CostsCurvesDiminishing Returns •Accounting Costs•Economic Costs•Supply

ACCOUNTING COSTS

• Accounting costs are monetary (usually explicit).

• Accounting profit = Revenue – Accounting costs.

ECONOMIC COSTS

• Economic costs = accounting costs + opportunity costs. • Economic profit = revenue – economic costs.• Economic profit = revenue – (accounting costs + opportunity costs).

ECONOMIC COSTS• Economic costs = accounting costs + opportunity

costs.• • In economic analysis we use economic costs.

• To make a wise decision we need to consider all costs and not only monetary costs.

• Opportunity costs should be considered as they have an important bearing on our decision making. These include opportunity cost for resources owned by the firm itself.

OPPORTUNITY COSTS

• Bill owns a farm worth $1m. His yearly revenue is $100,000 and his expenses are $60,000. The current interest rate is 5% for savings. What is Bill’s accounting profit and what is his economic profit?

Accounting profit$$40,000

Economic profit-($10,000)

OPPORTUNITY COSTS• Chen runs her own business. She receives no wage or salary. She

could work full-time for $25,000pa. Her business revenue for last year was $30,000 and her expenses $10,000. What is her accounting profit and her economic profit?

Accounting profit$20000

Economic profit-($5000)

OPPORTUNITY COSTS

• Tao must travel from Wellington to Auckland for business. Tao is paid $20 per hour and he must travel in work time. Prices and times are:

Mode Price $

Hours

Plane $150 1

Car $100 6

Bus $70 10

Which is cheapest?

Plane is cheapest. If we consider opportunity costs, total cost for plane travel is $170 – much cheaper than the other options.

Economic costs in more detail• Rent- Economic return to land (return to any factor

that is in fixed supply)

• Wages- Economic return to labour. It includes all ways people a compensated for providing their time, efforts and skills. (except for enterprise)

• Interest- Economic return on capital.

• Profit- Economic return to enterprise for taking risk. It is the reward to those who run the risk of failure when they bring together all the other factors of production

Do this Now• Last year Mona had a job as a manager for a fishing company,

which paid her $65,000 a year,• She had $80,000 in savings, which gave her a rate of return of

10%. • She thought she could do better by going fishing herself, so

gave up her job and invested $80,000 of her own money in buying a fishing boat and quota.

• By the end of the first year she had sold $140,000 worth of fish and her costs of running the business had been $70,000. She expected the costs to be quite high in the first year, because she was getting the business established, but though these would fall in future years.

• 1. Calculate her accounting profit• 2. Calculate her economic profit• 3. Which are always greater? Economic or accounting profits? Explain

Answers!• 1. Calculate her accounting profit

Revenue - Accounting costs140,000 – 70,000 = 70,000

• 2. Calculate her economic profit Revenue – Economic Costs (accounting costs +

opportunity costs)140,000 – 70,000 – 65,000- (80,000 x0.10) = -

3000

• 3. Which are always greater? Economic or accounting profits? Explain

• Accounting profits are equal to Revenue minus accounting costs. Economic profits are equal to revenue minus accounting costs and opportunity costs. Thus Accounting profits will always be greater than Economic profits due to economic profits taking into account an extra cost, opportunity costs.

Fixed costs are costs that do not vary with output Q FC VC TC

0 100

1 100

2 100

3 100

Fixed costs are costs that do not vary with output Q FC VC TC

0 100 0

1 100 30

2 100 50

3 100 80

Variable costs are costs that increase as output increases

Fixed costs are costs that do not vary with output Q FC VC TC

0 100 0 100

1 100 30 130

2 100 50 150

3 100 80 180

Variable costs are costs that increase as output increases

Total costs = Fixed + Variable costs

FC, VC & TC

Costs($)

Quantity

FC

Fixed costs are costs that do not vary with output

VCVariable costs are costs that increase as output increases

TC

Total costs = Fixed + Variable costs

Average and Marginal CostOutput (Q)

Total Cost

Average Cost

Marginal Cost

0 100 - -1 200 200 1002 320 160 1203 420 140 1004 640 160 2205 1100 220 460

AC = TC/Q

Average and Marginal CostOutput (Q)

Total Cost

Average Cost

Marginal Cost

0 100 - -1 200 200 1002 320 160 1203 420 140 1004 640 160 2205 1100 220 460

AC = TC/Q

MC = TC2 - TC1

Starter Activity Number of people in the group (Workers)

Total Product Marginal Product

1

2

3

4

We will assume all groups are equally skilled, so the marginal product is the difference between group one’s total and group two’s total product.

Graph the number of workers on the horizontal axis against the number of blocks sorted on the vertical axis. What do you notice?

fig

Short-run costs

In economics we distinguish between various time periods - ie short and long run.

The short run, which our particular concern, is a period when at least one input to the production process is fixed.

This means that in the short run all production will be subject to the law of diminishing return.

Diminishing Returns

The law of diminishing returns states that where additional units of a variable input are added to a fixed amount of another input, the additional output, or marginal product, will eventually fall.

Diminishing Returns

Fixed Input

Variable input

The additional output(MP) eventually falls

Fixed Input Variable Input

Capital Labour AC MC

Cement Mixer Bricklayers TP (Q) MP Returns (per brick) (per brick)

1 0 0

1 1 70 70 Increasing 6 6

1 2 210 140 Increasing 4 3

1 3 420 210 Increasing 3 2

1 4 630 210 Constant 2.67 2

1 5 770 140 Diminishing 2.73 31 6 840 70 Diminishing 3 6

The Shape of the MC curve

Costs($)

Quantity

MC

MC decreases initially because of increasing returns

MC increases because of diminishing returns

Note: always plot the MC curve at the mid-point!

The Shape of Average Cost Curves

Costs($)

Quantity

FC

FC are constant so AFC will continually decline as FC are spread over increasing output

AFC

The Shape of Average Cost Curves

Costs($)

Quantity

AFC

ACAC decreases because of short run economies:•Technical•Marketing•Managerial•Financial

Costs($)

Quantity

AFC

ACAC increases as short run diseconomies set in.

The Shape of Average Cost Curves

Costs($)

Quantity

AFC

ACThe difference between AC and AVC is equal to AFC

AVC

The Shape of Average Cost Curves

Marginal Cost & Average CostCosts($)

Quantity

ACMC

If MC<AC then AC will be decreasing

Costs($)

Quantity

ACMC

If MC>AC then AC will be increasing

Marginal Cost & Average Cost

Costs($)

Quantity

ACMC

MC cuts AC at its minimum point - this is the technical optimum

Marginal Cost & Average Cost

Marginal Cost & Average Variable Cost

Costs($)

Quantity

ACMC

MC also cuts AVC at its minimum point

AVC

Break Even & Shut DownCosts($)

Quantity

ACMC

A firm must cover AC if it is to break even

AVC

This is the break even point

Break even point is where AR=AC.

Where the price is enough to cover all costs and the firms make normal profits.

Break Even & Shut DownCosts($)

Quantity

ACMC

In the SR a firm can survive if P > AVC

AVC

This is the shut down point

The Supply CurveCosts($)

Quantity

ACMC

A firm’s Supply curve is derived from the MC curve above the shut-down point

AVC

=SWhy do you think the supply curve is upwards sloping?Because of diminishing returns!

Producing higher levels of output results in progressively less efficient resource combinations. Because of this the firm will only supply a larger quantity at higher prices.