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Production Costs

Economics for Today by Irvin Tucker, 6th edition©2009 South-Western College Publishing

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What is the purpose of this chapter?

The purpose of this chapter is to study production and its relationship to various types of costs

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What economic puzzles will I learn to solve?

• Why would an accountant say a firm is making a profit and an economists say it’s losing money?

• What is the difference between the short run and the long run?

• Why have multiscreen movie theatres replaced single screen theatres?

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What is a basic assumption in economics?

The motivation for business decisions is profit maximization

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To understand profit, what is necessary?

To distinguish between the way economists measure costs and the way accountants measure costs

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What are explicit costs?Payments to nonowners of a firm for their resources

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What are implicit costs?

The opportunity costs of using resources owned by the firm

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What is an example of implicit costs?

When you invest your nest egg in your own enterprise, you give up earning interest on that money

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What are total opportunity costs?

Explicit costs + Implicit costs

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What iseconomic profit?

Total revenue minus explicit and implicit costs, or total revenue minus total opportunity costs

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What is normal profit?

The minimum profit necessary to keep a firm in operation

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What about opportunity cost?

A firm that earns normal profits earns total revenue equal to its total opportunity cost

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How is accounting profit defined?

Total revenue minus total explicit costs

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What conclusion can we make?

Since business decision making is based on economic profit, rather than accounting profit, the word profit in this text always means economic profit

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What is a fixed input?Any resource for which the quantity cannot change during the period of time under consideration

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What is avariable input?

Any resource for which the quantity can change during the period of time under consideration

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What is the short run?A period of time so short that there is at least one fixed input

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What is a variable input?

Any resource for which the quantity can change during the period of time under consideration

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What is the long run?A period of time so long that all inputs are variable

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What is theproduction function?

The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs

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What do technological advances make

possible?More output is possible from a given quantity of inputs

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What ismarginal product?

The change in total output produced by adding one unit of a variable input, with all other inputs used held constant

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What is the law of diminishing returns?

The principle that beyond some point the marginal product decreases as additional units of a variable resource are added to a fixed factor

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What does the law of diminishing

returns assume?Fixed inputs; it is therefore a short-run concept

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10

1 2 4

Production Function

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20

5

50

63

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To

tal O

utp

ut

Quantity of Labor

Total Output

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8

2

1 2 4

Marginal Product Curve

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4

5

10

63

12

Mar

gin

al P

rod

uct

Law of Diminishing

Returns

Quantity of Labor

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What istotal fixed cost?

Costs that do not vary as output varies and that must be paid even if output is zero

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What istotal variable cost?

Costs that are zero when output is zero and vary as output varies

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What is total cost?

The sum of total fixed cost and total variable cost at each level of output

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TC = TFC + TVC

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What isaverage fixed cost?

Total fixed cost divided by the quantity of output produced

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AFC = TFC / Q

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What is average variable cost?

Total variable cost divided by the quantity of output produced

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AVC = TVC / Q

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What isaverage total cost?

Total cost divided by the quantity of output produced

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ATC = AFC + AVC = TC/Q

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What is marginal cost?The change in total cost when one unit of output is produced

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MC = TC/Q = TVC/Q

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$400

$300

$200

$100

1 2 3 4

$500

$600

$700

$800

5 6 7 8 9

Short-Run Cost Curves

TCTVC

TFC

TFC

Co

st p

er u

nit

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$40$30$20

$10

1 2 3 4

$50$60$70

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MC

AFC

AFC

Co

st p

er u

nit

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What is themarginal-average rule?

When MC < AC, AC fallsWhen MC > AC, AC rises

If MC = AC, AC at minimum

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What is the relationship between slopes of the MC and

MP curves?The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa

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What is the relationship between

the minimum and maximum points of the

MR and MP curves?The maximum point of the MP curve corresponds to the minimum point of the MC curve

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8

2

1 2 4

Marginal Product Curve

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4

5

10

63

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To

tal O

utp

ut

Quantity of Labor

Maximum

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$40

$30

$20

$10

1 2 3 4

$50

$60$70

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MCC

ost

per

un

itMinimum

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What is the long-run average cost curve?The curve that traces the

lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size

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$40

$30

$20

$10

2 4 6 8

$50

$60

$70

10 12 14 16 18

Short and Long-run Average Cost Curves

Short-run average total cost curves

Long-run average cost curve

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What areeconomies of scale?A situation in which the long-run average cost curve declines as the firm increases output

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What are constant returns to scale?

A situation in which the long-run average cost curve does not change as the firm increases output

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What arediseconomies of scale?

A situation in which the long-run average cost curve rises as the firm increases output

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$40

$30

$20

$10

2 4 6 8

$50

$60

$70

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Economies of scale

Diseconomies of scale

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END