Ch.

21: Production and Costs

Del Mar College

John Daly
©2003 South-Western Publishing, A Division of Thomson Learning
The Firm’s Objective:
Maximizing Profit
• An explicit cost is a cost that is incurred when an
actual payment is made.
• An implicit cost represents the value of resources
used in production for which no actual payment is
made. This is incurred as a result of a firm using its
own resources that it owns or that the owners of
the firm contribute to it.
Accounting Profit vs. Economic Profit
• Accounting Profit is the
difference between total
revenue and explicit costs.
• Economic Profit is the
difference between total
revenue and total
opportunity cost, including
both its explicit and
implicit components.
Accounting and Economic Profit
Zero Economic Profit?
• It is possible for a firm to earn both a positive
accounting profit and a zero economic profit.
• A firm that makes zero economic profit is said to be
earning normal profit.
• Zero economic profit means the owner has
generated total revenues sufficient to cover total
opportunity costs.
Q&A
• Suppose everything about two people is the
same except that one person currently earns a
high salary and the other person currently earns
a low salary. Which is more likely to start his or
her own business? Why?
• Is accounting or economic profit larger? Why?
• When can a business owner be earning a profit
but not covering expenses?
Production
• A fixed input is an input • A variable input is an
whose quantity cannot input whose quantity
be changed as output can be changed as
changes in the short output changes in the
run. short run.
• The costs associated • The costs associated
with fixed inputs are with variable inputs are
fixed costs. A fixed cost variable costs. A
doesn’t change as variable cost changes as
output changes. output changes.
Short Run & Long Run Production
• The short run is a
period in which some
inputs are fixed.
• The long run is a period
in which all inputs can
be varied.
• The Total Cost is the
sum of fixed and
variable costs
Periods of Production, Inputs, and
Costs
Production In the Short Run
• As more and more variable inputs, such as labor
and capital, were added to a fixed input, such as
land, the variable inputs would yield smaller and
smaller additions to output
• As ever larger amounts of a variable input are
combined with fixed inputs, eventually the
marginal physical product of the variable input will
decline.
• The marginal physical product of a variable input is
equal to the change in output that results from
changing the variable input by one unit, holding all
other inputs fixed.
The Law of Diminishing Returns
Marginal Physical Product and
Marginal Cost (Continued)
• If the law of diminishing marginal returns did not
hold, then it would be possible to continue to add
additional units of a variable input to a fixed input,
and the marginal physical product of the variable
input would never decline. We could increase
output indefinitely as long as we continued to add
units of a variable input to a fixed input.
• The law of diminishing marginal returns says that
as more units of the variable input are added, each
one has fewer units of the fixed input to work
with; consequently, output rises at a decreasing
rate.
The Law of Diminishing Marginal
Returns and Marginal Cost
 Marginal Physical Product and
Marginal Cost

• Marginal cost is a reflection of the marginal

physical product of the variable input.
• As the marginal physical product curve rises, the
marginal cost curve falls; and as the marginal
physical product curve falls, the marginal cost
curve rises.
• What the marginal cost curve looks like depends
on what the marginal physical product curve looks
like.
Average Productivity
• Average physical product is
output divided by the
quantity of labor.
• When the term labor
productivity is used in the
newspaper and in
government documents, it
refers to the average
physical productivity of
labor on an hourly basis.
Q&A
• If the short run is six months, does it follow that
the long run is longer than six months?
• “As we add more capital to more labor, eventually
the law of diminishing marginal returns will set in.”
What is wrong with this statement?
• Suppose a marginal cost (MC) curve falls when
output is in the range of 1 unit to 10 units, flattens
out and remains constant over an output range of
10 units to 20 units, and then rises over a range of
20 units to 30 units. What does this have to say
about the marginal physical product of the
variable input?
Costs of Production: Total, Average, And
Marginal
• The Average Fixed Cost (AFC) = Total fixed cost
divided by quantity of output
• The Average Variable Cost (AVC) = Total variable
cost divided by quantity of output.
• The Average Total Cost (ATC) or Unit Cost= Total
Cost divided by quantity of output.
• The Marginal Cost is the change in total cost or
total variable cost that results from a change in
output
Total, Average, and Marginal Costs
Total, Average, and Marginal Costs
(Continued)
The Average-Marginal Rule
When the marginal
magnitude is above the
average magnitude,
the average magnitude
rises; when the
marginal magnitude is
below the average
magnitude, the
average magnitude
falls.
Average and Marginal Cost Curves
Tying Short-Run Production To Costs
• Production underlies what
many of the various cost
curves looks like.
• What happens in terms of
production affects
Marginal Cost, which in
turn eventually effects
Average Variable Cost and
Average Total Cost.
Tying Products to Costs
 Sunk Cost
Sunk cost is a cost
incurred in the
past that cannot
be changed by
current decisions
and therefore
cannot be
recovered.
Q&A
• Identify two ways to compute average total cost
(ATC).
• Would a business ever sell its product for less than
cost? Explain your answer. (Hint: Think of sunk
cost)
• What happens to unit costs as marginal costs rise?
Explain your answer.
• Do changes in marginal physical productivity
influence unit costs? Explain your answer.
Long – Run Average Total Cost Curve
• Long Run Average Total Cost Curve shows the
lowest unit cost at which the firm can produce any
given level of output.
Economies of Scale, Diseconomies of
Scale, and Constant Returns to Scale
• Economies of Scale exist when inputs are increased by some
percentage and output increases by a greater percentage,
causing unit costs to fall.
• Constant Returns to Scale exist when inputs are increased
by some percentage and output increases by an equal
percentage, causing unit costs to remain constant.
• Diseconomies of Scale exist when inputs are increased by
some percentage and output increases by a smaller
percentage, causing unit costs to rise.
• Minimum Efficient Scale is the lowest output level at which
average total costs are minimized.
Why Economies of Scale?
• Growing firms offer greater
opportunities for
employees to specialize.
• Growing firms can take
advantage of highly efficient
mass production techniques
and equipment that
ordinarily require large
setup costs and thus are
economical only if they can
be spread over a large
number of units
Minimum Efficient Scale and
Number of Firms in an Industry
Minimum Efficient
Scale can be divided as
a percentage of U.S.
consumption into 100,
we can estimate the
number of efficient
firms it takes to satisfy
U.S. consumption for a
particular product.
Shifts In Cost Curves
• Taxes: affects variable costs. Because variable
costs rise, total costs rise, and their average curves
are shifted upward. Because marginal cost is the
change in total cost divided by the change in
output, marginal cost rises.
• Input Prices: A rise or a fall in variable input prices
causes a corresponding change in the firm’s
average total, variable, and marginal cost curves.
• Technological changes often bring either the
capability of using fewer inputs to produce a good
or lower input prices.
Q&A
• Give an arithmetical example to illustrate
economies of scale.
• What would the LRATC curve look like if there were
always constant returns to scale? Explain your
answer.
• Firm A charged $4 per unit when it produced 100
units of good X, and it charged $3 per unit when it
produced 200 units. Furthermore, the firm earned
the same profit per unit in both cases. How can
this be?