SAYRE | MORRIS Seventh Edition

A Firm’s Production Decisions and Costs in the

Short Run

CHAPTER 6

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Explicit and Implicit Costs

Explicit Costs • a cost that is actually paid out in money

Implicit Costs • a cost that does not require an actual expenditure

of money

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Explicit and Implicit CostsProfit and Loss Statement

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Total Revenue: Cash sales (excluding sales tax) $20 000Explicit Costs: Rent $1500

Materials and Supplies 4200Utilities 1000Hired labour 10 000Depreciation on equipment 500

Total Explicit Costs: 17 200Accounting Profit: 2 800Implicit Costs: Opportunity costs of $96 000

put into business 800Labour put in by owners 4000

Total Implicit Costs: 4 800Total Explicit and Implicit Costs: 22 000Economic Profit or (Loss): (2 000)

Implicit Costs

Assume a rate of return of 10% per year:

$96,000 x 0.10 = $9,600 per year$9,600 / 12 = $800 per month

*They are working for themselves at the new business. If they didn’t they would be able to earn $4,000 elsewhere.

*This gives them total implicit costs of $4,800 per month.

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Accounting v Economic Profit

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Accounting profit total revenue total explicit costs

Economic profit total revenue total costs (including implicit and explicit costs)

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Accounting v Economic Profit

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Normal Profit • the minimum profit that must be earned to keep

the entrepreneur in that type of business

Economic Profit • revenue over and above all costs, including

normal profits

Sunk Cost • the historical costs of an asset that are

unrecoverable

Theory of Production

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Short Run • any period of time in which at least one input in

the production process is fixed

Total Product • the total output of any productive process

Theory of Production

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Marginal Product • the increase in total product

as a result of adding one more unit of input

Average Product • total product (or total output)

divided by the quantity of inputs used to produce that total

LPMP

L

LPAP

L

Theory of Production

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Marginal and Average Product Units of Labour

TP MP AP

0 0 — —1 8 8 82 20 12 103 45 25 154 75 30 18.85 100 25 206 120 20 207 130 10 18.68 135 5 16.99 135 0 15

10 130 –5 13

Theory of Production

Law of Diminishing Returns • as more of a variable input is added to a fixed

input in the production process, the resulting increase in output will, at some point, begin to diminish.

Division of Labour • Dividing the production process into a series of

specialized tasks, each done by a different worker

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Benefits of Division of Labour

1. ability to fit the best person to the right job

2. increased dexterity achieved when one worker focuses on a single operation

3. time savings from not having to change tools

4. time savings gained by not moving from one operation to another

5. machine specialization can be developed around specific, discrete operations

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Average product will rise if marginal product exceeds it and will fall if marginal product is less than it.

Marginal and Variable Costs

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• Production relates the number of units produced to the amount of labour used

• Costs relate the number of units produced to dollars

• Costs depend on the level of production, i.e. how many workers and the level of total product

Marginal and Variable Costs

Total Variable Cost• the total of all costs that vary with the level of

output

Marginal Cost • the increase in total variable

costs as a result of producing one more unit of output

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VCMCtotal output

Marginal and Variable Costs

Average Variable Cost• total variable cost divided

by total output

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VCAVC

total output

Cost Data for a Firm

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Units ofLabour TP MP AP TVC MC AVC

0 0 / / 0 / /1 8 8 8 $100 $12.50 $12.502 20 12 10 200 8.33 10.003 45 25 15 300 4.00 6.674 75 30 18.8 400 3.33 5.335 100 25 20 500 4.00 5.006 120 20 20 600 5.00 5.007 130 10 18.6 700 10.00 5.388 135 5 16.9 800 20.00 5.939 135 0 15 900 —— 6.67

10 130 –5 13 1000 —— 7.69

MP = TP = 20 – 8 = 12 = 12 L 2 – 1 1

AP = TP = 20 = 10 L 2

MC = TVC = 200 – 100 = 100 = 8.33 output 20 – 8 12

AVC = TVC = 300 = 6.67 output 45

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Variable costs of production are a reflection of productivity

Total and Average Total Costs

Total Fixed Costs• costs that do not vary with the level of output

Average Fixed Cost • total fixed cost divided by

the quantity of output

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TFCAFC

total output

Total and Average Total Costs

Total Cost• the sum of both total

variable cost and total fixed cost

Average Total Cost • total cost divided by

quantity of output

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TC TVC TFC

TC TVC TFC

TCATCtotal output

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• Both MC and AVC curves reflect the division of labour as they decline and the law of diminishing returns as they rise.• MC is initially below AVC and ATC but then rises above each of these.• MC intersects AVC and ATC at their minimum points.• AFC continuously declines.

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*Please disregard an incorrect statement made in the lecture on this slide regarding AP being at a maximum when ATC is at a minimum. This is incorrect. The correct statement is that AP is ata maximum when AVC is at a minimum.

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Cutting Costs

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• Cutting costs involves a reduction in average costs rather than total costs

• The firm is assumed to be producing at the lowest possible cost for each output level

• Costs will decrease if: the price of either fixed or variable inputs decreases the marginal product of a productive process

increases a firm is operating at excess capacity, and then

increases output

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