The Costs of Production

1. 20 The Costs of Production

2. Chapter Objectives • Why Do Economic Costs Include Both Explicit Costs and Implicit Costs • How Does the Law of Diminishing Returns Relate to a Firm’s Short-Run Production Costs • Learn the Distinctions Between Fixed and Variable Costs and Among Total, Average, and Marginal Costs • Learn the Link Between a Firm’s Size and Its Average Costs in the Long Run

3. W 20.1 Economic Profit Total Revenue Economic Cost - = Economic Costs • Economic Cost • Opportunity Cost • Explicit Costs • Implicit Costs • Normal Profit as a Cost • Economic or Pure Profit

4. Economics Accounting Profits Compared Economic Profit Versus Accounting Profits Accounting Profit Economic Profit Implicit Costs (Including a Normal Profit) Economic (Opportunity) Costs Total Revenue Explicit Costs Accounting Costs (Explicit Costs Only) • Short Run and Long Run • Short Run: Fixed Plant • Long Run: Variable Plant

5. W 20.2 Change in Total Product = Marginal Product Change in Labor Input Total Product = Average Product Units of Labor Short-Run Production Relationships • Total Product (TP) • Marginal Product (MP) • Average Product (AP)

6. O 20.1 (3) Marginal Product (MP), Change in (2)/ Change in (1) (3) Average Product (AP), (2)/(1) (1) Units of the Variable Resource (Labor) (2) Total Product (TP) ] ] ] ] ] ] ] ] Law of Diminishing Returns • Rationale • Tabular Example - 10.00 12.50 15.00 15.00 14.00 12.50 10.71 8.75 0 10 25 45 60 70 75 75 70 0 1 2 3 4 5 6 7 8 10 15 20 15 10 5 0 -5 Increasing Marginal Returns Diminishing Marginal Returns Negative Marginal Returns

7. O 20.2 30 Total Product, TP 20 10 0 20 Marginal Product, MP 10 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9 Law of Diminishing Returns • Graphical Portrayal TP Increasing Marginal Returns Negative Marginal Returns Diminishing Marginal Returns AP MP

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

9. TFC TVC AFC = AVC = Q Q TC = AFC + AVC ATC = Q Change in TC MC = Change in Q Short-Run Production Costs • Per-Unit or Average Costs • Average Fixed Cost (AFC) • Average Variable Cost (AVC) • Average Total Cost (ATC) • Marginal Cost (MC) Graphically…

10. $1100 1000 900 800 700 600 Costs 500 400 300 200 100 0 10 1 2 3 4 5 6 7 8 9 Q Short-Run Production Costs Total Cost, Fixed and Variable Costs TC TVC Fixed Cost Total Cost Variable Cost TFC

11. G 20.1 $200 150 100 Costs 50 0 10 1 2 3 4 5 6 7 8 9 Q Short-Run Production Costs Average and Marginal Costs MC AFC ATC AVC AVC AFC

12. W 20.3 Short-Run Production Costs • MC and Marginal Product • Marginal Decisions • Relation of MC to AVC and ATC • Relationship Between Productivity Curves and Cost Curves • Shifts in Cost Curves Graphically…

13. Average Product and Marginal Product Cost (Dollars) Short-Run Production Costs Production Curves AP MP Quantity of Labor Cost Curves MC AVC Quantity of Output

14. 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

15. Long-Run Production Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 ATC-4 ATC-3 Average Total Costs Output Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed

16. Long-Run Production Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 Long-Run ATC ATC-4 ATC-3 Average Total Costs Output The Long-Run ATC Curve Just “Envelopes” the Short Run ATCs

17. Long-Run Production Costs Long-Run ATC Curve ATC-1 ATC-5 ATC-2 Long-Run ATC ATC-4 ATC-3 Average Total Costs Output The Long-Run ATC Curve Just “Envelopes” the Short Run ATCs

18. Long-Run Production Costs Alternative Long-Run ATC Shapes Diseconomies Of Scale Constant Returns To Scale Economies Of Scale Average Total Costs Long-Run ATC q1 q2 Output Long-Run ATC Curve Where Economies Of Scale Exist

19. Long-Run Production Costs Alternative Long-Run ATC Shapes Economies Of Scale Diseconomies Of Scale Average Total Costs Long-Run ATC Output Long-Run ATC Curve Where Costs Are Lowest Only When Large Numbers Are Participating

20. Long-Run Production Costs Alternative Long-Run ATC Shapes Diseconomies Of Scale Economies Of Scale Long-Run ATC Average Total Costs Output Long-Run ATC Curve Where Economies Of Scale Exist, are Exhausted Quickly, And Turn Back Up Substantially

21. O 20.3 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

22. Don’t Cry Over Sunk Costs Last Word • 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!

23. 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 (MES) natural monopoly Key Terms

24. Next Chapter Preview… Pure Competition Chapter 21!