1 Understanding Economics 3 rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 4...

1

Understanding Economics

3rd editionby Mark Lovewell, Khoa Nguyen and Brennan Thompson

Chapter 4Costs of Production

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

2Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives

In this chapter you will:1. learn about economic costs (explicit and

implicit) of production and economic profit2. analyze short-run (total, average, and

marginal) products, and the law of diminishing marginal returns

3. derive short-run (total, average, and marginal) costs

4. examine long-run results of production (increasing returns to scale, constant to scale, and decreasing to scale) and long-run costs


T 1, Production,costs, and profit

Define:”business”,”production”,”inputs”,”output”, See page 85.

Types of Production There are three main sectors in the economy

• the primary sector consists of industries that extract or cultivate natural resources

• the secondary sector consists of industries that fabricate or process goods

• the service sector consists of trade and information industries


Productive Efficiency

Productive efficiency: making a given quantity of output at the lowest cost

Businesses choose from different production processes• a labour-intensive process employs more

labour and less capital• a capital-intensive process employs more

capital and less labour


Economic Costs & Economic profit

Economic costs include• explicit costs: payments made by a

business to business or people outside of it• implicit costs:the owner’s opportunity costs

of being involved with a business.• Economic costs = explicit costs + implicit

costs Economic profit: the excess of a business’s

total revenue over its economic costs• Accounting profit: the excess of a business’s

total revenue over its explicit costs• Economic profit = total revenue – economic

costs


Accounting Vs. Economic Profit

Accounting profit is total revenue minus explicit costs

Because accountants only consider explicit costs, accounting profit always exceeds economic profit by the amount of the business’s implicit costs.


T 2, Production in the Short Run (a)

In the short run• some inputs (such as capital) are fixed• other inputs (such as labour) are variable

Inputs are combined to make a business’s total product• Total product: the overall quantity of

output produced with a given workforce• average product is total product divided

by the number of workers• marginal product is the extra total

product with an additional worker


Average product = total product (q)

number of workers (L)

Marginal product = change in total product (Δ q) change in workforce (Δ L)


The Law of Diminishing Marginal Returns

Short-run production is determined by the law of diminishing marginal returns

the law of diminishing marginal returns:• At some point, as more units of a variable

input are added to a fixed input, the marginal product will start to decrease

average product also falls after some point


Relating Average and Marginal Values

Average and marginal values are related using three rules• if an average value rises then the marginal

value must be above the average value• if an average value falls then the marginal

value must be below the average value• if an average value stays constant then the

marginal value must equal the average value


0 1 2 3 4 5 6

Number of Workers Employed per Day

T-S

hir

ts P

rod

uced

per

Day

50

100

150

200

250

300

Total, Marginal, and Average ProductsFigure 4.2, Page 89 and Figure 4.3, Page 91

0

1 2 3 4 5 6

Number of Workers Employed per DayT-S

hir

ts P

rod

uced

per

Day

40

60

80

100

120

-20

20

Labour(L)

(workersper day)

Total Product

(q)(T-shirtsper day)

MarginalProduct(Δq/ΔL)(T-shirtsper day)

Average Product

(q/L)(T-shirts per day)

0

1

2

3

4

5

6

0

80

200

250

270

280

270

--

80

100

83.3

67.5

56

45

80

120

50

20

10

-10

TP

MP

AP

Diminishingreturns set in


T 3, Costs in the Short Run

Short-run costs include• fixed costs (costs of all fixed inputs)• variable costs (costs of all variable inputs)• total cost (fixed costs + variable costs)

Marginal Cost (a) Marginal cost is the extra cost of producing an

extra unit of output• it equals the change in total cost divided by the

change in total product The marginal cost curve is shaped like a “J”

because of the law of diminishing marginal returns


Marginal Cost (b)Figure 4.6, Page 93

0 50 100 150 200 250 300

Quantity of T-Shirts Produced Per Day

$ p

er

T-S

hir

t

2

4

6

8

10

12

MC

Diminishingreturns set in


Per-Unit Costs

Per-unit costs include• average fixed cost (fixed costs divided by total

product) AFC = FC/Q

• average variable cost (variable costs divided by total product) AVC = VC/Q

• average cost either total cost divided by total product or average fixed cost + average variable

cost AC= AFC + AVC


Short-Run Costs for Pure ‘n’ Simple T-Shirts Figure 4.5, Page 93

Labour

(L)

TotalProduct

(q)

FixedCosts(FC)

VariableCosts(VC)

TotalCost(TC)

(FC + VC)

MarginalCost(MC)

(ΔTC/Δq)

AverageFixed Costs

(AFV)(FC/q)

AverageVariable

Costs(AVC)(VC/q)

AverageCost(AC)

(AFC + AVC)

0

1

2

3

4

5

0

80

200

250

270

280

$825

825

825

825

825

825

$0

140

300

425

535

640

$825

965

1125

1250

1360

1465

$1.75

1.33

2.50

5.50

10.50

140

160

125

110

105

80

120

50

20

10

$10.31

4.13

3.30

3.06

2.95

$1.75

1.50

1.70

1.98

2.29

$12.06

5.63

5.00

5.04

5.24

Marginal Product

(MP)


The Family of Short-Run Cost CurvesFigure 4.7, page 95

0 50 100 150 200 250 300

Quantity of T-Shirts Produced Per Day

$ p

er

T-S

hir

t

2

4

6

8

10

12

AVC

AFC

MC

AC

b

a


T 4, Returns to Scale (a)

All inputs can be changed by the same proportion in the long run increasing returns to scale means

the % change in output > the % change in inputs

constant returns to scale means the % change in output = the % change in inputs

decreasing returns to scale means the % change in output < the % change in inputs


Returns to Scale (b)

Increasing returns to scale are caused by the division of labour or specialized capital or specialized management (see page 97)

Constant returns to scale arise whenever making more of a product means repeating exactly the same tasks

Decreasing returns to scale are caused by management difficulties or limited natural resources (see page 98)


Costs in the Long Run (a)

Long-run average cost is the minimum short-run average cost at every output

The long-run average cost curve is saucer-shaped because of various ranges of returns to scale• initial range of increasing returns to scale• middle range of constant returns to scale• final range of decreasing returns to scale


Quantity of Magazines per Week

$ p

er

Mag

azi

ne

Range A Range B Range C

Long-Run Average Costs

Costs in the Long Run (b)Figure 4.8, page 99

AC1

AC2 AC3

AC4 Long-Run AC


Costs in the Long Run (b)Figure 4.9, page 100

Possible Long-Run Average Costs

Quantity of Output

$ p

er

Un

it

Extended Range ofIncreasing Returnsto Scale

Quantity of Output

$ p

er

Un

it

Extended Range ofConstant Returnsto Scale

Quantity of Output

$ p

er

Un

it

Extended Range ofDecrease Returnsto Scale

1 Understanding Economics 3 rd edition by Mark Lovewell, Khoa Nguyen and Brennan Thompson Chapter 4...

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