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Principles of Economics
Session 5
Topics To Be Covered
Categories of CostsCosts in the Short RunCosts in the Long RunEconomies of Scope
The Firm’s Objective
The economic goal of the firm is to maximize profits.
A Firm’s Profit
Profit is the firm’s total revenue minus its total cost.
Profit = Total revenue - Total cost
Costs as Opportunity Costs
A firm’s cost of production includes all the opportunity costs of making its output of
goods and services.
Opportunity Cost
The value of the next best use for an economic good, or the value of the sacrificed alternative.
Explicit and Implicit Costs
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs involve a direct money outlay for factors of production. Implicit costs, also called normal profit, refer to the opportunity cost of using the owner’s own resources.
Economic Profit versus Accounting Profit
Economists measure a firm’s economic profit as total revenue minus all the opportunity costs (explicit and implicit).
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. In other words, they ignore the implicit costs.
Economic Profit versus Accounting Profit
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.
Economic Profit versus Accounting Profit
RevenueTotalopportunitycosts
How an EconomistViews a Firm
Explicitcosts
Economicprofit
Implicitcosts
Explicitcosts
Accountingprofit
How an AccountantViews a Firm
Revenue
Total Cost of Production
Total cost of production may be divided into fixed costs and variable costs.
Fixed and Variable Costs
Fixed costs are those costs that do not vary with the quantity of output produced.
Variable costs are those costs that do change as the firm alters the quantity of output produced.
Family of Total Costs
TC = Total Costs
TFC=Total Fixed Costs
TVC=Total Variable Costs
TVCTFCTC
Fixed CostCost paid by a firm that is in business regardless of the level of output
Sunk CostCost that have been incurred and cannot be recoverede.g. advertising expenditure
Fixed Cost vs. Sunk Cost
Personal Computers: most costs are variablee.g. components, labor
Software: most costs are sunke.g. cost of developing the software
Variable Cost and Sunk Cost
Total CostOutput(Units)
Fixed Cost ($)
Variable Cost ($)
Total Cost ($)
0 50 0 501 50 50 1002 50 78 1283 50 98 1484 50 112 1625 50 130 1806 50 150 2007 50 175 2258 50 204 2549 50 242 292
10 50 300 35011 50 385 435
Total Cost Curves
Output
Cost($ peryear)
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
TVC
Variable cost increases with
production and the rate varies with
increasing & decreasing returns.
TC
Total costis the vertical
sum of FC and VC.
TFC50
Fixed cost does notvary with output
Average Costs
The average cost is the cost of each typical unit of product.
Average costs can be determined by dividing the firm’s costs by the quantity of output produced.
Family of Average Costs
ATC=Average Total Costs
AFC=Average Fixed Costs
AVC=Average Variable Costs
AVCAFCATC
Family of Average Costs
Q
TC=
Quantity
cost Total=ATC
Q
TVC=
Quantity
costVariable =AVC
Q
TFC=
Quantity
cost Fixed=AFC
Average CostsOutput(Units)
TFC ($)
TVC ($)
TC($)
AFC($)
AVC($)
ATC($)
0 50 0 50 -- -- --1 50 50 100 50 50 1002 50 78 128 25 39 643 50 98 148 16.7 32.7 49.34 50 112 162 12.5 28 40.55 50 130 180 10 26 366 50 150 200 8.3 25 33.37 50 175 225 7.1 25 32.18 50 204 254 6.3 25.5 31.89 50 242 292 5.6 26.9 32.4
10 50 300 350 5 30 3511 50 385 435 4.5 35 39.5
Average Cost Curves
Output (units/yr.)
Cost($ per
unit)
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
ATC
AVC
AFC
U-Shaped ATC and AVC Curves
The ATC curve is U-shaped. At very low levels of output average total cost
is high because fixed cost is spread over only a few units.
Average total cost declines as output increases. Average total cost starts rising because
average variable cost rises substantially.The AVC curve is also U-shaped for its
relationship with the ATC curve.
Marginal Cost
Marginal Cost (MC) is the cost of expanding output by one unit. Since
fixed cost have no impact on marginal cost, it can be written as:
Q
TC
Q
VCMC
Marginal CostOutput(Units)
TFC ($)
TVC ($)
TC($)
AFC($)
AVC($)
ATC($)
MC($)
0 50 0 50 -- -- -- --1 50 50 100 50 50 100 502 50 78 128 25 39 64 283 50 98 148 16.7 32.7 49.3 204 50 112 162 12.5 28 40.5 145 50 130 180 10 26 36 186 50 150 200 8.3 25 33.3 207 50 175 225 7.1 25 32.1 258 50 204 254 6.3 25.5 31.8 299 50 242 292 5.6 26.9 32.4 38
10 50 300 350 5 30 35 58
11 50 385 435 4.5 35 39.5 85
Marginal Cost Curve
Output (units/yr.)
Cost($ per
unit)
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
MC
Cost Curves for a Firm
Output (units/yr.)
Cost($ per
unit)
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
MC
ATC
AVC
AFC
From TC to AC and MC
P
Q
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
TFC
TVC
A
TC
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
MC
ATC
AVC
AFC
B
A'
B'
AFC= slope of line from origin to a point on TFCAVC = slope of line from origin to a point on TVCATC = slope of line from origin to a point on TCMC = slope of tangent to a point on TC or TVC
P
Q
Properties of Cost Curves
AFC falls continuously When MC < AVC or
MC < ATC, AVC and ATC decrease
When MC > AVC or MC > ATC, AVC and ATC increase
Output (units/yr.)
Cost($ per
unit)
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
MC
ATC
AVC
AFC
Properties of Cost Curves
MC crosses AVC and ATC at the minimums of AVC and ATC, respectively.
Minimum AVC occurs at a lower output than minimum ATC
Output (units/yr.)
Cost($ per
unit)
25
50
75
100
0 1 2 3 4 5 6 7 8 9 10 11
MC
ATC
AVC
AFC
Costs in the Long Run
For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.
In the short run some costs are fixed. In the long run fixed costs become variable
costs.
Costs in the Long Run
Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.
If LMC < LAC, LAC will fall
If LMC > LAC, LAC will rise
LMC = LAC at the minimum of LAC
Long-Run Average and Marginal Cost
Long-Run Average and Marginal Cost
Output
Cost($ per unitof output
LAC
LMC
A
Average Total Cost in the Short and Long Runs
Quantity ofCars per Day
0
AverageTotalCost
ATC in shortrun with
small factory
ATC in shortrun with
medium factory
ATC in shortrun with
large factory
ATC in long run
The optimal plant size will depend on the anticipated output.
Firms can change scale to change output in the long-run.
The long-run average cost curve is the envelope of the firm’s short-run average cost curves.
Long-Run Costs andReturns to Scale
Long-Run Cost with Economiesand Diseconomies of Scale
Output
Cost($ per unitof output
SMC1
SAC1
SAC2
SMC2LMC If the output is Q1 a manager
would choose the small plantSAC1 and SAC $8.
$10
Q1
$8B
A
LAC SAC3
SMC3
Economies and Diseconomies of Scale
Economies of scale occur when long-run average total cost declines as output increases.
Diseconomies of scale occur when long-run average total cost rises as output increases.
Constant returns to scale occur when long-run average total cost does not vary as output increases.
Economies and Diseconomies of Scale
Diseconomies
of scale
Quantity ofCars per Day
0
AverageTotalCost
ATC in long run
Economies
of scale
Constant Returnsto scale
Economies of scope exist when the joint output of a single firm is greater than the output that could be achieved by two different firms each producing a single output.
Chicken farm—poultry and eggsAutomobile company—cars and trucksUniversity—Teaching and research
Economies of Scope
Both use similar, relative, and even the same capital and labor.
The firms share management resources.
The production of one good results in the production of another good at little or no extra cost.
Advantages of Economiesof Scope
C(Q1)= cost of producing Q1
C(Q2)=cost of producing Q2
C(Q1Q2)=joint cost of producing both products
)(
)()()C( SC
2,1
2,121
QQC
QQCQCQ
Measuring Degree of Economies of Scope
If SC > 0 — Economies of scope
If SC < 0 — Diseconomies of scope
There is no direct relationship between economies of scope and economies of scale.
A firm may experience economies of scope and diseconomies of scale
A firm may have economies of scale and not have economies of scope
Economies of Scope vs.Economies of Scale
Assignment
Review Chapter 7Answer questions on P130Preview Chapter 8
Thanks
