07

Businesses and the Costs of Production

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Costs
• Costs exist because resources are scarce, are
productive, and have alternative uses.
• When society uses a combination of resources to
produce a particular product, it forgoes all alternative
opportunities to use those resources for other
purposes.
• The measure of the economic cost, or opportunity
cost, of any resource used to produce a good is the
value or worth the resource would have in its best
alternative use.
 Economic Costs
• The payment that must be made to obtain and retain the services of a
resource
• Explicit Costs
• Monetary payments it makes to those who supply labor services,
materials, fuel, transportation services, and the like.
• Implicit Costs
• are the opportunity costs of using its self-owned, self-employed
resources.
• to the firm, implicit costs are the money payments that self-employed
resources could have earned in their best alternative use.
• Normal profit is the payment you could otherwise receive for
performing entrepreneurial functions.It is an implicit cost of the
entrepreneurship.
LO1 7-3
Accounting Profit and Economic Profit

• Accounting profit
= Revenue – Explicit Costs
• Economic profit
= Accounting Profit – Implicit Costs
• Economic profit (to summarize)
=Total Revenue – Economic Costs
=Total Revenue – Explicit Costs – Implicit
Costs

LO1 7-4
Economic Profit

Economic
profit Accounting profit

Total Revenue
Implicit costs
(including a
(Opportunity)

normal profit)
Economic

Costs

Accounting costs
Explicit (explicit costs
costs only)

LO1 7-5
Short Run and Long Run

• Short Run:
• In the short run, a firm’s plant capacity is fixed;
• Some variable inputs
• Fixed plant
• Long Run:
• In the long run, a firm can vary its plant size and
firms can enter or leave the industry
• All inputs are variable
• Variable plant
• Firms enter and exit
LO1 7-6
 Short-Run Production Relationships
• Total Product (TP): is the total quantity, or total output, of a
particular good or service produced
• Marginal Product (MP): is the extra output or added product
associated with adding a unit of a variable resource
Change in Total Product
Marginal Product =
Change in Labor Input

• Average Product (AP) also called labor productivity, is output per

unit of labor input
Total Product
Average Product = Units of Labor

LO2 7-7
 The law of diminishing returns

• The law of diminishing returns indicates that, beyond some point,

output will increase by diminishing amounts as more units of a
variable resource (labor) are added to a fixed resource (capital)
The law of diminishing returns
The Law of Diminishing Returns

Total Product, TP
30
TP

20

10

0
1 2 3 4 5 6 7 8 9
Marginal Product, MP

Increasing Diminishing Negative

Marginal Marginal Marginal
20 Returns Returns Returns

10 AP

1 2 3 4 5 6 7 8 9
MP

LO2 7-10
• Geometrically, marginal product—shown by the MP curve in Figure—is
the slope of the total product curve
• Where total product is increasing at an increasing rate, marginal product is
rising
• where total product is increasing but at a decreasing rate, marginal
product is positive but falling
• When total product is at a maximum, marginal product is zero. When
total product declines, marginal product becomes negative
• Where marginal product exceeds average product, average product rises.
• And where marginal product is less than average product, average product
declines.
• Marginal product intersects average product where average product is at a
maximum
Short-Run Production Costs

• Fixed Costs (TFC)

• Costs do not vary with output
• Variable Costs (TVC)
• Costs vary with output
• Total Costs (TC)
• Sum of TFC and TVC
• TC = TFC + TVC

LO3 7-12
Short-Run Production Costs
$1100
1000 TC
900
TVC
800
700
Costs 600
Fixed
500 Cost
400
300 Total Variable
Cost Cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3 7-13
Per-Unit, or Average, Costs

• Average-cost data are more meaningful for making

comparisons with product price, which is always stated on a
per-unit basis
• Average Fixed Costs AFC = TFC/Q
• Because the total fixed cost is, by definition, the same
regardless of output, AFC must decline as output increases.
• Average Variable Costs AVC = TVC/Q
• Average Total Costs ATC = TC/Q
• Marginal Costs MC = ΔTC/ΔQ
LO3 7-14
Per-Unit, or Average, Costs
$200

150

ATC
Costs
100
AVC
AFC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3 7-15
Marginal Cost

$200 • Marginal-cost
curve MC
intersects both the
MC AVC and the ATC
150 curves at their
respective
minimum points
• As long as MC lies
ATC
Costs

100 below ATC, ATC will

AVC
fall, and whenever
AFC
MC lies above ATC,
ATC will rise
50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q

LO3 7-18
 MC and Marginal Product
• As long as marginal Production Curves

Average Product and

• When average
product is rising,

Marginal Product
product is initially low,
marginal cost will fall.
AVC is high.
• when marginal
• As workers are added,
product is rising,
average product rises
marginal cost is
and AVC falls.
necessarily falling. AP • When average
• When marginal MP product is at its
product is at its
Quantity of Labor maximum, AVC is at
maximum, marginal
its minimum.
cost is at its • Then, as still more
minimum. And when MC
AVC workers are added
marginal product is
Cost (Dollars)

and average product

falling, marginal cost
declines, AVC rises.
is rising • the two are mirror
• The MC curve is a
images of each other
mirror reflection of
the marginal-product
curve Cost Curves
Quantity of Output
LO3 7-19
Summary points
• Average fixed cost declines continuously as output increases;
• average-variable-cost and average-total-cost curves are U-shaped,
reflecting increasing and then diminishing returns;
• the marginal-cost curve falls but then rises, intersecting both the
average-variable-cost curve and the average-total-cost curve at their
minimum points
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
• Different short run ATCs

LO4 7-21
 The Long-Run Cost Curve

The long-run
average-total-cost
curve is made up
of segments of the
short-run cost Average Total Costs
ATC-1
curves (ATC-1, ATC- ATC-5
2, etc.) of the ATC-2
various-size plants
ATC-3 ATC-4 Long-Run
from which the ATC
firm might choose.
Each point on
curve shows the
lowest unit cost
attainable for any
output when firm
changes in its plant
size Output

LO4 7-22
 Economies and Diseconomies of Scale
• The long-run ATC curve is U-shaped. But why?
• Economies of scale: Economies of scale, or economies of mass production,
explain the downward sloping part of the long-run ATC curve, As plant size
increases, average costs of production decreases because of:
• Labor specialization: Workers can work full-time on the tasks for which
they have special skills
• Managerial specialization: With large scale production there is better
use of, and greater specialization in, management
• Efficient capital Small scale producers often cannot afford the most
efficient equipment. Only large-scale producers can afford to purchase
and use this equipment efficiently.
• Other factors like “start-up” costs, advertising , decline per unit as
output is increased
LO4 7-23
Economies and Diseconomies of Scale
• Constant returns to scale
• over which long-run average cost does not change
• Here a given percentage increase in all inputs of, say,
10 percent will cause a proportionate 10 percent
increase in output.
• Diseconomies of scale
• Control and coordination problems
• Communication problems
• Worker alienation
• Shirking, neglecting duty

LO4 7-24
MES and Industry Structure

• Minimum Efficient Scale (MES):

• Lowest level of output where long- run
average costs are minimized
• Can determine the structure of the
industry

LO4 7-25
MES and Industry Structure

Economies Constant Returns Diseconomies

Average Total Costs

Of Scale To Scale Of Scale

Long-Run
ATC

q1 q2
Output

LO4 7-26