Copyright 2008 The McGraw-Hill Companies 20-1 20 The Costs of Production

Copyright 2008 The McGraw-Hill Companies20-1

20The Costs ofProduction


Chapter Objectives• Why Do Economic Costs Include Both Explicit Why Do Economic Costs Include Both Explicit

Costs and Implicit CostsCosts and Implicit Costs

• How Does the Law of Diminishing Returns How Does the Law of Diminishing Returns Relate to a Firm’s Short-Run Production CostsRelate to a Firm’s Short-Run Production Costs

• Learn the Distinctions Between Fixed and Learn the Distinctions Between Fixed and Variable Costs and Among Total, Average, and Variable Costs and Among Total, Average, and Marginal CostsMarginal Costs

• Learn the Link Between a Firm’s Size and Its Learn the Link Between a Firm’s Size and Its Average Costs in the Long RunAverage Costs in the Long Run


Economic costsEconomic costs • are the payments a firm must make, or incomes it must are the payments a firm must make, or incomes it must

provide, to resource suppliers to attract those resources provide, to resource suppliers to attract those resources away from their best alternative production opportunities. away from their best alternative production opportunities.

• Payments may be explicit or implicit. Payments may be explicit or implicit.

Explicit costsExplicit costs • are payments to non-owners - of the firm - for resources they are payments to non-owners - of the firm - for resources they

supply.supply.

Implicit costsImplicit costs

• are the money payments the self‑employed resources could are the money payments the self‑employed resources could

have earned in their best alternative employmentshave earned in their best alternative employments. .


Example • Ali runs a small 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 equipments that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a manager for a competitor. He also estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from his firm sales is $72,000. Calculate accounting profits and economic profits for Ali.

• Explicit costs: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials).

• Implicit costs: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship).Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs);

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


Normal profitsNormal profits • are considered an implicit cost because they are the are considered an implicit cost because they are the

minimum payments required to keep the owner’s minimum payments required to keep the owner’s entrepreneurial abilities self‑employedentrepreneurial abilities self‑employed. This is $3,000 in the . This is $3,000 in the example.example.

Accounting profitsAccounting profits • Are the total revenue less explicit costs.Are the total revenue less explicit costs.

Economic or pure profits Economic or pure profits • are total revenue less all costs (explicit and implicit including are total revenue less all costs (explicit and implicit including

a normal profit). a normal profit).


Profits ComparedEconomic Profit Versus Accounting Profits

EconomicProfit

AccountingCosts (Explicit

Costs Only)

AccountingProfit

ExplicitCosts

Implicit Costs(Including a

Normal Profit)

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Economics Accounting


The short runThe short run • is the time period that is is the time period that is too brieftoo brief for a firm to alter its plant for a firm to alter its plant

capacity. capacity. The plant size is fixed in the short runThe plant size is fixed in the short run. Short‑run . Short‑run costs, are the wages, raw materials, etc., used for production costs, are the wages, raw materials, etc., used for production in a fixed plant.in a fixed plant.

The long run The long run • is a period of time long enough for a firm to change the is a period of time long enough for a firm to change the

quantities of all resources employed, including the quantities of all resources employed, including the plant sizeplant size. . Long‑run costs are all costs, including the cost of varying Long‑run costs are all costs, including the cost of varying the size of the production plant.the size of the production plant.

Short-Run Production RelationshipsShort-Run Production RelationshipsShort‑run productionShort‑run production • reflects the law of diminishing returns that states that “reflects the law of diminishing returns that states that “as as

successive units of a variable resource are added to a successive units of a variable resource are added to a fixed resource, beyond some point the product fixed resource, beyond some point the product attributable to each additional resource unit (MP) will attributable to each additional resource unit (MP) will declinedecline”.”.


Total product (TP) Total product (TP) • is the total quantity, or total output, of a particular good is the total quantity, or total output, of a particular good

produced.produced.

Marginal product (MP)Marginal product (MP) • is the change in total output resulting from each additional is the change in total output resulting from each additional

input of labor.input of labor.

Average product (AP)Average product (AP) • is the total product divided by the total number of workers.is the total product divided by the total number of workers.

• The following figure illustrates the law of diminishing returns The following figure illustrates the law of diminishing returns graphically and shows the relationship between marginal, graphically and shows the relationship between marginal, average, and total product concepts. average, and total product concepts.


IncreasingMarginalReturns

Law of Diminishing Returns

(1)Units of the

Variable Resource(Labor)

(2)Total Product

(TP)

(3)Marginal Product

(MP),Change in (2)/Change in (1)

(3)AverageProduct

(AP),(2)/(1)

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DiminishingMarginalReturns

NegativeMarginalReturns

O 20.1


Law of Diminishing Returns• Graphical Portrayal

0

10

20

30

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, TP

1 2 3 4 5 6 7 8 9

20

10

Mar

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, MP

1 2 3 4 5 6 7 8 9

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

O 20.2


Note:Note:• When marginal product begins to diminish, the rate of When marginal product begins to diminish, the rate of

increase in total product stops accelerating and grows increase in total product stops accelerating and grows at a at a diminishing ratediminishing rate. .

• The average product declines at the point at which the The average product declines at the point at which the marginal product marginal product slips below average productslips below average product..

• Total product declines when the marginal product becomes Total product declines when the marginal product becomes negativenegative..

• The law of diminishing returns assumes all units of variable The law of diminishing returns assumes all units of variable inputs - workers in this case - are of equal quality. Marginal inputs - workers in this case - are of equal quality. Marginal product diminishes not because successive workers are product diminishes not because successive workers are inferior but because inferior but because more workers are being used more workers are being used relative to relative to the amount of plant and equipment availablethe amount of plant and equipment available..


Short Run Production CostsShort Run Production Costs• Fixed, variable and total costs are the short‑run Fixed, variable and total costs are the short‑run

classifications of costs; classifications of costs;

Total fixed costsTotal fixed costs• Are those costs whose total does not vary with changes in Are those costs whose total does not vary with changes in

short‑run output.short‑run output.

Total variable costsTotal variable costs• Are those costs that change with the level of output. They Are those costs that change with the level of output. They

include payment for materials, fuel, power, transportation include payment for materials, fuel, power, transportation services, most labor, and similar costs.services, most labor, and similar costs.

Total costTotal cost• Is the sum of total fixed and total variable costs at each level Is the sum of total fixed and total variable costs at each level

of output (see Figure 20.3).of output (see Figure 20.3).


Short-Run Production CostsTotal Cost, Fixed and Variable Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

100

200

300

400

500

600

700

800

900

1000

$1100

TFC

TC

TVC

TotalCost

VariableCost

FixedCost


Per unit or average costs Per unit or average costs • There are three types of average or per unit costs:There are three types of average or per unit costs:

Average fixed cost:Average fixed cost: is the total fixed cost divided by the level is the total fixed cost divided by the level of output (TFC/Q). It will decline as output rises.of output (TFC/Q). It will decline as output rises.

Average variable cost:Average variable cost: is the total variable cost divided by the is the total variable cost divided by the level of output (AVC = TVC/Q).level of output (AVC = TVC/Q).

Average total cost:Average total cost: is the total cost divided by the level of is the total cost divided by the level of output (ATC = TC/Q), sometimes called unit cost or per unit output (ATC = TC/Q), sometimes called unit cost or per unit cost. Note that ATC also equals AFC + AVC.cost. Note that ATC also equals AFC + AVC.

Marginal costMarginal cost • Is the additional cost of producing one more unit of output Is the additional cost of producing one more unit of output

(MC = change in TC/change in Q). (MC = change in TC/change in Q).


• Marginal cost can also be calculated as MC = Marginal cost can also be calculated as MC = change in change in TVC/change in Q.TVC/change in Q.

• Marginal decisions are very important in determining profit Marginal decisions are very important in determining profit levels. levels. Marginal revenue and marginal cost are comparedMarginal revenue and marginal cost are compared..

• Marginal cost is a reflection of marginal product and Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the diminishing returns. When diminishing returns begin, the marginal cost will begin its rise.marginal cost will begin its rise.

• The marginal cost is related to AVC and ATC. These The marginal cost is related to AVC and ATC. These average costs will fall as long as the marginal cost is less average costs will fall as long as the marginal cost is less than either average cost. As soon as the marginal cost rises than either average cost. As soon as the marginal cost rises above the average, the average will begin to rise.above the average, the average will begin to rise.

• Cost curves will shift if the resource prices change or if Cost curves will shift if the resource prices change or if technology or efficiency change.technology or efficiency change.


Short-Run Production CostsAverage and Marginal Costs

Co

sts

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

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Short-Run Production Costs

MPAP

MCAVC

Quantity of Output

Quantity of Labor

Production Curves

Cost Curves


• Long-Run Production Costs• In the long‑run, all production costs are variable, i.e., long-In the long‑run, all production costs are variable, i.e., long-

run costs reflect changes in plant size and industry size can run costs reflect changes in plant size and industry size can be changed (expand or contract).be changed (expand or contract).

• The following figure illustrates different short‑run cost curves The following figure illustrates different short‑run cost curves for five different plant sizes.for five different plant sizes.

• The long‑run ATC curve shows the least per unit cost at The long‑run ATC curve shows the least per unit cost at which any output can be produced after the firm has had which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size.time to make all appropriate adjustments in its plant size.


Long-Run Production CostsLong-Run ATC Curve

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sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed


Long-Run Production CostsLong-Run ATC Curve

Long-RunATC

Ave

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sATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

The Long-Run ATC Curve Just“Envelopes” the Short Run ATCs


Economies of ScaleEconomies of Scale• Economies or diseconomies of scale exist in the long run.Economies or diseconomies of scale exist in the long run.

Economies of scaleEconomies of scale or economies of mass production explain or economies of mass production explain the downward sloping part of the long‑run ATC curve, i.e. as the downward sloping part of the long‑run ATC curve, i.e. as plant size increases, long-run ATC decrease. plant size increases, long-run ATC decrease.

Reasons for economies of scaleReasons for economies of scale• Labor and managerial specialization is one reason for this.Labor and managerial specialization is one reason for this.

• Ability to purchase and use more efficient capital goods also Ability to purchase and use more efficient capital goods also may explain economies of scale.may explain economies of scale.

• Other factors may also be involved, such as design, Other factors may also be involved, such as design, development, or other “start up” costs such as advertising development, or other “start up” costs such as advertising and “learning by doing.”and “learning by doing.”


Diseconomies of scale Diseconomies of scale • may occur if a firm becomes too large as illustrated by the may occur if a firm becomes too large as illustrated by the

rising part of the long‑run ATC curve. For example, if a 10 rising part of the long‑run ATC curve. For example, if a 10 percent increase in all resources result in a 5 percent percent increase in all resources result in a 5 percent increase in output, ATC will increase. Some reasons for this increase in output, ATC will increase. Some reasons for this include distant management, worker alienation, and include distant management, worker alienation, and problems with communication and coordination.problems with communication and coordination.

Constant returns to scale Constant returns to scale • will occur when ATC is constant over a variety of plant sizes.will occur when ATC is constant over a variety of plant sizes.

• Both economies of scale and diseconomies of scale can be Both economies of scale and diseconomies of scale can be demonstrated in the real world. Larger corporations at first demonstrated in the real world. Larger corporations at first may successful in lowering costs and realizing economies of may successful in lowering costs and realizing economies of scale. To keep from experiencing diseconomies of scale, scale. To keep from experiencing diseconomies of scale, they may decentralize decision making by utilizing smaller they may decentralize decision making by utilizing smaller production units.production units.


Long-Run Production CostsAlternative Long-Run ATC Shapes

Output

Long-Run ATC Curve Where EconomiesOf Scale Exist

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Long-RunATC

EconomiesOf Scale

Constant ReturnsTo Scale

DiseconomiesOf Scale

q1 q2



Output

Long-Run ATC Curve Where Costs AreLowest Only When Large Numbers AreParticipating

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Of ScaleDiseconomies

Of Scale

Long-RunATC



Output

Long-Run ATC Curve Where EconomiesOf Scale Exist, are Exhausted Quickly,And Turn Back Up Substantially

Ave

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Long-RunATC

EconomiesOf Scale

DiseconomiesOf Scale


Minimum efficient scaleMinimum efficient scale

• The concept of minimum efficient scale defines the smallest The concept of minimum efficient scale defines the smallest level of output at which a firm can minimize its average costs level of output at which a firm can minimize its average costs in the long run.in the long run.

• The firms in some industries realize this at a small plant size: The firms in some industries realize this at a small plant size: apparel, food processing, furniture, wood products, apparel, food processing, furniture, wood products, snowboarding, and small-appliance industries are examples.snowboarding, and small-appliance industries are examples.

• In other industries, in order to take full advantage of In other industries, in order to take full advantage of economies of scale, firms must produce with very large economies of scale, firms must produce with very large facilities that allow the firms to spread costs over an facilities that allow the firms to spread costs over an extended range of output. Examples would be: automobiles, extended range of output. Examples would be: automobiles, aluminum, steel, and other heavy industries. This pattern aluminum, steel, and other heavy industries. This pattern also is found in several new information technology also is found in several new information technology industries.industries.


Applications and illustrations

• The terrorist attacks on September 11, 2001, have led to The terrorist attacks on September 11, 2001, have led to rising insurance and security costs. Some of these costs are rising insurance and security costs. Some of these costs are fixed (insurance premiums and security cameras), while fixed (insurance premiums and security cameras), while others are variable (number of security guards). Both have others are variable (number of security guards). Both have resulted in an upward shift of resulted in an upward shift of the ATC curves.the ATC curves.

• Recently there have been a number of start-up firms that Recently there have been a number of start-up firms that have been able to take advantage of economies of scale by have been able to take advantage of economies of scale by spreading product development costs and advertising costs spreading product development costs and advertising costs over larger and larger units of output and by using greater over larger and larger units of output and by using greater specialization of labor, management, and capital.specialization of labor, management, and capital.

• In 1996 Verson (a firm located in Chicago) introduced a In 1996 Verson (a firm located in Chicago) introduced a stamping machine the size of a house weighing as much as stamping machine the size of a house weighing as much as 12 locomotives. This $30 million machine enables 12 locomotives. This $30 million machine enables automakers to produce in 5 minutes what used to take 8 automakers to produce in 5 minutes what used to take 8 hours to produce.hours to produce.


• Newspapers can be produced for a low cost and thus sold Newspapers can be produced for a low cost and thus sold for a low price because publishers are able to spread the for a low price because publishers are able to spread the cost of the printing equipment over an extremely large cost of the printing equipment over an extremely large number of units each day.number of units each day.

• The aircraft assembly and ready-mixed concrete industries The aircraft assembly and ready-mixed concrete industries provide extreme examples of differing MESs. Economies of provide extreme examples of differing MESs. Economies of scale are extensive in manufacturing airplanes, especially scale are extensive in manufacturing airplanes, especially large commercial aircraft. As a result, there are only two large commercial aircraft. As a result, there are only two firms in the world (Boeing and Airbus) that manufacture large firms in the world (Boeing and Airbus) that manufacture large commercial aircraft. The concrete industry exhausts its commercial aircraft. The concrete industry exhausts its economies of scale rapidly, resulting in thousands of firms in economies of scale rapidly, resulting in thousands of firms in that industry.that industry.


LAST WORD: Don’t Cry over Sunk CostsLAST WORD: Don’t Cry over Sunk Costs• Sunk costs are irrelevant in decision-making.Sunk costs are irrelevant in decision-making.• The old saying “Don’t cry over spilt milk” sends the message The old saying “Don’t cry over spilt milk” sends the message

that if there is nothing you can do about it, forget about it.that if there is nothing you can do about it, forget about it.• A sunken ship on the ocean floor is lost, it cannot be A sunken ship on the ocean floor is lost, it cannot be

recovered. It is what economists’ call a “sunk cost.”recovered. It is what economists’ call a “sunk cost.”• Economic analysis says that you should not take actions for Economic analysis says that you should not take actions for

which marginal cost exceeds marginal benefit.which marginal cost exceeds marginal benefit.• Suppose you have purchased an expensive ticket to a Suppose you have purchased an expensive ticket to a

football game and you are sick the day of the game; the football game and you are sick the day of the game; the price of the ticket should not affect your decision to attend.price of the ticket should not affect your decision to attend.

• In making a new decision, you should ignore all In making a new decision, you should ignore all costs that are not affected by the decision.costs that are not affected by the decision.

• A prior bad decision should not dictate a second A prior bad decision should not dictate a second decision for which the marginal benefit is less than decision for which the marginal benefit is less than marginal cost.marginal cost.


• Suppose a firm spends a million dollars on R&D only to Suppose a firm spends a million dollars on R&D only to discover that the product sells very poorly. The loss cannot discover that the product sells very poorly. The loss cannot be recovered by losing still more money in continued be recovered by losing still more money in continued production.production.

• If a cost has been incurred and cannot be partly or fully If a cost has been incurred and cannot be partly or fully recouped by some other choice, a rational consumer or firm recouped by some other choice, a rational consumer or firm should ignore it. should ignore it.

• Sunk costs are irrelevant! Don’t cry over spilt milk or sunk Sunk costs are irrelevant! Don’t cry over spilt milk or sunk costs!costs!


Key Terms• economic (opportunity) cos

t• explicit costs• implicit costs• normal profit• economic profit• short run• long run• total product (TP)• marginal product (MP)• average product (AP)• law of diminishing returns• fixed costs

• variable costs• total cost• average fixed cost (AFC)• average variable cost (AVC)• average total cost (ATC)• marginal cost (MC)• economies of scale• diseconomies of scale• constant returns to scale• minimum efficient scale (ME

S)• natural monopoly


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Copyright 2008 The McGraw-Hill Companies 20-1 20 The Costs of Production