Chapter 8

The Cost of Production Explicit cost are money payment a firm makes to outside suppliers

of resources; Implicit costs are the opportunity costs associated with a firm’s use of resources it owns.

Normal profit is the implicit cost of entrepreneurship.

Economics profit is total revenue less all explicit and implicit costs including normal profit.

In the short run, a firm’s plant capacity is fixed. In the long run, a firm can very its plant size and firm can enter or leave the industry.

The law of diminishing returns indicates that beyond some point, output will increase by diminishing amount as more units of a variable resource (Labor) are added to a fixed resource (Capital).

In the short run, the total cost of any level of output is the sum of fixed and variable costs (TC = TFC + TVC).

Average fixed, Average variable and Average total costs are fixed, variable and total costs per unit of output; marginal cost is the extra cost of producing one more unit of output.

Average fixed cost declines continuously as output increases; Average variable costs and average total cost curves are U-shaped, reflecting increasing and then diminishing returns; the marginal cost curve falls but then rises, intersecting both the average variable cost curve and the average total curve at their minimum point.

Most firms have U-shaped long-run average total cost curves reflecting economics and then diseconomies scale.

Economics of scale are the consequences of greater specialization of labor and management, more efficient capital equipment, and the spreading of start-up costs among more units of output.

Diseconomies scales are caused by the problems of coordination and communication that arise in large firms.

Minimum efficient scale is the lowest level of output at which a firm’s long-run average total cost is at a premium.

MCQ’s on “The cost of Production”

I. The WXY Corporation has fixed costs of $50. Its total variable costs (TVC) vary with output as shown in the following table: Refer to the table. The average total cost of 4 units of output is:

o $27.50

o $40.00

o $52.50

o $210.00

II. Use the following graph to answer the next question: The diagram shows the short-run average total cost curves for five different plant sizes for a firm. The firm experiences economies of scale over the range of plant sizes:

o 1 through 2 only

o 1 through 3 only

o 1 through 5

o 3 through 5 only

III. Explicit costs and implicit costs:o Are alike in that both represent opportunity costs

o Are alike in that both reflect an outlay of cash

o Are alike in that both are deducted from revenue to find accounting profit

o Differ in that only explicit costs are deducted from revenue to find economic profit

IV. Suppose that a business incurred implicit costs of $300,000 and explicit costs of $1,300,000 over the past year. If the firm earned $1,400,000 in revenue, its:

o Accounting profits were $400,000 and its economic profits were $100,000

o Accounting losses were $200,000 and its economic profits were $100,000

o Accounting profits were $100,000 and its economic profits were zero

o Accounting profits were $100,000 and its economic losses were $200,000

V. Which one of the following short-run cost curves would not be affected by an increase in the wage paid to a firm's labor?

o Average variable cost

o Average fixed cost

o Average total cost

o Marginal Cost

VI. If marginal product is positive but falling:o marginal cost must also be falling

o average product must be falling

o total product is increasing at a decreasing rate

o total product is falling

VII. The distinguishing feature of the short run is that:o at least one input is fixed

o Output is fixed

o Input prices are variable

o Technology is variable

VIII. The WXY Corporation has fixed costs of $30. Its total variable costs (TVC) vary with output as shown in the following table: Refer to the table. The marginal cost of the fourth unit of output is:

o $30

o $40

o $50

o $60

IX. Use the following average total cost data to answer the next question. The letters A, B, and C designate three successively larger plant sizes: Refer to the data. In the long run, the firm should use plant size "A" for:

o All possible levels of output

o 100 to 200 units of output

o 300 to 600 units of output

o 600 or more units of output

X. Suppose a particular firm exhibits constant returns to scale as it increases its output over any reasonable range. If it increases all its inputs by 10%, its:o total cost will increase by less than 10%

o average total cost will increase by 10%

o output will increase by 10%

o long run average cost curve will shift to the right by 10%

Problems on Elasticity, Consumer & Producer Surplus

Problem 1:After working as a head chef for years, Jared gave up his $60,000 salary to open his own restaurant last year. He withdrew $50,000 of his own savings that had been earning 4% interest and borrowed another $100,000 from the bank at a rate of 5%. As the restaurant space he was leasing had no separate office, Jared converted his basement apartment into office space. He had previously rented the apartment to a student for $300/month. The following table summarizes his operations for the past year.

Total Sales Revenue $590,000

Employee wages $120,000Material $350,000Interest on loan $5,000Utilities $10,000Rent $25,000

Total explicit costs $510,000a) What is Jared's accounting profit?b) Suppose Jared could have used his talents to run a similar kind of

business instead. If he values his entrepreneurial skill at $10,000 annually, find Jared’s total implicit costs

c) What was Jared's economic profit last year?

Answer:a) Jared's accounting profit is the difference between total sales

revenue and his explicit costs: $590,000 – $510,000 = $80,000.b) Implicit costs include his foregone wages ($60,000), the value of

his entrepreneurial skill ($10,000), foregone rent on the apartment ($3,600 = 12 x $300) plus the foregone interest on his savings ($2,000 = .04 x $50,000). These total $75,600.

c) Jared's total economic cost, explicit plus implicit, was $585,600 = $510,000 + $75,600. His economic profit is the difference between revenue and economic cost, or $4,400 (= $590,000 – $585,600).

Problem 2:The following table summarizes the short-run relationship between a firm's total labor input and its total output.

Inputs of Labour

Total Products

Marginal Products

Average Products

0 0 - -1 20 - -2 46 - -3 75 - -4 102 - -5 125 - -6 138 - -7 140 - -8 136 - -

a) Fill in the columns labeled "Marginal Product" and "Average Product."

b) Over what range of labor input does the firm experience increasing marginal return? Diminishing marginal returns? And Negative marginal returns?

c) Comparing marginal product to average product, under what circumstances will average product rise? Under what circumstances will average product fall?

Answer:a) Formula of Marginal Product is:

Change∈2 (Total Products )−Change∈1(Total Products)

And Formula of Average Product is:

Total Productnumber of labour input

Inputs of Total Marginal Average

Labour Products Products Products0 01 20 20 202 46 26 233 75 29 254 102 27 25.55 125 23 256 138 13 237 140 2 208 136 -4 17

b) Increasing marginal returns corresponds to an increasing marginal product of labor. Marginal product increases through the addition of the third worker. Diminishing returns begins with the addition of the fourth worker, while negative returns appear with the addition of the eighth worker.

c) Average product will rise provided marginal product exceeds average product and fall if marginal product is below average product.

Problem 3:Suppose a firm is currently producing 10 units. It is spending $100 on fixed costs, $40 on variable costs. At an output level of 10 units, what is the firm's current:

a) Total cost?

Marginal Products20 Increasing

Marginal Returns

262927 Decreasing

Marginal Returns

2313

2-4 Negative

b) Average fixed cost?c) Average variable cost? d) Average total cost?e) If the total cost of producing 11 units is $147, what is the marginal

cost of the eleventh unit?f) Is average total cost rising or falling? How do you know?g) Is average variable cost rising or falling? How do you know?

Answer:a) Total cost (TC )=total¿ cost+total variable cost

TC = $100 + $40 = $140.

b) Average¿cost (AFC )= ¿costthe number of units produced .

AFC=$10010

=$10.

c) Average veriable cost (AVC )= Veriablecostthenumber of units produced .

AVC= $4010

=$ 4.

d) Average Total cost ( ATC )= Veriable cost+¿Costthe number of units produced

ATC=$14010

=$14.

ATC=Average ¿cost+Average variable costATC=$10+$ 4=$14.

e) Marginal cost is the increase in total cost associated with the next unit. From part a., the total cost of 10 units is $140. Since the cost of 11 units is $147, the marginal cost of the eleventh unit is $7 = $147 – $140.

f) Average total cost is falling. This is because marginal cost ($7) is less than average total cost ($14). When the cost of the next (marginal) one is below the average, the average must fall.

g) Average variable cost is rising. This is because marginal cost ($7) is more than average variable cost ($4). When the cost of the next (marginal) one is above the average, the average must rise.

Question on Elasticity, Consumer & Producer Surplus

Question 1:

Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. Calculate the accounting profit and the economic profit for Gomez's pottery firm. Firm predict will happen to its sales?

Answers:

Explicit costs= $12,000 for the helper + $5,000 of rent + $20,000 of materials.

Implicit costs= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship.

Explicit costs: $37,000Implicit costs: $22,000

Now,Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs)

Economic profit = $13,000 (= $72,000 - $37,000 of explicit - $22,000 of implicit costs).

Question 2:

a) Complete the table directly below by calculating marginal product and average product.

b) Plot total, marginal, and average product. And explain in detail the relationship between each pair of curves.

c) Explain why marginal product first rises, then declines, and ultimately becomes negative.

d) What bearing does the law of diminishing returns have on short-run costs? Be specific. "When marginal product is rising, marginal cost is falling. And when marginal product is diminishing, marginal cost is rising." Illustrate and explain graphically.

Answers:

Inputs of Labour

Total Products

Marginal Products

Average Products

0 0 - -1 15 15 152 34 19 173 51 17 174 65 14 16.255 74 9 14.86 80 6 13.337 83 3 11.868 82 -1 10.25

b) MP is the slope—the rate of change—of the TP curve. When TP is rising at an increasing rate, MP is positive and rising. When TP is rising at a diminishing rate, MP is positive but falling. When TP is falling, MP is negative and falling. AP rises when MP is above it; AP falls when MP is below it.

c) MP first rises because the fixed capital gets used more productively as added workers are employed. Each added worker contributes more to output than the previous worker because the firm is better able to use its fixed plant and equipment. As still more labor is added, the law of diminishing returns takes hold. Labor becomes so abundant relative to the fixed capital that congestion occurs and marginal product falls. At the extreme, the addition of labor so overcrowds the plant that the marginal product of still more labor is negative—total output falls.

d) Illustrated by Figure 8.6.

Because labor is the only variable input and its price (its wage rate) is constant, MC is found by dividing the wage rate by MP. When MP is rising, MC is falling; when MP reaches its maximum, MC is at its minimum; when MP is falling, MC is rising.Question 3:

A firm has fixed costs of $60 and variable costs as indicated in the table at the bottom of this page. Complete the table and check your calculations by referring to question 4 at the end of Chapter 9.

a) Graph total fixed cost, total variable cost, and total cost. Explain how the law of diminishing returns influences the shapes of the variable-cost and total-cost curves.

b) Graph AFC, AVC, ATC, and MC. Explain the derivation and shape of each of these four curves and their relationships to one another. Specifically, explain in nontechnical terms why the MC curve intersects both the AVC and ATC curves at their minimum points.

c) Explain how the locations of each curve graphed in question 7b would be altered if (1) total fixed cost had been $100 rather than $60, and (2) total variable cost had been $10 less at each level of output.

Answers:

TP TFC TVC TC AFC AVC ATC MC

0 - - - - - - -

1 60 45 105 60 45 105 45

2 60 85 145 30 42.5 72.5 40

3 60 120 180 20 40 60 30

4 60 150 210 15 37.5 52.5 35

5 60 185 245 12 37 49 40

6 60 225 285 10 37.5 47.5 45

7 60 270 310 8.57 38.57 47.14 55

8 60 325 385 7.5 40.63 48.13 65

9 60 390 450 6.67 43.33 50 75

10 60 465 525 6 46.5 52.5 -

a)

Over the 0 to 4 range of output, the TVC and TC curves slope upward at a decreasing rate because of increasing marginal returns. The slopes of the curves then increase at an increasing rate as diminishing marginal returns occur.

b) See the graph.

AFC falls continuously since a fixed amount of capital cost is spread over more units of output. The MC, AVC, and ATC curves are U-shaped, reflecting the influence of first increasing and then diminishing returns. The ATC curve sums AFC and AVC vertically. The ATC curve falls, when the MC curve is below it; the ATC curve rises, when the MC curve is above it. This means the MC curve must intersect the ATC curve at its lowest point. The same logic holds for the minimum point of the AVC curve.

c) (1) If TFC has been $100 instead of $60, the AFC and ATC curves would be higher—by an amount equal to $40 divided by the specific output. Example: at 4 units, AVC = $25.00 [= ($60 + $40)/4]; and ATC = $62.50 [= ($210 + $40)/4]. The AVC and MC curves are not affected by changes in fixed costs.

c) (2) If TVC has been $10 less at each output, MC would be $10 lower for the first unit of output but remain the same for the remaining output. The AVC and ATC curves would also be lower—by an amount equal to $10 divided by the specific output. Example: at 4 units of output, AVC = $35.00 [= $150 - $10)/4], ATC = $50 [= ($210 - $10)/4]. The AFC curve would not be affected by the change in variable costs.

Question 4:

Use the concepts of economies and diseconomies of scale to explain the shape of a firm's long-run ATC curve. What is the concept of minimum efficient scale? What bearing can the shape of the long-run ATC curve have on the structure of an industry?

Answers:

The long-run ATC curve is U-shaped. At first, long-run ATC falls as the firm expands and realizes economies of scale from labor and managerial specialization and the use of more efficient capital. The long-run ATC curve later turns upward when the enlarged firm experiences diseconomies of scale, usually resulting from managerial inefficiencies.

The MES (minimum efficient scale) is the smallest level of output needed to attain all economies of scale and minimum long-run ATC.If long-run ATC drops quickly to its minimum cost which then extends

over a long range of output, the industry will likely be composed of both large and small firms. If long-run ATC descends slowly to its minimum cost over a long range of output, the industry will likely be composed of a few large firms. If long-run ATC drops quickly to its minimum point and then rises abruptly, the industry will likely be composed of many small firms.