AGENDA Mon 10/5

• QOD #19: Pot Profit

• Amazing Tortilla

• Costs of Production (Review HW)

• Short & Long Run

• Law of Diminishing Marginal Returns

• Partner Practice Ch 7 P # 2&3

• HW: Read 152-158 Q#9,10

QOD #19: Pot Profit

Gomez runs a small pottery firm. He hires one helper at

$12,000 per year, pays annual rent of $5,000 for his

shop, and spends $20,000 per year on materials. He

has $40,000 of his own funds invested in equipment

(pottery wheels, kilns, and so forth) that could earn him

$4,000 per year if alternatively invested.

• He has been offered $15,000 per year to work as a

potter for a competitor. He estimates his

entrepreneurial talents are worth $3,000 per year.

• Total annual revenue from pottery sales is $72,000.

• Calculate the accounting profit and the economic

profit for Gomez’s pottery firm.

QOD #19: Pot Profit Solution

1. Explicit costs: $37,000 • (= $12,000 for the helper + $5,000 of rent +

$20,000 of materials)

2. Implicit costs: $22,000 • (= $4,000 of forgone interest + $15,000 of forgone

salary + $3,000 of entrepreneurship)

3. Accounting profit = $35,000 • (= $72,000 of revenue - $37,000 of explicit costs)

4. Economic profit = $13,000 • (= $72,000 - $37,000 of explicit costs - $22,000 of

implicit costs)

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 7-4

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 7-5

Economic Profit

LO1

Explicit

costs

Accounting

costs (explicit

costs only)

Implicit costs

(including a

normal profit)

Economic

profit Accounting

profit

Eco

no

mic

(O

pp

ort

un

ity)

Co

sts

To

tal R

even

ue

7-6

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 7-7

Short-Run Production Relationships

• Total Product (TP)

• Marginal Product (MP)

• Average Product (AP)

LO2

Marginal Product Change in Total Product

Change in Labor Input =

Average Product Total Product

Units of Labor =

7-8

The Law of Diminishing Returns

LO2

TP

MP

AP

Increasing

Marginal

Returns

Diminishing

Marginal

Returns

Negative

Marginal

Returns

1 2 3 4 5 6 7 8 9

0

10

20

30

To

tal

Pro

du

ct,

TP

1 2 3 4 5 6 7 8 9

20

10

Marg

inal

Pro

du

ct,

MP

7-9

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 7-10

Short-Run Production Costs

LO3

Co

sts

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

100

200

300

400

500

600

700

800

900

1000

$1100

TFC

TC

TVC

Total Cost

Variable Cost

Fixed Cost

7-11

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 7-12

Per-Unit, or Average, Costs

LO3

Co

sts

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

50

100

150

$200

AFC

ATC

AVC

AVC

AFC

7-13

Marginal Cost

LO3

Co

sts

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

50

100

150

$200

AFC

MC

ATC

AVC

AVC

AFC

7-14

MC and Marginal Product

LO3

Avera

ge P

rod

uct

an

d

Marg

inal

Pro

du

ct

Co

st

(Do

llars

)

MP

AP

MC AVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves

7-15

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 7-16

The Long-Run Cost Curve

LO4

Long-Run ATC

Ave

rag

e T

ota

l C

osts

ATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

7-17

Economies and Diseconomies of Scale

• Economies of scale

• Labor specialization

• Managerial specialization

• Efficient capital

• Other factors

• Constant returns to scale

LO4 7-18

Economies and Diseconomies of Scale

• Diseconomies of scale

• Control and coordination problems

• Communication problems

• Worker alienation

• Shirking

LO4 7-19

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 7-20

MES and Industry Structure

LO4

Output

Ave

rag

e T

ota

l C

os

ts

Long-Run ATC

Economies

Of Scale

Constant Returns

To Scale

Diseconomies

Of Scale

q1 q2

7-21

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

7-22