Copyright 2008 The McGraw-Hill Companies 20-1 Economic Costs Profits Compared Short-Run Production...

Copyright 2008 The McGraw-Hill Companies20-1

Economic CostsProfits ComparedShort-Run Production RelationshipsLaw of Diminishing ReturnsShort-Run Production CostsLong-Run Production CostsMinimum Efficient Scale and Industry StructureLast Word

Key Terms

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20The Costs ofProduction



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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



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Economic Costs• Economic Cost• Opportunity Cost• Explicit Costs• Implicit Costs• Normal Profit as a Cost• Economic or Pure ProfitEconomic

ProfitTotal

RevenueEconomic

Cost= -W 20.1



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Profits ComparedEconomic Profit Versus Accounting Profits

EconomicProfit

AccountingCosts (Explicit

Costs Only)

AccountingProfit

ExplicitCosts

Implicit Costs(Including a

Normal Profit)

Eco

no

mic

(Op

po

rtu

nit

y)C

ost

s

To

tal

Rev

enu

e

Economics Accounting

Short Run and Long Run•Short Run: Fixed Plant•Long Run: Variable Plant



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Short-Run Production Relationships

• Total Product (TP)• Marginal Product (MP)• Average Product (AP)

Average Product Total Product

Units of Labor=

Marginal ProductChange in Total Product

Change in Labor Input=

W 20.2



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IncreasingMarginalReturns

Law of Diminishing Returns• Rationale

• Tabular Example(1)

Units of theVariable Resource

(Labor)

(2)Total Product

(TP)

(3)Marginal Product

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

(3)AverageProduct

(AP),(2)/(1)

012345678

01025456070757570

1015201510

50

-5

-10.0012.5015.0015.0014.0012.5010.71 8.75

]]]]]]]]

DiminishingMarginalReturns

NegativeMarginalReturns

O 20.1



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Law of Diminishing Returns• Graphical Portrayal

0

10

20

30

To

tal P

rod

uct

, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

gin

al P

rod

uct

, MP

1 2 3 4 5 6 7 8 9

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

O 20.2



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Short-Run Production Costs

•Fixed Costs•Variable Costs•Total Cost

TC = TFC + TVC



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Short-Run Production Costs• Per-Unit or Average Costs

–Average Fixed Cost (AFC)–Average Variable Cost

(AVC)–Average Total Cost (ATC)–Marginal Cost (MC)

AFC =TFC

Q AVC =TVC

Q

ATC =TCQ

= AFC + AVC

MC =Change in TCChange in Q G

raph

ical

ly…



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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



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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

G 20.1



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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…

W 20.3



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Ave

rag

e P

rod

uct

an

dM

arg

inal

Pro

du

ctC

ost

(D

olla

rs)

Short-Run Production Costs

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves



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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



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Long-Run Production CostsLong-Run ATC Curve

Ave

rag

e T

ota

l C

ost

sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

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



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Long-RunATC

Ave

rag

e T

ota

l C

ost

sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

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



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Long-RunATC

Ave

rag

e T

ota

l C

ost

sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

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



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Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where EconomiesOf Scale Exist

Ave

rag

e T

ota

l C

ost

s

Long-RunATC

EconomiesOf Scale

Constant ReturnsTo Scale

DiseconomiesOf Scale

q1 q2



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Output

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

Ave

rag

e T

ota

l C

ost

sEconomies

Of ScaleDiseconomies

Of Scale

Long-RunATC



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Output

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

Ave

rag

e T

ota

l C

ost

s

Long-RunATC

EconomiesOf Scale

DiseconomiesOf Scale



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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

O 20.3



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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!

Last

Word



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Key Terms• economic (opportunit

y) 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 ret

urns• 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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