Chapter 8Businesses and the Costs of Production

This chapter develops a number of crucial cost concepts that will be employed in the succeeding chapters to analyze the four basic market models. A firm’s implicit and explicit costs are explained for both short and long run periods. The explanation of short run costs includes arithmetic and graphic analyses of both the total, average, and marginal cost concepts. These concepts prepare students for both the total revenue minus total cost and marginal revenue = marginal cost approaches to profit maximization, which are presented in the next few chapters.

The law of diminishing returns is explained as an essential concept for understanding average and marginal cost curves. The general shape of each cost curve and the relationship they bear to one another are analyzed with special care.

The final part of the chapter develops the long run average cost curve and analyzes the characteristics and factors involved in economies and diseconomies of scale. In the Last Word, there is a discussion about 3-D printers, a new technology that may revolutionize manufacturing.

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Key Terms• 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

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Economic Costs• Economic cost• The payment that must be made to obtain

and retain the services of a resource• Explicit costs• Monetary outlay

• Implicit costs• Opportunity cost of using self-owned

resources• Includes a normal profit

LO1

Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those resources away from their best alternative production opportunities. Payments may be explicit or implicit. (Recall the opportunity-cost concept)

Explicit costs are payments to non-owners for resources they supply. In the textbook’s T-shirt example, this would include the cost of the T-shirts, clerk’s salary, and utilities, for a total of $63,000.

Implicit costs are the money payments the self-employed resources could have earned in their best alternative employment. In the textbook’s T-shirt example, this would include forgone interest, forgone rent, forgone wages, and forgone entrepreneurial income, for a total of $33,000.

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Accounting Profit and Normal Profit• Accounting profit

= Revenue - explicit costs• Economic profit

= Accounting profit - implicit costs• Economic profit (to summarize)

= Revenue - economic costs= Revenue - explicit costs - implicit costs

LO1

Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit). Economic profit will always be smaller than accounting profit, which excludes implicit costs. The normal profit is the return to the entrepreneur and is the amount of money required by the entrepreneur to stay in that market.

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5

Explicitcosts

Accounting costs (explicit costs

only)

Implicit costs (including a

normal profit)

Economicprofit

Accounting profit

Econ

omic

(o

ppor

tuni

ty)

cost

s

Tota

l rev

enue

LO1

Economic Profit

Economic profit versus accounting profit. Economic profit is equal to total revenue less economic costs. Economic costs are the sum of explicit and implicit costs and includes a normal profit to the entrepreneur. Accounting profit is equal to total revenue less accounting (explicit) costs.

Short Run and Long Run

• Short run• Some variable inputs• Fixed plant

• Long run• All inputs are variable• Firms can adjust plant size as well as

enter and exit industry

LO2

The short run is a period of time that is too brief for a firm to alter its plant capacity, but can change output somewhat by increasing or decreasing its variable inputs. The long run is a period of time that is long enough for the firm to adjust the plant size as well as enter or leave the industry. All inputs are variable in the long run. One of the primary characteristics of the long run is that it is enough time for firms to enter and exit the industry. Notice that the actual time associated with the short and long run will differ among industries. Light industry and retailing (small t-shirt manufacturer) can adjust quickly compared to heavy industry (an oil company) which may take years to change capacity.

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Short Run Production Relationships• Total product (TP)• Marginal product (MP)

• Average product (AP)

LO2

Marginal product change in total productchange in labor input

=

Average product total productunits of labor

=

The production relationships reflect how labor and output are related in the short run. The total product is the total quantity that is produced. Marginal product (MP) is the amount that total product changes when labor changes by one unit. It reflects the change in output when one more unit of labor is hired. Average product is the output that is produced per unit of labor.

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Law of Diminishing Returns

• Law of diminishing returns• Resources are of equal quality• Technology is fixed• Variable resources are added to fixed

resources• At some point, marginal product will fall

• Rationale

LO2

As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will decrease. Essentially the fixed plant gets overcrowded with variable resources. If we focus on labor being the variable resource, when there isn’t any labor, then the plant is underused because none of the machinery is being used, etc. When hiring one unit of labor, the machinery is still underused – there is machinery that is often idle as that one unit of labor has to perform all of the tasks. As the firm continues to hire more and more labor, the TP is rising by increasing amounts because the machinery is being used more and more to its capacity. However, at some point there will be so much labor that the fixed resources are over utilized and the individuals will have to wait to use the necessary equipment. This is where we might see diminishing marginal returns – where the TP is still increasing when hiring one more unit of labor, but it doesn’t increase as much as it did with the previous unit of labor.

The table on the next slide presents a numerical example of the law of diminishing returns.

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Total, Marginal, and Average Product: The Law of Diminishing Returns

(1)Units of the Variable

Resource (Labor)

(2)Total Product (TP)

(3)Marginal Product

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

(4)Average Product

(AP),(2)/(1)

0 0 -

1 10 10 Increasingmarginalreturns

10.00

2 25 15 12.50

3 45 20 15.00

4 60 15Diminishing

marginalreturns

15.00

5 70 10 14.00

6 75 5 12.50

7 75 0 10.71

8 70 -5 Negativemarginalreturns

8.75

The Law of Diminishing Returns Continued

You can see that at first TP is rising at an increasing rate, so MP is positive and getting larger. This is called increasing marginal returns. Then TP continues to increase, but by smaller and smaller amounts. This is called diminishing marginal returns. TP is still positive and rising but it is now rising at a slower rate. MP measures the rate of change of TP. So, when the firm has hired so many workers that it is overcrowded and impedes the workers’ abilities to produce, the TP starts to fall and MP becomes negative. AP starts out increasing due to increasing marginal returns. Then, at some point, AP will begin to fall as a result of the effects of diminishing marginal returns. It takes AP longer to reflect the diminishing marginal returns.

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The Law of Diminishing Returns Concluded

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

1 2 3 4 5 6 7 8 90

10

20

30

Tota

l pro

duct

, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

gina

l pro

duct

, MP

LO2

The law of diminishing returns states that as successive amounts of a variable resource (labor) are added to fixed amounts of other resources (land or capital), beyond some point the extra, or marginal, product that can be attributed to each additional unit of the variable resource will decline. In other words, as more of the variable inputs are added, the total product (output) that results will eventually increase by diminishing amounts, reach a maximum, and then decline.

Marginal product is the change in total product associated with each new unit of labor. Average product is simply output per labor unit. Note that marginal product intersects average product at maximum average product.

Short Run Production Costs

• Fixed costs (TFC)• Costs that do not vary with output

• Variable costs (TVC)• Costs that do vary with output

• Total cost (TC)• Sum of TFC and TVC• TC = TFC + TVC

LO3

Fixed, variable, and total costs are the short-run classifications of costs. In the short run, costs can be variable or fixed. Fixed cost examples: rental payments, insurance premiums, interest payments. Variable cost examples: payments for materials, fuel, power, transportation services, labor. Total cost is the sum of total fixed and total variable costs at each level of output.

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Cost

s

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

LO3

Short Run Cost Curves

Total fixed cost (TFC) is independent of the level of output. Total cost is the sum of fixed cost and variable cost. Total variable cost (TVC) changes with output.

Since the only thing that differentiates the TC and TVC is the constant fixed costs, the TC and TVC look very similar and are parallel to each other. The total cost (TC) at any output is the vertical sum of the fixed cost and variable cost at that output.

Per-Unit, or Average, Costs

• Average fixed cost AFC = TFC/Q• Average variable cost AVC = TVC/Q• Average total cost ATC = TC/Q• Marginal cost MC = ΔTC/ΔQ

LO3

These per-unit costs are useful in making comparisons to product price. Average fixed costs reflect the fixed costs per unit produced whereas the average variable costs reflect the variable costs per unit produced. The average total costs can also be found by adding the AFC and AVC. Marginal costs play an extremely important role in the firm’s decision-making about how much they will produce. Marginal costs reflect the additional cost associated with producing one more unit of output. MC tells a firm how much it will cost to increase output by 1 more unit. Marginal cost essentially measures the rate of change in the total costs.

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Short Run Cost SchedulesTotal, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run

Total Cost Data Average Cost Data Marginal Cost

(1)Total Product

(Q)

(2)Total Fixed Cost

(TFC)

(3)Total Variable

Cost(TVC)

(4)Total Cost (TC)

TC=TFC+TVC

(5)Average Fixed

Cost(AFC)

AFC = TFC/Q

(6)AverageVariable

Cost (AVC)

AVC=TVC/Q

(7)Average Total

Cost(ATC)

ATC = TC/Q

(8)Marginal Cost

(MC)MC =ΔTC/ΔQ

0 $100 $0 $100

1 100 90 190 $100.00 $90.00 $190.00 $90

2 100 170 270 50.00 85.00 135.00 80

3 100 240 340 33.33 80.00 113.33 70

4 100 300 400 25.00 75.00 100.00 60

5 100 370 470 20.00 74.00 94.00 70

6 100 450 550 16.67 75.00 91.67 80

7 100 540 640 14.29 77.14 91.43 90

8 100 650 750 12.50 81.25 93.75 110

9 100 780 880 11.11 86.67 97.78 130

10 100 930 1030 10.00 93.00 103.00 150

LO3

This table shows total costs on the left and per-unit costs on the right for an individual firm in the short run. We know this is the short run because there are fixed costs.

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Average Cost Curves

Cost

s

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

ATCAVC

AVC

AFC

LO3

AFC falls as a given amount of fixed costs is apportioned over a larger and larger output. AVC initially falls because of increasing marginal returns but then rises because of diminishing marginal returns. Average total cost (ATC) is the vertical sum of average variable cost (AVC) and average fixed cost (AFC). The only difference between the ATC and AVC is the AFC (remember ATC = AFC + AVC or AFC = ATC - AVC), so the vertical distance between the ATC and AVC is the AFC. You want to get used to measuring AFC in this way because at some point the AFC will no longer be included in the graphs.

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Marginal Cost

Cost

s

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

LO3

Shifts in the curves will occur if either resource prices or technology change. For example, if fixed costs increase, both AFC and ATC shift up. If labor costs (or some other variable input costs) rise, then the AVC, ATC, and MC would shift up. This graph shows the relationship of the marginal-cost curve to the average-total-cost and average-variable-cost curves. The marginal-cost (MC) curve cuts through the average-total-cost (ATC) curve and the average-variable-cost (AVC) curve at their minimum points. When MC is below average total cost, ATC falls; when MC is above average total cost, ATC rises. Similarly, when MC is below average variable cost, AVC falls; when MC is above average variable cost, AVC rises. Marginal decisions are very important in determining profit levels. In order to make marginal decisions, marginal revenue and marginal cost are compared. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise.

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Marginal Cost and Marginal Product

Aver

age

prod

uct a

ndm

argi

nal p

rodu

ctCo

st (d

olla

rs)

MPAP

MCAVC

Quantity of output

Quantity of labor

Cost curves

LO3

The marginal-cost (MC) curve and the average-variable-cost (AVC) curve are mirror images of the marginal-product (MP) and average-product (AP) curves. Assuming that labor is the only variable input and that its price (the wage rate) is constant, then when MP is rising, MC is falling, and when MP is falling, MC is rising. Under the same assumptions, when AP is rising, AVC is falling, and when AP is falling, AVC is rising.

Long Run Production Costs

• The firm can change all input amounts, including plant size

• All costs are variable in the long run• Long run ATC• Now consider costs in terms of average

total costs

LO4

An industry and the individual firms that are in it can make all desired resource adjustments in the long run. All resources are variable, therefore all costs are variable in this time period.

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Firm Size and Costs

Aver

age

tota

l cos

ts

ATC-1ATC-2

ATC-3ATC-4

ATC-5

Output

LO4

Any number of short-run optimum size cost curves can be constructed. The long-run average-total-cost curve is made up of segments of the short-run cost curves (ATC-1, ATC-2, etc.) of the various-size plants from which the firm might choose. The long run cost curve is also called the planning curve. Each point on the bumpy planning curve shows the lowest unit cost attainable for any output when the firm has had time to make all desired changes in its plant size.

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The Long Run Cost Curve

Long-runATC

Aver

age

tota

l cos

ts

ATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

LO4

The long-run ATC curve just “envelopes” the short run ATCs. If the number of possible plant sizes is very large, the long-run average-total-cost curve approximates a smooth curve. Economies of scale, followed by diseconomies of scale, cause the curve to be U-shaped.

Economies of Scale

• Economies of scale• Labor specialization• Managerial specialization• Efficient capital• Other factors

• Constant returns to scale

LO4

Economies of scale refers to the idea that, for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there are economies of scale will lead to a more than proportionate increase in output. Labor specialization leads to economies of scale because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. Managerial specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can specialize in their respective area of expertise. Efficient capital leads to economies of scale because high volume production warrants the expensive large scale equipment. Other factors lead to economies of scale because costs such as design, development, and advertising are spread out over larger quantities.

Constant returns to scale will occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an increase in inputs will result in a proportionate increase in output.

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Diseconomies of Scale

• Diseconomies of scale• Control and coordination problems• Communication problems• Worker alienation• Shirking

LO4

Diseconomies of scale may occur if a firm becomes too large, as illustrated by the rising part of the long run ATC curve. As the firm expands over time, the expansion may lead to higher average total costs. With diseconomies of scale, an increase in inputs will cause a less than proportionate increase in output.

Reasons that diseconomies of scale occur include the difficulty in controlling and coordinating large scale operations; large bureaucracies lead to communication problems; workers may feel alienated and therefore may not work efficiently; and shirking, or work avoidance, may be easier in a larger firm.

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Minimum Efficient Scale

• Minimum efficient scale (MES)• Lowest level of output at which long run

average costs are minimized• Can determine the structure of the

industry• Natural monopoly• Long run costs are minimized when only

one firm produces the product

LO4

Where MES occurs on an industry’s long-run ATC determines if there will be many or few producers and whether they will be large, small, or different sizes. A natural monopoly is a rare situation where economies of scale extend beyond the market size. Therefore, one large firm can provide the product more cheaply than a multi-firm market.

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MES and Industry Structure

Output

Aver

age

tota

l cos

ts

Long-runATC

Economiesof scale

Constant returnsto scale

Diseconomiesof scale

q1 q2

LO4

This is a long-run ATC curve showing industries with an extended range of constant returns to scale. These industries will be populated by firms of many different sizes. Small and large scale producers will coexist and be equally successful. MES occurs at an output of q1.

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MES and Industry Structure Continued

Output

Aver

age

tota

l cos

tsEconomies

of scaleDiseconomies

of scale

Long-runATC

LO4

Industries with economies of scale over a wide range of outputs will lead to a few large scale firms. Small firms cannot realize the minimum efficient scale and will not be able to compete. The long-run ATC curve is lowest only when there is a large output.

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MES and Industry Structure Concluded

Output

Aver

age

tota

l cos

ts

Long-runATC

Economiesof scale

Diseconomiesof scale

LO4

This is a long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially. Here minimum efficient scale occurs at a very low level of output. This results in a large number of small producers.

Applications and Illustrations

• Rising gasoline prices• Successful start-up firms• Verson stamping machine• The daily newspaper• Aircraft and concrete plants

LO5

Rising gasoline prices will cause the short-run costs such as AVC, MC, and ATC all to rise for firms that use this type of energy as an input. As a result, firms like FedEx will see substantial cost increases whereas firms that do not need to transport products physically will not be affected by the rise in fuel costs.

Start-up firms have been successful by lowering their ATC as they increased output and achieved economies of scale. This spreads out R&D and advertising costs over a larger number of units. Some examples of these types of firms are Starbucks, Microsoft, and Google.

The Verson stamping machine can make as many as 5 million auto parts per year. Though the machine is expensive, $30 million, it can make parts quickly and cheaply. This machine is only warranted in factories with very large scale production. This would be for those companies that can achieve economies of scale by using the low-cost productive machine.

Daily newspapers have experienced decreases in advertising revenues, falling subscriptions, and increases in their AFC. Advertising revenue has shifted to the Internet and daily newspapers may be a thing of the past. If they raise the price of the newspaper, they will sell fewer papers, but then the AFC rises too.

A commercial aircraft requires large scale production which easily achieves economies of scale and requires few production plants. Concrete requires small scale production and therefore there are thousands of plants.

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3D Printers and Mass Customization• First industrial revolution began in 1700s• Mass production led to mass affordability• Second industrial revolution began late

1800s• Mass sales were necessary to spread R&D

costs• Third industrial revolution beginning now• Affordable mass customization with zero

transportation costs

3D printers are inexpensive so nearly any household or business can afford one. This additive manufacturing method uses metal or plastic particles that are fused together in the desired shape with a laser. No large factory is needed and no transportation is needed to transport the finished product.

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