1. Businesses and the Costs of
Production
07
McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Economic Costs
• The payment that must be made to
obtain and retain the services of a
resource
• Explicit Costs
•Monetary payments
• Implicit Costs
•Value of next best use
•Self-owned resources
•Includes normal profit
LO1 7-2

3. Accounting Profit and Normal Profit
• Accounting profit
= Revenue – Explicit Costs
• Economic profit
= Accounting Profit – Implicit Costs
• Economic profit (to summarize)
=Total Revenue – Economic Costs
=Total Revenue – Explicit Costs –
Implicit Costs
LO1 7-3

4. Economic Profit
LO1
Explicit
costs
Accounting
costs (explicit
costs only)
Implicit costs
(including a
normal profit)
Economic
profit Accounting
profit
Economic
(Opportunity)
Costs
TotalRevenue
7-4

5. Short Run and Long Run
• Short Run
•Some variable inputs
•Fixed plant
• Long Run
•All inputs are variable
•Variable plant
•Firms enter and exit
LO1 7-5

6. Short-Run Production Relationships
• Total Product (TP)
• Marginal Product (MP)
• Average Product (AP)
LO2
Marginal Product
Change in Total Product
Change in Labor Input=
Average Product
Total Product
Units of Labor
=
7-6

7. The Law of Diminishing Returns
LO2
TP
MP
AP
Increasing
Marginal
Returns
Diminishing
Marginal
Returns
Negative
Marginal
Returns
1 2 3 4 5 6 7 8 9
0
10
20
30
TotalProduct,TP
1 2 3 4 5 6 7 8 9
20
10
MarginalProduct,MP
7-7

8. Short-Run Production Costs
• Fixed Costs (TFC)
•Costs do not vary with output
• Variable Costs (TVC)
•Costs vary with output
• Total Costs (TC)
•Sum of TFC and TVC
•TC = TFC + TVC
LO3 7-8

9. Short-Run Production Costs
LO3
Costs
1 2 3 4 5 6 7 8 9 100 Q
100
200
300
400
500
600
700
800
900
1000
$1100
TFC
TC
TVC
Total
Cost
Variable
Cost
Fixed
Cost
7-9

10. Per-Unit, or Average, Costs
• Average Fixed Costs AFC = TFC/Q
• Average Variable Costs AVC = TVC/Q
• Average Total Costs ATC = TC/Q
• Marginal Costs MC = ΔTC/ΔQ
LO3 7-10

11. Per-Unit, or Average, Costs
LO3
Costs
1 2 3 4 5 6 7 8 9 100 Q
50
100
150
$200
AFC
ATC
AVC
AVC
AFC
7-11

12. Marginal Cost
LO3
Costs
1 2 3 4 5 6 7 8 9 100 Q
50
100
150
$200
AFC
MC
ATC
AVC
AVC
AFC
7-12

13. MC and Marginal Product
LO3
MP
AP
MC
AVC
Quantity of Output
Quantity of Labor
Production Curves
Cost Curves
7-13

14. Long-Run Production Costs
• The firm can change all input
amounts, including plant size.
• All costs are variable in the long run.
• Long run ATC
•Different short run ATCs
LO4 7-14

15. The Long-Run Cost Curve
LO4
Long-Run
ATC
AverageTotalCosts
ATC-1
ATC-2
ATC-3 ATC-4
ATC-5
Output
7-15

16. Economies and Diseconomies of
Scale
• Economies of scale
•Labor specialization
•Managerial specialization
•Efficient capital
•Other factors
• Constant returns to scale
LO4 7-16

17. Economies and Diseconomies of
Scale
• Diseconomies of scale
•Control and coordination problems
•Communication problems
•Worker alienation
•Shirking
LO4 7-17

18. MES and Industry Structure
• Minimum Efficient Scale (MES):
•Lowest level of output where long-
run average costs are minimized
•Can determine the structure of the
industry
LO4 7-18

19. MES and Industry Structure
LO4
Output
AverageTotalCosts
Long-Run
ATC
Economies
Of Scale
Constant Returns
To Scale
Diseconomies
Of Scale
q1 q2
7-19

20. Don’t Cry Over Sunk Costs
• Sunk costs
•Costs have already been incurred
and thus are irrecoverable
• Rule: Do not engage in any activity
where MB<MC
• Rule: Ignore sunk costs
•They are irrecoverable
7-20