07

Businesses and the Costs of

Production

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Economic Costs
• The payment that must be made to
obtain and retain the services of a
resource
• Explicit Costs
• Monetary payments
• Implicit Costs
• Value of next best use
• Self-owned resources
• Includes normal profit
LO1 7-2
 Accounting Profit and Normal 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 7-3
 Economic Profit

Economic
profit Accounting
profit

Total Revenue
Implicit costs
(including a
(Opportunity)

normal profit)
Economic

Costs

Accounting
Explicit costs (explicit
costs costs only)

LO1 7-4
 Short Run and Long Run

• Short Run
• Some variable inputs
• Fixed plant
• Long Run
• All inputs are variable
• Variable plant
• Firms enter and exit

LO1 7-5
 Short-Run Production Relationships

• Total Product (TP)

• Marginal Product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input

• Average Product (AP)

Total Product
Average Product = Units of Labor

LO2 7-6
 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 7-7
 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 7-8
 Short-Run Production Costs
$1100
1000 TC
900
TVC
800
700

600
Costs

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 7-9
 Per-Unit, or Average, Costs

• Average Fixed Costs AFC = TFC/Q

• Average Variable Costs AVC = TVC/Q
• Average Total Costs ATC = TC/Q
• Marginal Costs MC = ΔTC/ΔQ

LO3 7-10
 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 7-11
 Marginal Cost

$200

MC
150

ATC
Costs

100
AVC
AFC

50
AVC

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

LO3 7-12
 MC and Marginal Product
Production Curves

AP
MP
Quantity of Labor

MC
AVC

Cost Curves
Quantity of Output
LO3 7-13
 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 7-14
 The Long-Run Cost Curve
Average Total Costs

ATC-1
ATC-5
ATC-2
ATC-3 ATC-4 Long-Run
ATC

Output

LO4 7-15
 Economies and Diseconomies of Scale

• Economies of scale
• Labor specialization
• Managerial specialization
• Efficient capital
• Other factors
• Constant returns to scale

LO4 7-16
 Economies and Diseconomies of Scale

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

LO4 7-17
 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 7-18
 MES and Industry Structure

Economies Constant Returns Diseconomies

Average Total Costs

Of Scale To Scale Of Scale

Long-Run
ATC

q1 q2
Output

LO4 7-19
 Don’t Cry Over Sunk Costs

• Sunk costs
• Costs have already been incurred
and thus are irrecoverable
• Rule: Do not engage in any activity
where MB<MC
• Rule: Ignore sunk costs
• They are irrecoverable

7-20