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Chapter 7 Production Costs

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

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In this chapter, you will learn to solve these economic puzzles:

Why would an accountant say a firm is making a

profit and an economist say it’s losing money?

What is the difference between the short-run and

the long-run?

Why are multi-screen movie theatres replacing single-

screen theaters?

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What is a basic assumption in economics?

The motivation for business decisions is profit maximization

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To understand Profit, what is necessary?

To distinguish between the way economists measure costs and the way accountants measure costs

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What are Explicit Costs?Payments to nonowners of

a firm for their resources

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What are Implicit Costs?The opportunity costs

of using resources owned by the firm

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What is an example of Implicit Costs?

When you invest your nest egg in your own enterprise, you give up earning interest on that money

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How is Accounting Profit defined?

Total revenue minus total explicit costs

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What are Total Opportunity Costs?

Explicit costs + Implicit costs

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What is Economic Profit?Total revenue minus

total opportunity costs

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Computech’s Accounting Versus Economic Profit

Total Revenue

Less Explicit costs:

Wages & salariesMaterials

Interest paidOther payments

Less implicit costs:Foregone salaryForegone rent

Foregone interest

Equals profit

$500,000

$400,000$50,000$10,000$10,000

000

$30,000

Item Accounting Profit Economic Profit

Exhibit 1

$500,000

$400,000$50,000$10,000$10,000

50,00010,0005,000

-$30,000

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What is Normal Profit?The minimum profit

necessary to keep a firm in operation

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When economists use the term “Profit”, which profit do they mean?Economic profit which,

unlike accounting profit, includes implicit costs

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What is a Fixed Input?Any resource for which the quantity cannot change during the period of time under consideration

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What is the Short Run?A period of time so

short that there is at least one fixed input

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What is the Long Run?A period of time so long that all inputs are variable

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What is a Variable Input?Any resource for which the quantity can change during the period of time under consideration

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What is theProduction Function?

The relationship between the maximum amounts of outputs a firm can produce and various quantities of inputs

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What do Technological Advances make possible?

More output is possible from a given quantity of inputs

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What isMarginal Product?

The change in total output produced by adding one unit of a variable input, with all other inputs used held constant

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What is the Law of Diminishing Returns?The principle that beyond

some point the marginal product decreases as additional units of a variable resource are added to a fixed factor

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What does the Law of Diminishing

Returns assume?Fixed inputs; it is therefore

a short-run concept

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40

10

1 2 4

Production Function

30

20

5

50

63

60

Tot

al O

utpu

t

Quantity of Labor

Total Output

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8

2

1 2 4

Marginal Product Curve

6

4

5

10

63

12

Mar

gina

l Out

put

Quantity of Labor

Law of Diminishing

Returns

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What isTotal Fixed Cost?

Costs that do not vary as output varies and that must be paid even if output is zero

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What isTotal Variable Cost?Costs that are zero when

output is zero and vary as output varies

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What is Total Cost?The sum of total fixed cost and total variable cost at each level of output

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TC = TFC + TVC

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What isAverage Fixed Cost?Total fixed cost divided

by the quantity of output produced

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AFC = TFC / Q

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What is Average Variable Cost?

Total variable cost divided by the quantity of output produced

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AVC = TVC / Q

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What isAverage Total Cost?

Total cost divided by the quantity of output produced

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ATC = AFC + AVC = TC/Q

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What is Marginal Cost?The change in total cost

when one unit of output is produced

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MC = TC/Q = TVC/Q

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$400$300$200$100

1 2 3 4

$500$600$700$800

5 6 7 8 9

Short-Run Cost Curves

TCTVC

TFC

TFC

Cos

t per

uni

t

Q

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MC

AFC

Cos

t per

uni

t

AFC

Q

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What is the Marginal-Average Rule?

When MC < AC, AC fallsWhen MC > AC, AC rises

If MC = AC, AC at minimum

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What is the relationship between slopes of the MC and MP curves?

The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa

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What is the relationship between the minimum

and maximum points of the MR and MP curves?The maximum point of the

MP curve corresponds to the minimum point of the MC curve

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8

2

1 2 4

Marginal Product Curve

6

4

5

10

63

12

Tot

al O

utpu

t

Quantity of Labor

Maximum

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

Short-Run Cost Curves

ATCAVC

MCC

ost p

er u

nit Minimum

Q

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What is the Long-run Average Cost Curve?

The curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size

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$40$30$20$10

2 4 6 8

$50$60$70$80

10 12 14 16 18

Short and Long-run Average Cost Curves

Short-run average total cost curves

Long-run average cost curve Q

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What areEconomies of Scale?A situation in which the

long-run average cost curve declines as the firm increases output

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What are Constant Returns to Scale?

A situation in which the long-run average cost curve does not change as the firm increases output

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What areDiseconomies of Scale?A situation in which the long-run average cost curve rises as the firm increases output

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$40$30$20$10

2 4 6 8

$50$60$70$80

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Diseconomies of scale

Economies of scale

Q

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Key Concepts

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Key Concepts• What is a basic assumption in economics?• What are Explicit Costs?• What are Implicit Costs?• How is Accounting Profit defined?• What are Total Opportunity Costs?• What is Economic Profit?• What is Normal Profit?

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Key Concepts cont.• When economists use the term “Profit”, whi

ch profit do they mean?• When economists study the economy, what

time frame do they assume?• What is a Fixed Input?• What is the Short Run?• What is the Long Run?• What is a Variable Input?• What is Marginal Product?

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Key Concepts cont.• What is the Law of Diminishing Returns?• What is Total Fixed Cost?• What is Total Variable Cost?• What is Total Cost?• What is Average Fixed Cost?• What is Average Variable Cost?• What is Average Total Cost?• What is Marginal Cost?• What are Economies of Scale?• What are Diseconomies of Scale?

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Summary

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Economic profit is equal total revenue minus both explicit and implicit costs. Implicit costs are the opportunity costs of foregone returns to resources owned by the firm. Economic profit is important for decision-making purposes because it includes implicit costs and accounting profit does not. Accounting profit equals total revenue minus explicit costs.

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The short run is a time period during which a firm has at least one fixed input, such as its factory size. The long run for a firm is defined as as a period during which all inputs are variable.

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A production function is the relationship between output and inputs. Holding all other factors of production constant, the production function shows the total output as the amount of one input, such as labor, varies.

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Marginal product is the change in total output caused by a one-unit change in a variable input, such as the number of workers hired, the law of diminishing returns states that after some level of output in the short run, each unit of the variable input yields smaller and smaller marginal product. This range of declining marginal product is the region of diminishing returns.

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Total fixed costs consists of costs that cannot vary with the level of output, such as rent for office space. Total fixed costs is the cost of inputs that do not change as the firm changes output in the short run. Total variable cost consists of costs that vary with the level of output, such as wages. Total variable cost is the cost of variable inputs used in production. Total cost is the sum of total fixed cost and total variable cost.

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$400$300$200$100

1 2 3 4

$500$600$700$800

5 6 7 8 9

Short-Run Cost Curves

TCTVC

TFC

TFC

Cos

t per

uni

t

Q

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Marginal cost is the change is total cost associated with one additional unit of output. Average fixed cost is the total fixed cost divided by total output. Average variable cost is the total variable cost divided by total output. Average total cost is the total cost, or the sum of average fixed cost and average variable cost, divided by output.

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

Short-Run Cost Curves

ATC

AVC

MC

AFC

Cos

t per

uni

t

AFC

Q

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The marginal-average rule explains the relationship between marginal cost and average cost. When the marginal cost is less than the average cost, the average cost falls. When the marginal cost is greater than the average cost, the average cost rises. Following this rule, the marginal cost curve intersects the average total cost curve at their minimum points.

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Marginal cost and marginal product are mirror images of each other. Assuming a constant wage rate, marginal cost equals the wage rate divided by the marginal product. Increasing returns cause marginal cost to fall, and diminishing returns cause marginal cost to rise. This explains the U-shaped marginal cost curve.

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8

2

1 2 4

Marginal Product Curve

6

4

5

10

63

12

Tot

al O

utpu

t

Quantity of Labor

Maximum

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

MCM

argi

nal c

ost Minimum

Q

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The long-run average cost curve is a curve drawn tangent to all possible short-run average total curves. When the long-run average cost curve decreases as output increases, the firm experiences economies of scale. If the long-run average cost curve remains unchanged as output increases, the firm experiences constant returns to scale. If the long-run average cost curve increases, the firm experiences diseconomies of scale.

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$40$30$20$10

2 4 6 8

$50$60$70$80

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Diseconomies of scale

Economies of scale

Q

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Chapter 7 Quiz

©2000 South-Western College Publishing

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1. Explicit costs are payments to a. hourly employees.b. insurance companies.c. utility companies.d. all of the above.

D. Explicit costs are payments to non owners of a firm.

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2. Implicit costs are the opportunity costs of using the resources of a. outsiders.b. owners.c. banks.d. retained earnings.

B. Implicit costs are opportunity costs that a business owner incurs when using resources owned by the firm.

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3. Which of the following equalities is true? a. Economic profit = total revenue - accounting

profit.b. Economic profit = total revenue - explicit

costs - accounting profit. c. Economic profit = total revenue - implicit

costs - explicit costs.d. Economic profit = opportunity costs +

accounting costs. C. The difference between accounting profit

and economic profit is that economic profit is total revenue minus both explicit and implicit costs. Accounting profit is total revenue minus explicit costs only.

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4. Fixed inputs are factors of production that a. are determined by a firm’s size. b. can be increased or decreased quickly as

output changes.c. cannot be increased or decreased quickly as

output changes.d. none of the above.

C. In the short run, there are two types of inputs, fixed and variable. Because a firm cannot change its plant capacity, some of its inputs are fixed. In the long run, all costs are variable.

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5. An example of a variable input is a. raw materials.b. energy.c. hourly labor.d. all of the above

D. As a firm produces more, it will use more raw materials, energy, and labor. Therefore, all are variable costs.

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6. Suppose a car wash has 2 washing stations and 5 workers and is able to wash 100 cars per day. When it adds a third station, but no more workers, it is able to wash 150 cars per day. The marginal product of the third washing station is a. 100 cars per day.b. 150 cars per day.c. 5 cars per day.d. 50 cars per day.

D. 50 cars is how many extra cars can be washed by adding a new machine, ceteris paribus.

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7. If the units of variable input in a production process are 1, 2, 3, 4, and 5 and the corresponding total outputs are 10, 22, 33, 42, and 48, respectively, the marginal product of the fourth unit is a. 2.b. 6.c. 9.d. 42.

C. The difference between 42 and 33 is 9, the extra output when producing 4 units instead of 3.

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8. The total fixed cost curve is a. upward sloping.b. downward sloping.c. upward, and then downward sloping.d. unchanged with the level of output.

D. Fixed costs never change regardless of the units of output; therefore its curve has to be horizontal at a fixed cost dollar value.

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9. Assuming that the marginal cost curve is a smooth U-shaped curve, the corresponding total cost curve has a (an)a. linear shape.b. S-shape.c. U-shape.d. reverse S-shape.

D. Marginal cost decreases as output increases from zero, and then increases beyond a certain output level. A reverse-S-Shape total cost curve corresponds to the changes in its slope (MC) as output expands.

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$1,000

$250

50 100 200

$750

TC

$500

250

$1,250

300150

$1,500

Tot

al C

ost

Quantity of Output

Total Cost CurveExhibit 10

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10. If both the marginal cost and the average variable cost curves are U-shaped, at the point of minimum average variable cost, the marginal cost must be a. greater than the average variable cost.b. less than the average variable cost. c. equal to the average variable cost. d. at its minimum.

C. If the margin is above the average, the average will increase. If the margin is less than the average, the average will decrease. If the margin equals the average, average does not change, that is, it is a horizontal curve.

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11. Which of the following is true at the point where diminishing returns set in? a. Both marginal product and marginal cost

are at a maximum. b. Both marginal product and marginal cost

are at a minimum.c. Marginal product is at a maximum and

marginal cost at a minimum. d. Marginal product is at a minimum and

marginal cost at a maximum.

C. The rising portion of the MP curve corresponds to the declining portion of the MC curve, and vice versa

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12. As shown in Exhibit 10, total fixed cost for the firm is a. Zero.b. $250c. $500.d. $750e. $1,000

B. $250 is the answer because total cost is 0 when output is zero. These are costs that have to be paid even when output is zero.

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13. As shown in Exhibit 10, the total cost of producing 100 units of output per day isa. Zero.b. $250.c. $500.d. $750.e. $1,000.

C. A vertical line drawn at 100 units crosses the total cost curve at $500.

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14. In Exhibit 10, if the total cost of producing 99 units of output per day is $475, the marginal cost of producing the 100th unit of output per day is approximatelya. Zero.b. $25.c. $475.d. $500

B. When total cost at 99 units is $475 and total cost at 100 units is $500, the cost of producing the 100th unit is $25.

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15. Each potential short-run average total cost curve is tangent to the long-run average cost curve at a. the level of output that minimizes short-run average total cost.b. the minimum point of the average

total cost curve.c. the minimum point of the long-run

average cost curve. d. a single point on the short-run

average total cost curve.

D. The long-run LRAC is derived from all possible SRAC. Geometrically, the only way to draw this is to connect all the curves by a smooth curve; thus, the LRAC curve touches each SRAC curve at only one place.

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$40$30$20$10

2 4 6 8

$50$60$70$80

10 12 14 16 18

Short and Long-run Average Cost Curves

Short-run average total cost curves

Long-run average cost curveQ

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16. Suppose a typical firm is producing X units of output per day. Using any other plant size, the long-run average cost would increase. The firm is operating at a point which its a. long-run average cost curve is at a

minimum.b. short-run average total cost curve is at a

minimum.c. both (a) and (b) are true.d. neither (a) nor (b) is true.

C. When a firm is producing at the minimum points of the long-run average cost curve, it is operating at the most efficient level possible.

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17. The downward-sloping segment of the long-run average cost curve corresponds to a. diseconomies of scale.b. both economies and diseconomies of scale.c. the decrease in average variable cost.d. economies of scale.

D. Economies of scale takes place when a firm increases its efficiency by producing more units of output.

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$40$30$20$10

2 4 6 8

$50$60$70$80

10 12 14 16 18

Long-run Average Cost Curve

Constant returns to scale

Diseconomies of scale

Economies of scale

Q

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18. Long-run diseconomies of scale exist when the a. short-run average total cost curve falls.b. long-run marginal cost curve rises.c. long-run average cost curve falls.d. short-run average cost curve rises.e. long-run average cost curve rises.

E. Diseconomies of scale are evident when increasing output leads to inefficiencies.

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19. Long-run constant returns to scale exist when the a. short-run average total cost curve is

constant.b. long-run average cost curve rises.c. long-run average cost curve is flat.d. long-run average cost curve falls.

C. Constant returns to scale are evident when there is no change in costs as output increases.

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