cost of the firm’s variable inputs. Variable costs do change with output. • Total cost equals total fixed cost plus total variable cost. That is: TC = TFC + TVC Chapter 4 by TITH Seyla

11. Short-run production costs (b) Chapter 4 by TITH Seyla

12. Short-run production costs (c) • Marginal cost (MC) is the increase in total cost that results from a one-unit increase in total product. • Average fixed cost (AFC) is total fixed cost per unit of output. • Average variable cost (AVC) is total variable cost per unit of output. • Average total cost (ATC) is total cost per unit of output. ATC = AFC + AVC Chapter 4 by TITH Seyla

13. Short-run production costs (d) Chapter 4 by TITH Seyla

14. Chapter 4 by TITH Seyla

15. Long-run production costs (a) • In the long run, all inputs are variable and all costs are variable. • Diminishing Marginal Product of Capital • The marginal product of capital is the increase in output resulting from a one-unit increase in the amount of capital employed, holding constant the amount of labor employed. • For each plant, diminishing marginal product of labor creates a set of short run, U-shaped costs curves for MC, AVC, and ATC. • The larger the plant, the greater is the output at which ATC is at a minimum. Chapter 4 by TITH Seyla

16. Chapter 4 by TITH Seyla

17. Long-run production costs (b) • Economies of scale are features of a firm’s technology that lead to falling long-run average cost as output increases. • Diseconomies of scale are features of a firm’s technology that lead to rising long-run average cost as output increases. • Constant returns to scale are features of a firm’s technology that lead to constant long-run average cost as output increases. Chapter 4 by TITH Seyla