Production & Cost in the FirmECO 2013Chapter 7

Created: M. MariFall 2007

Economic Costs• Costs exists because resources are

scarce and have alternative uses• When society uses a combination of

resources to produce a particular product, it foregoes all alternative opportunities to use those resources for other purposes.

• The measure of the economic cost or the opportunity cost of any resource used to produce a good is the value or worth the resource would have in its best alternative.

Economic Costs• (opportunity costs) are those

payments a firm must make or income it must provide to resource suppliers to attract the resources away from alternative production.

Costs• Two types of costs

– Explicit– Implicit

• Total costs = Explicit Costs + Implicit Total costs = Explicit Costs + Implicit CostsCosts

Explicit Costs•are monetary payments to non-owners of the firm for the resources they supply.

–Rent–Labor–Materials–Utilities

Implicit Costs•costs of self-owned, self-employed resources.

–Salary of owner not taken–Capital invested by owners–Foregone rent, interest, wages

•Not seen in accounting profit analysis

Profits• Accounting profit

– A firm’s total revenue minus its explicit costs

– Total revenue – explicit costs

• Economic profit– A firm’s total revenue minus explicit and

implicit costs– Earn more than expected– Normal profit

• The accounting profit earned when all resources earn their opportunity costs

• What you expect to earn

Production in the Short Run• Long run

– A period during which all resources under the firm’s control are variable

• Short run– A period during at least one of a firm’s

resources is fixed

Short-run Production Relationships• A firm’s costs of producing a specific

output depend not only on the price of needed resources but also on the quantities of resources needed to produce that output.

• Resource supply and demand determine the resource prices

• The technological aspects of production specifically the relationship between inputs and outputs, determine the quantity of resources needed.

Law of Diminishing Marginal Returns

• Total product– The total output produced by a firm

• Production function– The relationship between the amount of

resources employed and a firm’s total product

• Marginal product– The change in total product that occurs

when the sue of a particular resource increases by one unit

Marginal Returns• Law of diminishing marginal returns

– As more of a variable resource is added to a given amount of a fixed resource, marginal product eventually declines and could become negative

Graphical

Total product

Total product

Workers per day

MP

Increasing

Diminishing but positive

Negative marginal returns

Costs in the Short run•Fixed costs

–Any production cost that is independent of the firm’s rate of output

•Depreciation on building•Insurance•Property taxes

•Variable costs–An production cost that changes as the rate of output changes–Labor–Materials–utilities

Formula

Total Costs = Fixed Costs + Variable Cost

Variable costs = Variable cost per unit x units

At zero output then:Total costs = Fixed costs

Formula

Average Fixed Costs (AFC) = Total Fixed Costs Output (Q)

Average Variable Costs (AVC) = Total Variable Costs Output (Q)

Average Total Costs (ATC) = Total Costs Output (Q)

Marginal Costs = Change in total cost Change in quantity

ChartTons per

dayFixed

Costs

Workers per day

Variable costs

Total Costs

Marginal Costs

0 $200 0 0 $200 -

2 $200 1 $100 $300 $50

5 $200 2 $200 $400 $33.33

9 $200 3 $300 $500 $25

12 $200 4 $400 $600 $33.33

14 $200 5 $500 $700 $50

15 $200 6 $600 $800 $100

Curves

Fixed Costs $200

Tons per day

Total cost

Variable costs

0

Curves

Marginal cost

Costs in the Long Run• No fixed costs exists

• Can increase facility size

• Long run Average cost curve– A curve that indicates the lowest

average cost of production at each rate of output when the size or scale of the firm varies

Economies of Scale• Explain the downward sloping part

of the long run ATC curve

• Economies of mass production

• Capital intensive firms

• As plant size increases, a number of factors will for a time lead to lower average costs of production

• Labor specialization

• Managerial specialization

• Efficient capital

Diseconomies of Scale

• Caused by the difficulty of efficiently controlling and coordinating a firm’s operations, as it becomes a large-scale producer.

• Alienation of workers

Constant Returns to Scale

• Long-run average costs do not change as output changes.

• Example: textbooks