Download Chapter 22 - The Costs of Production

22
C HAPTE R
The Costs of Production
1
Costs exist because resources
• Are scarce
• Productive
• Have alternative uses
• Use of a resource in a specific use implies an
economic or opportunity cost
2
Explicit and implicit costs
• Explicit costs: payments for the use of
resources owned by others.
• Implicit costs: payments that self-employed
resources could have earned in their best
alternative use.
3
Economic costs
• The payment the firm must make or income it must
provide to attract resources away from alternative
production opportunities.
• Normal profit as a cost
Implicit costs are a normal profit:
• Foregone wages
• Foregone interest
• Foregone rent
• Foregone entrepreneurial income
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•
•
•
•
•
•
•
Example:
Your salary: 22000 a year
Open your own business:
Invest your savings: 20000
The saving earn 1000 per year
Rent a store you own: 5000 per year
Hire an employee: 18000 a year
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• After 1 year:
• Total sale revenue ………………………..….120,000
•
costs of t-shirts ………….40,000
•
worker salary …………….18,000
•
rent …………………………..5,000
• Total (explicit) costs …………63,000
• Accounting profits ………………………...57,000
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• Accounting profit ……………….………….….57,000
•
forgone interest ……………...1,000
•
forgone rent …………………...5,000
•
forgone wages ………….…….22,000
•
forgone entrepreneurial income….5,000
• Total implicit costs ………………33,000
• Economic Profits ………………………………..24,000
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Economic profit
• Economic profit is = Total revenue – economic
costs
Or
Total revenue – (explicit + implicit costs)
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Example
• Hamad is working as a manager for 22000. his talent
worth 5000. He decides to open his own business.
• He invested his 20000 of savings that earn 1000
• The new firm will occupy a store he used to let out for
5000.
• He hired labor for 18000
• Cost of raw materials is 40000 and other utilities is
5000.
• Total revenue is 120000
• Calculate the explicit and implicit costs
• Calculate the accounting and economic profits.
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ECONOMIC COSTS
Economic (opportunity) Costs
Profits to an
Economist
Economic
Profit
Implicit costs
(including a
normal profit)
Explicit
Costs
Profits to an
Accountant
T
O
T
A
L
R
E
V
E
N
U
E
Accounting
Profit
Accounting
costs (explicit
costs only)
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SHORT RUN AND LONG RUN
Accounting:
Short and long run is based upon
annual chronology
Economics:
Short run has fixed plant capacity
size
Long run has variable plant
capacity size
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SHORT-RUN PRODUCTION
RELATIONSHIPS
Total Product (TP)
Marginal Product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input
Average Product (AP)
Average Product =
Total Product
Units of Labor
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Variable
resource
(labor)
Total
product
0
0
Marginal
product
Average
product
Comments
-
1
10
10
10
Increasing marginal returns
2
25
15
12.5
Increasing marginal returns
3
45
20
15
Increasing marginal returns
4
60
15
15
Diminishing marginal returns
5
70
10
14
Diminishing marginal returns
6
75
5
12.5
Diminishing marginal returns
10.71
Diminishing marginal returns
8.75
Negative marginal returns
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8
75
70
0
-5
Law of diminishing marginal returns
As successive units of a variable resource
are added to a fixed resource, beyond
some point, the extra, or marginal product
that can be attributed to each additional
unit of the variable resource will decline
WHY?
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Average Product, AP, and
marginal product, MP
Total Product, TP
SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product
Quantity of Labor
Quantity of Labor
Increasing
Marginal
Returns
Average
Product
Marginal
Product
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Average Product, AP, and
marginal product, MP
Total Product, TP
SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product
Quantity of Labor
Quantity of Labor
Diminishing
Marginal
Returns
Average
Product
Marginal
Product
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Average Product, AP, and
marginal product, MP
Total Product, TP
SHORT-RUN PRODUCTION
RELATIONSHIPS
Law of Diminishing Returns
Total Product
Quantity of Labor
Quantity of Labor
Negative
Marginal
Returns
Average
Product
Marginal
Product
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SHORT-RUN PRODUCTION COSTS
Fixed Costs
Total Fixed Costs
Average Fixed Costs =
Total Fixed Costs
Quantity
Variable Costs
Total Variable Costs
Average Variable Costs =
Total Variable Costs
Quantity
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SHORT-RUN PRODUCTION COSTS
Total Cost
Total Fixed and Variable Costs
Average Total Cost =
Total Costs
Quantity
Marginal Cost
Total Variable Costs
Marginal Cost =
Change in Total Costs
Change in Quantity
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Total Product
Total Fixed Costs
Total Variable Costs
Total Costs
0
1
2
3
4
5
6
7
8
9
10
100
100
100
100
100
100
100
100
100
100
100
0
90
170
240
300
370
450
540
650
780
930
100
190
270
340
400
470
550
640
750
880
1030
Total
Product
0
1
2
3
4
5
6
7
8
9
10
Average Fixed Costs
Average Variable
Costs
Average Total
Costs
Marginal Costs
100
50
33.33
25
20
16.67
14.29
12.50
11.11
10
90
85
80
75
74
75
77.14
81.25
86.67
93
190
135
113.33
100
94
91.67
91.43
93.75
97.78
103
90
80
70
60
70
80
90
110
130
150
SHORT-RUN PRODUCTION COSTS
Summary of Definitions
Total Fixed Costs =
Total Variable Costs =
Total Costs =
Average Fixed Costs =
Average Variable Costs =
Average Total Costs =
Marginal Cost =
TFC
TVC
TC
AFC
AVC
ATC
MC
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Costs (dollars)
SHORT-RUN COSTS GRAPHICALLY
Combining TVC
With TFC to get
Total Cost
Total
Cost
TC
TVC
Fixed Cost
Variable Cost
TFC
Quantity
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SHORT-RUN COSTS GRAPHICALLY
Costs (dollars)
MC
Plotting Average and
Marginal Costs
ATC
AVC
AFC
Quantity
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Average product and
marginal product
PRODUCTIVITY AND COST CURVES
AP
MP
Costs (dollars)
Quantity of labor
MC
AVC
Quantity of output
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LONG-RUN PRODUCTION COSTS
For every plant capacity size...
There is a short-run ATC curve
All such plant capacities
can be plotted...
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Unit Costs
LONG-RUN PRODUCTION COSTS
Output
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Unit Costs
LONG-RUN PRODUCTION COSTS
Output
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Unit Costs
LONG-RUN PRODUCTION COSTS
The Long-run ATC just “envelopes”
all of the short-run ATC curves
Output
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Unit Costs
LONG-RUN PRODUCTION COSTS
Long-run ATC
Output
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ECONOMIES AND
DISECONOMIES OF SCALE
Unit Costs
Economies
of scale
Long-run ATC
Output
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ECONOMIES AND
DISECONOMIES OF SCALE
Constant returns
to scale
Unit Costs
Economies
of scale
Long-run ATC
Output
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ECONOMIES AND
DISECONOMIES OF SCALE
Constant returns
to scale
Diseconomies
of scale
Unit Costs
Economies
of scale
Long-run ATC
Output
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Economies of scale
• Labor specialization: working at fewer tasks
workers become efficient in them. Greater
labor specialization eliminates the loss of time
that accompanies each shift of a worker from
one task to another
• Managerial specialization: small firms can’t
use management specialists to best
advantages. Large companies can use
specialists full time, which means greater
efficiency and lower costs
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Economies of scale
• Efficient capital. Large firms can afford the
most efficient equipments, these requires high
volume of production and large scale
producers, e.g., car robots.
• Other factors: design and development and
other startup costs,
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Diseconomies of scale
• The main reason is difficulty of efficiently
controlling and coordinating a firms operation
when it becomes large.
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Constant returns of scale
• Effect of factors of economies and factors of
diseconomies is equal.
• Minimum efficient size:
The lowest level of output at which a firm can
minimize long run average costs.
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ECONOMIES AND
DISECONOMIES OF SCALE
Unit Costs
Where extensive economies of
scale exist: Natural Monopolies.
Long-run ATC
Output
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Unit Costs
ECONOMIES AND
DISECONOMIES OF SCALE
Where economies of
scale are quickly
exhausted
Long-run ATC
Output
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MINIMUM EFFICIENT SCALE
AND INDUSTRY STRUCTURE
Minimum Efficient Scale -
MES
Natural Monopoly
Chapter Conclusions
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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
Copyright McGraw-Hill/Irwin 2002
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
natural monopoly
BACK
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END