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Chapter 7 Production Costs

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2002 South-Western College Publishing

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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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How is accounting profit defined?

Total revenue minus total explicit costs

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What are total opportunity costs?

Explicit costs + Implicit costs

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What is economic profit?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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When economists use the term “profit”, which

profit do they mean?Economic profit which, unlike accounting profit, includes implicit costs

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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 the short run?A period of time so short that there is at least one fixed input

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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 a variable input?

Any resource for which the quantity can change during the period of time under consideration

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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

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20

5

50

63

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To

tal O

utp

ut

Quantity of Labor

Total Output

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8

2

1 2 4

Marginal Product Curve

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4

5

10

63

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Mar

gin

al O

utp

ut

Quantity of Labor

Law of Diminishing

Returns

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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

TFCCo

st p

er u

nit

Q

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MC

AFC

Co

st p

er u

nit

AFC

Q

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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

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4

5

10

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To

tal O

utp

ut

Quantity of Labor

Maximum

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MCC

ost

per

un

it Minimum

Q

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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$80

10 12 14 16 18

Short and Long-run Average Cost Curves

Short-run average total cost curves

Long-run average cost curveQ

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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$80

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Diseconomies of scale

Economies of scale

Q

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Key Concepts

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Key Concepts

• What is a basic assumption in economics?• What are explicit costs?• What are implicit costs?• How is accounting profit defined?• What are total opportunity costs?• What is economic profit?• What is normal profit?

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Key Concepts cont.• When economists use the term “profit”, which pr

ofit do they mean?• When economists study the economy, what tim

e frame do they assume?• What is a fixed Input?• What is the short run?• What is the long run?• What is a variable input?• What is marginal product?

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Key Concepts cont.• What is the Law of diminishing returns?• What is total fixed cost?• What is total variable cost?• What is total cost?• What is average fixed cost?• What is average variable cost?• What is average total cost?• What is marginal cost?• What are economies of scale?• What are diseconomies of scale?

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Summary

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Economic profit is equal total revenue minus both explicit and implicit costs. Implicit costs are the opportunity costs of foregone returns to resources owned by the firm. Economic profit is important for decision-making purposes because it includes implicit costs and accounting profit does not. Accounting profit equals total revenue minus explicit costs.

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The short run is a time period during which a firm has at least one fixed input, such as its factory size. The long run for a firm is defined as as a period during which all inputs are variable.

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A production function is the relationship between output and inputs. Holding all other factors of production constant, the production function shows the total output as the amount of one input, such as labor, varies.

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Marginal product is the change in total output caused by a one-unit change in a variable input, such as the number of workers hired, the law of diminishing returns states that after some level of output in the short run, each unit of the variable input yields smaller and smaller marginal product. This range of declining marginal product is the region of diminishing returns.

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Total fixed costs consists of costs that cannot vary with the level of output, such as rent for office space. Total fixed costs is the cost of inputs that do not change as the firm changes output in the short run. Total variable cost consists of costs that vary with the level of output, such as wages. Total variable cost is the cost of variable inputs used in production. Total cost is the sum of total fixed cost and total variable cost.

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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

Q

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Marginal cost is the change is total cost associated with one additional unit of output. Average fixed cost is the total fixed cost divided by total output. Average variable cost is the total variable cost divided by total output. Average total cost is the total cost, or the sum of average fixed cost and average variable cost, divided by output.

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MC

AFC

Co

st p

er u

nit

AFC

Q

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The marginal-average rule explains the relationship between marginal cost and average cost. When the marginal cost is less than the average cost, the average cost falls. When the marginal cost is greater than the average cost, the average cost rises. Following this rule, the marginal cost curve intersects the average total cost curve at their minimum points.

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Marginal cost and marginal product are mirror images of each other. Assuming a constant wage rate, marginal cost equals the wage rate divided by the marginal product. Increasing returns cause marginal cost to fall, and diminishing returns cause marginal cost to rise. This explains the U-shaped marginal cost curve.

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8

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1 2 4

Marginal Product Curve

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To

tal O

utp

ut

Quantity of Labor

Maximum

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

MCM

arg

inal

co

st Minimum

Q

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The long-run average cost curve is a curve drawn tangent to all possible short-run average total curves. When the long-run average cost curve decreases as output increases, the firm experiences economies of scale.

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If the long-run average cost curve remains unchanged as output increases, the firm experiences constant returns to scale. If the long-run average cost curve increases, the firm experiences diseconomies of scale.

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$40$30$20$10

2 4 6 8

$50$60$70$80

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Diseconomies of scale

Economies of scale

Q

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