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o Marginal analysis (marginal costs & benefits)o Total, marginal & average quantitieso Production functiono Fixed & variable inputso Diminishing returns (i.e. decreasing marginal output)o Fixed & variable cost, total cost, marginal & average
costo Short-term & long-term costso Returns to scale
We’ll try to learn about:
Opportunity Cost
The opportunity cost of an action (buying or selling, consuming or producing) is the sum of explicit and implicit costs.
An explicit cost is a cost that involves actually laying out money.
An implicit cost does not require an outlay of money; it is measured by the value in dollars of the benefits that are forgone.
Opportunity Cost of an Additional Year of School
Accounting Profit vs. Economic Profit
The accounting profit of a business is the business’s revenue minus the explicit costs (including depreciation).
The economic profit of a business is the business’s revenue minus the opportunity cost of its inputs
Usually, economic profit < accounting profit.
Capital The capital of a business is the value of its
assets. The implicit cost of capital is the opportunity
cost of the capital used by a business. Usually, the opportunity cost of capital is the
interest that a business’ capital would gain otherwise.
Profits at B’s Cafe
Marginal CostThe marginal cost of producing a good is the additional cost incurred by producing one more unit of that good.
Example: Constant Marginal Cost
For every additional chicken wing per serving, Babette’s marginal cost is $0.80. Babette’s portion size decision is characterized by a constant marginal cost: each chicken wing costs the same amount to produce as the previous one.
Production of a good has constant marginal cost when each additional unit costs the same to produce as the previous one.
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$4.00
3.00
2.00
1.00
Marginal cost (per wing)
Quantity of chicken wings
Marginal cost curve, MC
Marginal Cost
Marginal BenefitThe marginal benefit of producing a good is the additional benefit earned from producing one more unit of that good.
Marginal Cost - Marginal BenefitThe cost of producing one more unit (MC)
depends on the quantity already being produced.Increasing, constant, decreasing (unusual) MCThe additional benefit derived from producing
one more unit of that good (MB)Decreasing, constant, increasing (unusual) MB
Decreasing Marginal Benefit
Each additional lawn mowed produces less benefit than the previous lawn with decreasing marginal benefit, each additional unit produces less benefit than the unit before.
There is decreasing marginal benefit from an activity when each additional unit of the activity produces less benefit than the previous unit.
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Marginal benefit curve, MB
Marginal cost (per wing)
Quantity of chicken wings
Marginal Benefit
Felix’s Net Gain from Mowing Lawns
Marginal Analysis
The optimal quantity is the quantity that generates the maximum possible total net gain.
The principle of marginal analysis says that the optimal quantity is the quantity at which marginal benefit is equal to marginal cost.
If the good is ‘lumpy’ (not divisible), then the optimal quantity is that at which the marginal benefit is just slightly greater than the marginal cost.
B’s net gain from increasing portion size
B’s optimal portion size
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$4.00
3.00
2.00
1.00
Marginal benefit (marginal cost per wing)
Quantity of chicken wings
Optimal point
MC
MB
Optimal quantity
01234567
Total net gain
(profit per
serving)
Net gain(per wing)
Quantity of chicken wings $0
3.505.205.906.306.406.306.10
$3.50 1.70 0.70 0.40 0.10–0.10–0.20
Sunk Cost
A sunk cost is a cost that has already been incurred and is non-recoverable. A sunk cost should be ignored in decisions about future actions.
Sunk costs should be ignored in making decisions about future actions. They have already been incurred and are non-
recoverable, they have no effect on future costs and benefits.
Production FunctionThe production function is the relationship
between the quantity of inputs a firm uses and the quantity of output it produces (the graph of the production function is called the “total output curve”)
A fixed input is an input whose quantity is fixed for a period of time and cannot be varied.
A variable input is an input whose quantity the firm can vary at any time.
Inputs and OutputLong run: time period in which all inputs can
be varied.Short run: time period in which at least one
input is fixed.Total product curve shows how the quantity
of output depends on the quantity of the variable input, for a given quantity of the fixed input.
Production function (total output curve) fora farm
0
1
2
3
4
5
6
7
8
19
17
15
13
11
9
7
5
0
19
36
51
64
75
84
91
96
Quantity of labor
L(worker)
Quantity of wheat
Q(bushels)
MP of laborMPL =Q/L
(bushels per worker)
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100
80
60
40
20
Quantity of wheat (bushels)
Quantity of labor (workers)
Total product, TP
Adding a 7th worker leads to an increase in output of only 7 bushels
Adding a 2nd worker leads to an increase in output of only 17 bushels
The marginal product of an input is the additional quantity of output that is produced by using one more unit of that input (marginal output due to labor).
Marginal Product of Labor
Diminishing Returns to an Input
There are diminishing returns to an input when an increase in the quantity of that input, holding the levels of all other inputs fixed, leads to a decline in the marginal product of that input.
Marginal Product of Labor Curve
Marginal product of labor, MPL
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19
17
15
13
11
9
7
5
Marginal product of
labor (bushels per
worker)
Quantity of labor (workers)
There are diminishing returns to labor.
(a) Total Product Curves (b) Marginal Product Curves
Marginal product of labor
(bushels per worker)
Quantity of wheat (bushels)
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30
25
20
15
10
5
7 86543210
16014012010080604020
TP20
TP10
MPL20MPL10
Quantity of labor (workers)Quantity of labor (workers)
Total Product, Marginal Product, and the Fixed Input
From the Production Function to Cost Curves
A fixed cost is a cost that does not depend on the quantity of output produced. It is the cost of the fixed input.
A variable cost is a cost that depends on the quantity of output produced. It is the cost of the variable input.
Total Cost CurveThe total cost of producing a given quantity of
output is the sum of the fixed cost and the variable cost of producing that quantity of output.
TC = FC + VC
The total cost curve becomes steeper as more output is produced due to diminishing returns.
Total Cost Curve: G&M’s Farm
19 36 51 64 75 84 91 960
$2,000
1,800
1,600
1,400
1,200
1,000
800
600
400
200
Cost
Quantity of wheat (bushels)
AB
CD
EF
G
Total cost, TC
H
I
ABCDEFGHI
Point on graph
012345678
$400400400400400400400400400
O200400600800
1,0001,2001,4001,600
400600800
1,0001,2001,4001,6001,8002,000
01936516475849196
Variable cost(VC)
Total cost
(TC = FC + VC)
$ $
Quantity of labor L
(worker)
Quantity of wheat Q(bushels)
Fixed Cost
(FC)
Two Key Concepts: Marginal Cost and Average Cost
As in the case of marginal product, marginal cost is equal to “rise” (the increase in total cost) divided by “run” (the increase in the quantity of output).
Costs at Selena’s Gourmet Salsas
TC & MC Curves for Selena’s Gourmet Salsas
$250
200
150
100
50
Cost of case
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$1,400
1,200
1,000
800
600
400
200
Cost
Quantity of salsa (cases)
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(b) Marginal Cost(a) Total Cost
TC MC
Quantity of salsa (cases)
8th case of salsa increases total cost by $180.
2nd case of salsa
increases total cost by
$36.
Why is the Marginal Cost Curve Upward Sloping?
Because there are diminishing returns to inputs in this example. As output increases, the marginal product of the variable input declines.
This implies that more and more of the variable input must be used to produce each additional unit of output as the amount of output already produced rises.
And since each unit of the variable input must be paid for, the cost per additional unit of output also rises.
Average CostAverage total cost, often referred to simply
as average cost, is total cost divided by quantity of output produced.
ATC = TC/Q = (Total Cost) / (Quantity of Output)
A U-shaped average total cost curve falls at low levels of output, then rises at higher levels.
Average fixed cost is the fixed cost per unit of output.
AFC = FC/Q = (Fixed Cost) / (Quantity of Output)
Average Cost
Average variable cost is the variable cost per unit of output.
AVC = VC/Q= (Variable Cost) / (Quantity of Output)
Average Total Cost Curve Increasing output has two opposing effects on
average total cost:
The spreading effect: the larger the output, the greater the quantity of output over which fixed cost is spread, leading to lower the average fixed cost.
The diminishing returns effect: the larger the output, the greater the amount of variable input required to produce additional units leading to higher average variable cost.
AC for Selena’s Gourmet Salsas
ATC Curve for Selena’s Gourmet Salsas
Average total cost, ATC
M
7 8 9 106543210
$140
120
100
80
60
40
20
Minimum average total cost
Minimum-cost output
Cost of case
Quantity of salsa (cases)
Putting the Four Cost Curves Together
Note that:1. Marginal cost is upward sloping due to
diminishing returns.2. Average variable cost also is upward sloping
but is flatter than the marginal cost curve. 3. Average fixed cost is downward sloping
because of the spreading effect.4. The marginal cost curve intersects the
average total cost curve from below, crossing it at its lowest point. This last feature is our next subject of study.
MC and AC Curves for Selena’s Gourmet Salsas
$250
200
150
100
50
7 8 9 10654321
M
0
MC
ATC
AVC
AFC
Minimum-cost output
Cost of case
Quantity of salsa (cases)
Facts
The minimum-cost output is the quantity of output at which average total cost is lowest—the bottom of the U-shaped average total cost curve.
At the minimum-cost output, average total cost is equal to marginal cost.
At output less than the minimum-cost output, marginal cost is less than average total cost and average total cost is falling.
And at output greater than the minimum-cost output, marginal cost is greater than average total cost and average total cost is rising.
Relationship between ATC and the MC CurvesCost of unit
Quantity
MC
ATC
MCL
MCH
A1
B1A
2
B2
M
If marginal cost is above average total cost, average total cost is rising.
If marginal cost is below average total cost, average total cost is falling.
Does the Marginal Cost Curve Always Slope Upward?In practice, marginal cost curves often slope
downward as a firm increases its production from zero up to some low level, sloping upward only at higher levels of production.
This initial downward slope occurs because a firm that employs only a few workers often cannot reap the benefits of specialization of labor. This specialization can lead to increasing returns at first, and so to a downward-sloping marginal cost curve.
Once there are enough workers to permit specialization, however, diminishing returns set in.
More realistic cost curves
MCATC
AVC
Cost of unit
Quantity
2. … but diminishing returns set in once the benefits from specialization are exhausted and marginal cost rises.
1. Increasing specialization leads to lower marginal cost…
Short-Run versus Long-Run Costs In the short run, fixed cost is completely outside
the control of a firm. But all inputs are variable in the long run.
The firm will choose its fixed cost in the long run based on the level of output it expects to produce.
Choosing the FC
ATC1
1248
108192300432588768972
1,200
$ 120156216300408540696876
1,0801,308
Total cost
$
ATC2
6245496
150216294384486600
$ $222240270312366432510600702816
Low fixed cost (FC = $108) High fixed cost (FC = $216)
$120.0078.0072.0075.0081.6090.0099.43
109.50120.00130.80
$222.00120.0090.0078.0073.2072.0072.8675.0078.0081.60
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10
Average total cost of case
Quantity of
salsa(salsa)
High variable
cost
Low variable cost
Total cost
Average total cost of case
$250
200
150
100
50
Cost of case
Quantity of salsa (cases)7 8 9 106543210
High fixed cost
Low fixed cost
ATC2
ATC1
At low output levels, low fixed cost yields lower average total cost
At high output levels, high fixed cost yields lower average total cost
The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output.
Long-run ATC curve
Short-Run and Long-Run ATC Curves
B
ATC6 ATC9ATC3 LRATC
3 5 84 70 6 9
Increasing returns to scale Decreasing returns to scale
Constant returns to scale
CXA
Y
Cost of case
Quantity of salsa (cases)
Returns to Scale
There are increasing returns to scale (economies of scale) when long-run average total cost declines as output increases.
There are decreasing returns to scale (diseconomies of scale) when long-run average total cost increases as output increases.
There are constant returns to scale when long-run average total cost is constant as output increases.
Summary3. Marginal analysis involves comparing the benefit
to the cost of doing an additional unit of an activity. The marginal cost of producing a good is the additional cost incurred by producing one more unit of that good. The marginal benefit of producing a good is the additional benefit earned by producing one more unit.
4. With constant marginal cost, each additional unit costs the same amount to produce as the unit before; this is represented by a horizontal MC curve. With increasing marginal cost, each unit costs more to produce than the unit before. In the case of decreasing marginal benefit, each additional unit produces a smaller benefit than the unit before.
Summary5. According to the principle of
marginal analysis, the optimal quantity is the quantity at which MC=MB.
6. A cost that has already been incurred and that is nonrecoverable is a sunk cost.
Summary1. The relationship between inputs and output is a
producer’s production function. In the short run, the quantity of a fixed input cannot be varied but the quantity of a variable input can. In the long run, the quantities of all inputs can be varied. For a given amount of the fixed input, the total product curve shows how the quantity of output changes as the quantity of the variable input changes.
2. There are diminishing returns to an input when its marginal product declines as more of the input is used, holding the quantity of all other inputs fixed.
3. Total cost is equal to the sum of fixed cost, which does not depend on output, and variable cost, which does depend on output.
Summary1. All economic decisions involve the allocation of scarce
resources. Some decisions are “either–or” decisions, other decisions are “how much” decisions.
2. The cost of using a resource for a particular activity is the opportunity cost of that resource. Some opportunity costs are explicit costs; they involve a direct payment of cash. Other opportunity costs, however, are implicit costs; they involve no outlay of money but represent the inflows of cash that are forgone. Companies use capital and their owners’ time. So companies should base decisions on economic profit, which takes into account implicit costs such as the opportunity cost of the owners’ time and the implicit cost of capital.
Summary4. Average total cost, total cost divided by quantity of
output, is the cost of the average unit of output, and marginal cost is the cost of one more unit produced. U-shaped average total cost curves are typical, because average total cost consists of two parts: average fixed cost, which falls when output increases (the spreading effect), and average variable cost, which rises with output (the diminishing returns effect).
5. When average total cost is U-shaped, the bottom of the U is the level of output at which average total cost is minimized, the point of minimum-cost output. This is also the point at which the marginal cost curve crosses the average total cost curve from below.
Summary6. In the long run, a producer can change its fixed
input and its level of fixed cost. The long-run average total cost curve shows the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost at each level of output.
7. As output increases, there are increasing returns to scale if long-run average total cost declines; decreasing returns to scale if it increases; and constant returns to scale if it remains constant. Scale effects depend on the technology of production.
