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Chapter 8

The Costs of
Production

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All


Chapter Objectives

Explicit and implicit costs


Law of diminishing returns
Fixed and variable costs
Total, average, and marginal
costs
The firms size in the long run

8-2
Economic Costs
Equal to opportunity costs
Explicit + implicit costs
Explicit costs
Monetary payments
Implicit costs
Value of next best use
Self-owned resources
Self-employed resources
8-3
Profit

Accounting profit
Total revenue less explicit cost
Normal profit
Equal to implicit cost
Economic or pure profit
Total revenue less economic cost

8-4
Profits Compared

Economic Accounting
Economic
Profit Accounting

Total Revenue
Implicit Costs Profit
(Opportunity)

(Including a
Economic

Normal Profit)
Costs

Accounting
Explicit
Costs (Explicit
Costs Costs Only)

8-5
Short and Long Run
The short run
Fixed plant capacity
Variable intensity of plant use
Variable output
The long run
Variable plant capacity
Firms enter and exit
8-6
Production Relationships
Total product (TP)
Marginal product (MP)

Change in Total Product


Marginal
Average (AP)=
Product
product
Change in Labor Input

Total Product
Average Product = Units of Labor

8-7
Law of Diminishing Returns
Fixed technology
Add variable resource to fixed
resource
Marginal product will decline
Beyond some point
Rationale

8-8
Law of Diminishing Returns

(3) (3)
(1) Marginal Product Average
Units of the (2) (MP), Product
Variable Resource Total Product Change in (2)/ (AP),
(Labor) (TP) Change in (1) (2)/(1)
0 0 -
1 10
] 10 Increasing 10.00
2 25
] 15 Marginal
12.50
Returns
3 45
] 20
15.00
4 60
] 15
Diminishing 15.00
5 70
] 10 Marginal 14.00
6 75
] 5 Returns
12.50
75
] 0 Negative
10.71
7
] -5 Marginal
8.75
8 70 Returns

8-9
Law of Diminishing Returns

Total Product, TP
30
TP

20

10

0
1 2 3 4 5 6 7 8 9
Marginal Product, MP

Increasing Diminishing Negative


Marginal Marginal Marginal
20 Returns Returns Returns

10 AP

1 2 3 4 5 6 7 8 9
MP
8-10
Short-Run Production Costs

Fixed Costs
Do not vary with output
Variable Costs
Materials, most labor
Total Cost
TC = TFC + TVC

8-11
Per-Unit Production Costs

Average fixed cost


AFC = TFC/Q
Average variable cost
AVC = TVC/Q
Average total cost
ATC = TC/Q = TFC/Q + TVC/Q
ATC = AFC+AVC
Marginal cost
MC = change in TC/change in Q 8-12
Short-Run Production Costs
$1100
1000 TC
900
TVC
800
700

600
Costs

Fixed
500 Cost
400
300 Total Variable
Cost Cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q
8-13
Short-Run Production Costs
$200

MC
150

ATC
Costs

100
AVC
AFC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q
8-14
Production Relationships
Marginal cost and diminishing returns
Marginal cost and marginal product
Marginal cost and average variable
cost
Marginal cost and average total cost
Production curves and cost curves
Shifts in cost curves

8-15
Graphical Relationships
Production Curves

Average Product and


Marginal Product

AP
MP
Quantity of Labor

MC
AVC
Cost (Dollars)

Cost Curves
Quantity of Output
8-16
Long-Run Production Costs
Choose your plant size
Minimize ATC
Different ATC curves
Short run
Long run ATC
Envelope of short run ATC

8-17
Long-Run ATC Curve

Average Total Costs


ATC-1
ATC-5
ATC-2
ATC-3 ATC-4

Output

Any number of short-run optimum


size cost curves can be constructed
8-18
Long-Run ATC Curve

Average Total Costs


ATC-1
ATC-5
ATC-2
ATC-3 ATC-4
Long-Run
ATC

Output

The long-run ATC curve just


envelopes the short run ATCs
8-19
Long Run Production Cost
Economies of Scale
Labor specialization
Managerial specialization
Efficient capital
Diseconomies of Scale
Constant Returns to Scale

8-20
Long-Run ATC Shapes
Economies Constant Returns Diseconomies
Average Total Costs Of Scale To Scale Of Scale

Long-Run
ATC

q1 q2
Output

Long-run ATC curve where economies


of scale exist
8-21
Long-Run ATC Shapes
Economies Diseconomies
Average Total Costs Of Scale Of Scale

Long-Run
ATC

Output
Long-run ATC curve where costs are
lowest only when large numbers are
participating
8-22
Long-Run ATC Shapes
Economies Diseconomies
Average Total Costs Of Scale Of Scale

Long-Run
ATC

Output
Long-run ATC curve where economies
of scale exist, are exhausted quickly,
and turn back up substantially
8-23
Industry Structure
Minimum efficient scale (MES)
Natural monopoly
Applications and illustrations
Price of corn
Successful start-up firms
The Verson stamping machine
The daily newspaper
Aircraft and concrete plants

8-24
Sunk Costs
Irrelevant in decision making
Cannot be recovered
Do not affect marginal
benefit and marginal cost
Firm example:
R&D costs

8-25
Key Terms
economic (opportunity) variable costs
cost total cost
explicit costs average fixed cost (AFC)
implicit costs average variable cost (AVC)
normal profit average total cost (ATC)
economic profit marginal cost (MC)
short run economies of scale
long run diseconomies of scale
total product (TP) constant returns to scale
marginal product (MP) minimum efficient scale
average product (AP) (MES)
law of diminishing returns natural monopoly
fixed costs
8-26