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CHAPTER 7
COSTS OF THE CONSTRUCTION FIRM
• Firm: A firm is an organization that brings together different factors of production, such as labour, land and capital, to produce a product or service which it is hoped can be sold for a profit.
Cost of Owner’s Resources– The income that the owner could have
earned in the best alternative job.
– Normal profit is the expected return for supplying entrepreneurial ability.
Economic Profit– A firm’s total revenue minus its opportunity
costs.
– The firm’s opportunity cost is the sum of its explicit costs and implicit costs.
– Not the same as accounting profit.
The Objective: Profit Maximization– All of the firm’s decisions are aimed at one overriding
objective: maximum attainable profit.
To study the relationship between a firm’s output decision and its costs, we distinguish two decision time frames:
– The short-run
– The long-run
The Short-Run and the Long-Run
The short-run is a time frame in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.
The long-run is a time frame in which the quantities of all inputs can be varied.
Production Function: The relationship between physical output and the quantity of capital and labour used in the production process is sometimes called a production function.
To increase output in the short-run, a firm must increase the quantity of labor employed.
Total product is the total output produced.
Marginal product is the increase in total product that result from a one-unit increase in an input.
Average product is the total product divided by the quantity of inputs.
Total Product Curve
• Read the schedule page 102
• Table: 7.1 Diminishing returns: a hypothetical case in construction
Attainable
Total Product Curve
0 1 2 3 4 5Labor (workers per day)
5
10
15TP
Unattainable
Out
put (
swea
ters
per
day
)
a
b
c
d
e f
Marginal product is also measured by the slope of the total product curve.
Increasing marginal returns occur when the marginal product of an additional worker exceeds the marginal product of the previous worker.
Diminishing marginal returns
Occur when the marginal product of an additional worker is less than the marginal product of the previous worker
Law of diminishing returns
As a firm uses more of a variable input, with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes
Marginal Product
0 1 2 3 4 5Labor (workers per day)
5
10
15 TP
Out
put (
swea
ters
per
day
)
0 1 2 3 4 5Labor (workers per day)
2
4
6
Mar
gina
l pro
duct
(sw
eate
rs p
er d
ay p
er w
orke
r)4
3
13
MP
c
d
Short-Run Cost
Total cost (TC) is the cost of all productive resources used by a firm.
Total fixed cost (TFC) is the cost of all the firm’s fixed inputs.
Total variable cost (TVC) is the cost of all the firm’s variable inputs.
Total cost (TC) is the cost of all productive resources used by a firm.
TC = TFC + TVC
TC
TVC
Total Cost Curves
0 5 10 15Output (sweaters per day)
50
100
150
Cos
t (do
llars
per
day
)
TFC
TC = TFC + TVC
Marginal Cost
Marginal cost is the increase in total cost that results from a one-unit increase in output.
It equals the increase in total cost divided by the increase in output.
Marginal costs decrease at low outputs because of the gains from specialization, but it eventually increases due to the law of diminishing returns.
Average Cost
Average fixed cost (AFC) is total fixed cost per unit of output.
Average variable cost (AVC) is total variable cost per unit of output.
Average total cost (ATC) is total cost per unit of output.
Average Cost
TC = TFC + TVC
TC TFC TVC
Q Q Q= +
OR
ATC = AFC + AVC
MC
ATC
AVC
AFC
Marginal Cost and Average Costs
0 5 10 15Output (sweaters per day)
5
10
15C
ost (
dolla
rs p
er s
wea
ter)
ATC = AFC + AVC
AP
MP
Product Curvesand Cost Curves
Labor
Ave
rage
pro
duct
and
mar
gina
l pro
duct
0 1.5 2.0
22
4
6
Rising MP andfalling MC:rising AP andfalling AVC
Falling MP andrising MC:rising AP andfalling AVC
Falling MP andrising MC:falling AP andrising AVC
AVC
MC
Product Curvesand Cost Curves
Labor
Ave
rage
pro
duct
and
mar
gina
l pro
duct
0 6.5 10
3
6
9
12
Maximum AP and minimum AVC
Maximum MP and minimum MC
Long-Run CostLong-run cost
– The cost of production when a firm uses the economically efficient quantities of labor and capital.Long-run costs are affected by the production function.
Production function
– The relationship between the maximum output attainable and the quantities of both labor an capital.
The Long-Run Average Cost Curve
The long-run average total cost curve is derived from the short-run average total cost curves.
The segment of the short-run average total cost curves along which average total cost is the lowest make up the long-run average total cost curve.
Short-Run Costs of Four Different Plants
Long-Run Average Cost Curve
Returns to Scale
Returns to scale are the increases in output that result from increasing all inputs by the same percentage.
Three possibilities:
– Constant returns to scale
– Increasing returns to scale
– Decreasing returns to scale
Returns to Scale
Constant returns to scale
Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by the same percentage
Returns to Scale
Increasing returns to scale
Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a larger percentage
Returns to Scale
Decreasing returns to scale
Technological conditions under which a given percentage increase in all the firm’s inputs results in the firm’s output increasing by a smaller percentage
Minimum Efficient Scale
A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level.
The End
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