20The Costs ofProduction

Economic Costs• Economic Cost / Opportunity Cost

– the measure of any resource used to produce a good is the value or worth the resource would have in its best alternative use

• Explicit Costs– Cash expenditures (i.e. labor costs)

• Implicit Costs– Opportunity costs; money payments that resources could have earned in their

best alternative use (i.e. interest in a savings account) • Normal Profit as a Cost

– Nick could be earning $30k but is not while he decides to go into being a DJ at parties. Giving up $30k is an opportunity cost. Add this to the start up costs of $5k for DJ equipment, for Nick to get his groove on and not go back to his old job.He needs to make $35k to cover his costs and opportunity cost.so... if revenue < $35k = lossrevenue = $35k = normal profit

• Economic or Pure Profit

EconomicProfit

TotalRevenue

EconomicCost= -

Profits ComparedEconomic Profit Versus Accounting Profits

EconomicProfit

AccountingCosts (Explicit

Costs Only)

AccountingProfit

ExplicitCosts

Implicit Costs(Including a

Normal Profit)

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Economics Accounting

Short Run and Long Run•Short Run: too short to alter its plants capacity. However, the firm can vary its output by applying larger or smaller amounts of labor, materials, or other resources.•Long Run: Variable Plant – every cost is a variable cost

Short-Run Production Relationships

Average Product Total ProductUnits of Labor=

Marginal Product Change in Total ProductChange in Labor Input=

• Total Product (TP) – total output

• Marginal Product (MP) – extra output associated with adding a unit of a variable resource

• Average product (AP) – also called labor productivity, output per unit of labor

IncreasingMarginalReturns

Law of Diminishing Returns• Definition: while one variable factor are increased, and other factor inputs remain constant, ceteris

paribus, a point is reached beyond which the addition of one more unit of the variable factor will result in a diminishing rate of return and the marginal physical product will fall.

– For example: Part time job?

(1)Units of the

Variable Resource(Labor)

(2)Total Product

(TP)

(3)Marginal Product

(MP),Change in (2)/Change in (1)

(3)AverageProduct

(AP),(2)/(1)

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DiminishingMarginalReturns

NegativeMarginalReturns

Law of Diminishing Returns

0

10

20

30

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1 2 3 4 5 6 7 8 9

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TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

Short-Run Production Costs

•Fixed Costs•Variable Costs•Total Cost

TC = TFC + TVC

So what’s the difference between Average vs. Marginal?

There are two twins enrolled in econ. Both have a “B” average (3.0).

Twin One gets a “C.” What happens to her GPA?

Twin Two gets an “A.” What happens to her GPA?

Average vs. Marginal

A “marginal” grade lower than the average pulls down the average.

A “marginal” grade higher than the average boosts the average.

Average vs. Marginal

The same is true of marginal cost and average cost.

Average vs. Marginal

If marginal cost is less than average cost, the average cost will fall.

If marginal cost is more than average cost, the average cost will rise.

Short-Run Production Costs

AFC =TFC

Q

AVC =TVC

Q

ATC =TCQ

= AFC + AVC

MC =Change in TCChange in Q

Graphically…

Short-Run Production CostsTotal Cost, Fixed and Variable Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

100

200

300

400

500

600

700

800

900

1000

$1100

TFC

TC

TVC

TotalCost

VariableCost

FixedCost

Short-Run Production CostsAverage and Marginal Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

*Notice that as MC increases, so does ATC

and AVC

* Notice AFC decreases as the

fixed cost is spread out with

qty.

Short-Run Production Costs• Shifts in Cost Curves

– Changes in either resources prices or technology will cause costs to change and therefore the cost curves to shift• For example, if fixed costs double from

$100 to $200, the AFC will shift upward– ATC will also shift upward because AFC is

apart of ATC

MC and Marginal Product • The marginal cost curve, the graphical relation between

marginal cost and output, is U-shaped. • Marginal cost is relatively high at small quantities of

output, then as production increases, it declines, reaches a minimum value, then rises once again.

• This U shape is directly attributable to increasing, then decreasing marginal returns (and the law of diminishing marginal returns). – As marginal marginal returns increases for relatively

small output quantities, marginal cost declines. Then as marginal returns decreases with the law of diminishing marginal returns for relatively large output quantities, marginal cost increases

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MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves

So Why are they mirror images of each other?

Economies of Scale / Diseconomies of Scale

• Reduction in long-run average and marginal costs, due to increase in size of an operating unit (a factory or plant, for example). Economics of scale can be internal to a firm (cost reduction due to technological and management factors) or external (cost reduction due to the effect of technology in an industry).

• In contrast, when production is low in comparison to the input costs, the result is diseconomies of scale. – This anomaly may be caused by factors such as (1)

over-crowding where workers and machines get in each other's way, (2) greater wastage due to lack of coordination

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

Long-Run Production CostsLong-Run ATC Curve

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sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed

Long-Run Production CostsLong-Run ATC Curve

Long-RunATC

Ave

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sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

The Long-Run ATC Curve Just“Envelopes” the Short Run ATCs

Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where EconomiesOf Scale Exist

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Long-RunATC

EconomiesOf Scale

Constant ReturnsTo Scale

DiseconomiesOf Scale

q1 q2

Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where Costs AreLowest Only When Large Numbers AreParticipating

Ave

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sEconomies

Of ScaleDiseconomies

Of Scale

Long-RunATC

Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where EconomiesOf Scale Exist, are Exhausted Quickly,And Turn Back Up Substantially

Ave

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Long-RunATC

EconomiesOf Scale

DiseconomiesOf Scale

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

Don’t Cry Over Sunk Costs

• 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!

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