Businesses and the Costs of Production10McGraw-Hill/IrwinCopyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Economic CostsThe payment that must be made to obtain and retain the services of a resourceExplicit CostsMonetary paymentsImplicit CostsValue of next best useSelf-owned resourcesIncludes normal profitLO1

Accounting Profit and Normal ProfitAccounting profit = Revenue Explicit CostsEconomic profit = Accounting Profit Implicit CostsEconomic profit (to summarize)=Total Revenue Economic Costs=Total Revenue Explicit Costs Implicit Costs

LO1

Economic ProfitLO1ExplicitcostsAccounting costs (explicit costs only)Implicit costs (including a normal profit)EconomicprofitAccounting profitEconomic(Opportunity)CostsTotal Revenue

Short Run and Long RunShort RunSome variable inputsFixed plantLong RunAll inputs are variableVariable plantFirms enter and exitLO1

Short-Run Production RelationshipsTotal Product (TP)Marginal Product (MP)

Average Product (AP) LO2

The Law of Diminishing ReturnsLO2TPMPAPIncreasingMarginalReturnsDiminishingMarginalReturnsNegativeMarginalReturns1234567890102030Total Product, TP1234567892010Marginal Product, MP

Short-Run Production CostsFixed Costs (TFC)Costs do not vary with outputVariable Costs (TVC)Costs vary with outputTotal Costs (TC)Sum of TFC and TVCTC = TFC + TVCLO3

Short-Run Production CostsLO3TFCTCTVCTotalCostVariableCostFixedCost

Per-Unit, or Average, CostsAverage Fixed CostsAFC = TFC/QAverage Variable CostsAVC = TVC/QAverage Total CostsATC = TC/QMarginal CostsMC = TC/Q

LO3

Per-Unit, or Average, CostsLO3AFCATCAVCAVCAFC

Marginal CostLO3AFCMCATCAVCAVCAFC

MC and Marginal ProductLO3MPAPMCAVCQuantity of OutputQuantity of Labor Production CurvesCost Curves

Long-Run Production CostsThe firm can change all input amounts, including plant size. All costs are variable in the long run.Long run ATCDifferent short run ATCs

LO4

The Long-Run Cost Curve LO4Long-RunATCAverage Total CostsATC-1ATC-2ATC-3ATC-4ATC-5Output

Economies and Diseconomies of ScaleEconomies of scaleLabor specializationManagerial specializationEfficient capitalOther factorsConstant returns to scaleLO4

Economies and Diseconomies of ScaleDiseconomies of scaleControl and coordination problemsCommunication problemsWorker alienationShirkingLO4

MES and Industry StructureMinimum Efficient Scale (MES):Lowest level of output where long- run average costs are minimizedCan determine the structure of the industryLO4

MES and Industry StructureLO4OutputAverage Total CostsLong-RunATCEconomiesOf ScaleConstant ReturnsTo ScaleDiseconomiesOf Scaleq1q2

Dont Cry Over Sunk CostsSunk costs Costs have already been incurred and thus are irrecoverableRule: Do not engage in any activity where MB