1 production costs economics for today by irvin tucker, 6 th edition ©2009 south-western college...
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1
Production Costs
Economics for Today by Irvin Tucker, 6th edition©2009 South-Western College Publishing
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What is the purpose of this chapter?
The purpose of this chapter is to study production and its relationship to various types of costs
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What economic puzzles will I learn to solve?
• Why would an accountant say a firm is making a profit and an economists say it’s losing money?
• What is the difference between the short run and the long run?
• Why have multiscreen movie theatres replaced single screen theatres?
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What is a basic assumption in economics?
The motivation for business decisions is profit maximization
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To understand profit, what is necessary?
To distinguish between the way economists measure costs and the way accountants measure costs
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What are explicit costs?Payments to nonowners of a firm for their resources
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What are implicit costs?
The opportunity costs of using resources owned by the firm
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What is an example of implicit costs?
When you invest your nest egg in your own enterprise, you give up earning interest on that money
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What are total opportunity costs?
Explicit costs + Implicit costs
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What iseconomic profit?
Total revenue minus explicit and implicit costs, or total revenue minus total opportunity costs
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What is normal profit?
The minimum profit necessary to keep a firm in operation
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What about opportunity cost?
A firm that earns normal profits earns total revenue equal to its total opportunity cost
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How is accounting profit defined?
Total revenue minus total explicit costs
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What conclusion can we make?
Since business decision making is based on economic profit, rather than accounting profit, the word profit in this text always means economic profit
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What is a fixed input?Any resource for which the quantity cannot change during the period of time under consideration
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What is avariable input?
Any resource for which the quantity can change during the period of time under consideration
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What is the short run?A period of time so short that there is at least one fixed input
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What is a variable input?
Any resource for which the quantity can change during the period of time under consideration
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What is the long run?A period of time so long that all inputs are variable
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What is theproduction function?
The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs
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What do technological advances make
possible?More output is possible from a given quantity of inputs
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What ismarginal product?
The change in total output produced by adding one unit of a variable input, with all other inputs used held constant
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What is the law of diminishing returns?
The principle that beyond some point the marginal product decreases as additional units of a variable resource are added to a fixed factor
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What does the law of diminishing
returns assume?Fixed inputs; it is therefore a short-run concept
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40
10
1 2 4
Production Function
30
20
5
50
63
60
To
tal O
utp
ut
Quantity of Labor
Total Output
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8
2
1 2 4
Marginal Product Curve
6
4
5
10
63
12
Mar
gin
al P
rod
uct
Law of Diminishing
Returns
Quantity of Labor
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What istotal fixed cost?
Costs that do not vary as output varies and that must be paid even if output is zero
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What istotal variable cost?
Costs that are zero when output is zero and vary as output varies
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What is total cost?
The sum of total fixed cost and total variable cost at each level of output
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TC = TFC + TVC
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What isaverage fixed cost?
Total fixed cost divided by the quantity of output produced
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AFC = TFC / Q
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What is average variable cost?
Total variable cost divided by the quantity of output produced
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AVC = TVC / Q
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What isaverage total cost?
Total cost divided by the quantity of output produced
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ATC = AFC + AVC = TC/Q
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What is marginal cost?The change in total cost when one unit of output is produced
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MC = TC/Q = TVC/Q
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$400
$300
$200
$100
1 2 3 4
$500
$600
$700
$800
5 6 7 8 9
Short-Run Cost Curves
TCTVC
TFC
TFC
Co
st p
er u
nit
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$40$30$20
$10
1 2 3 4
$50$60$70
5 6 7 8 9
Short-Run Cost Curves
ATC
AVC
MC
AFC
AFC
Co
st p
er u
nit
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What is themarginal-average rule?
When MC < AC, AC fallsWhen MC > AC, AC rises
If MC = AC, AC at minimum
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What is the relationship between slopes of the MC and
MP curves?The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa
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What is the relationship between
the minimum and maximum points of the
MR and MP curves?The maximum point of the MP curve corresponds to the minimum point of the MC curve
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8
2
1 2 4
Marginal Product Curve
6
4
5
10
63
12
To
tal O
utp
ut
Quantity of Labor
Maximum
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$40
$30
$20
$10
1 2 3 4
$50
$60$70
5 6 7 8 9
Short-Run Cost Curves
ATC
AVC
MCC
ost
per
un
itMinimum
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What is the long-run average cost curve?The curve that traces the
lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size
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$40
$30
$20
$10
2 4 6 8
$50
$60
$70
10 12 14 16 18
Short and Long-run Average Cost Curves
Short-run average total cost curves
Long-run average cost curve
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What areeconomies of scale?A situation in which the long-run average cost curve declines as the firm increases output
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What are constant returns to scale?
A situation in which the long-run average cost curve does not change as the firm increases output
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What arediseconomies of scale?
A situation in which the long-run average cost curve rises as the firm increases output
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$40
$30
$20
$10
2 4 6 8
$50
$60
$70
10 12 14 16 18
Long-run Average Cost Curve
Constant returns to scale
Economies of scale
Diseconomies of scale
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END