Chapter 8

The Costs of
Production

McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
 Chapter Objectives
• Explicit and implicit costs
• Law of diminishing returns
• Fixed and variable costs
• Total, average, and marginal
costs
• The firm’s 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 Product =
Change in Labor Input

• Average product (AP)

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
Returns 12.50
3 45
] 20
15.00
4 60
] 15
Diminishing 15.00
5 70
] 10 Marginal
14.00
75
] 5 Returns
12.50
6
] 0 Negative
7 75 10.71
] -5 Marginal
Returns
8 70 8.75

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
Costs

600
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
Costs 150

ATC
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
Long-Run
ATC-3 ATC-4
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)
cost
• 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
(MES)
• natural monopoly
8-26
Next Chapter Preview…

Pure
Competition

8-27