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Principles of Microeconomics : Ch.13 Second Canadian Edition
Chapter 13
The Costs of Production
© 2002 by Nelson, a division of Thomson Canada Limited
Principles of Microeconomics : Ch.13 Second Canadian Edition
Overview
Types of Costs and ProfitShort-Run Cost BehaviourLong-Run Cost Behaviour
Principles of Microeconomics : Ch.13 Second Canadian Edition
Supply
The Costs of ProductionThe Law of Supply:
Firms are willing to produce and sell a greater quantity of a good when
the price of a good is high, due
to typical productivity and cost behaviour.
P
Q
Principles of Microeconomics : Ch.13 Second Canadian Edition
Why Study Behaviour of Firms?
Gain a better understanding of the decisions made by producers.
Study how the behaviour of a firm depends on the structure of the market.
Principles of Microeconomics : Ch.13 Second Canadian Edition
Purpose Facing The Typical Firm
The economic purpose of the firm is to maximize profit!
Profit = Total Revenue - Total Cost.
Principles of Microeconomics : Ch.13 Second Canadian Edition
An Individual Firm’s Profit: Revenue minus Cost
Revenue: The amount that the firm receives for the sale of its product.
(Market Price x Amount Sold)= RevenueCost: The amount that the firm sacrifices to
buy inputs.Profit: Total revenue minus total costs.
Principles of Microeconomics : Ch.13 Second Canadian Edition
Costs of Production In general, three costs are often considered
when making business supply decisions.
Explicit Costs
Implicit Costs
Sunk Costs
Principles of Microeconomics : Ch.13 Second Canadian Edition
Costs as Opportunity CostsThe firm’s costs include Explicit Costs and
Implicit Costs:
– Explicit Costs: costs that involve a direct money outlay for factors of production.
– Implicit Costs: costs that do not involve a direct money outlay (e.g. opportunity costs of the owner’s own inputs used - implicit wages, implicit rent, cost of capital).
Principles of Microeconomics : Ch.13 Second Canadian Edition
Costs as Opportunity Costs
Accountants measure the explicit costs but often ignore the implicit costs.
Economists include all opportunity costs when measuring costs.
Accounting Profit = TR - Explicit CostsEconomic Profit = TR - Explicit Costs -
Implicit Costs
Principles of Microeconomics : Ch.13 Second Canadian Edition
Costs as Opportunity CostsA third, not so obvious implicit cost
includes sunk costs.Sunk costs are costs that have already
been committed and cannot be recovered. Sunk Costs are . . .
– an opportunity cost
– often ignored when making decisions about supplying a product
Principles of Microeconomics : Ch.13 Second Canadian Edition
Quick Quiz“A farmer has planted corn seeds but
has not yet fertilized the field.” Is the cost of seed an opportunity cost
or a sunk cost?Is the cost of fertilizer an opportunity
cost or a sunk cost?Which of these two costs is more
likely to affect the decision to continue farming?
Principles of Microeconomics : Ch.13 Second Canadian Edition
Overview
Types of Costs and ProfitShort-Run Cost BehaviourLong-Run Cost Behaviour
Principles of Microeconomics : Ch.13 Second Canadian Edition
Short-Run vs. Long-RunTwo different time horizons are important when analyzing costs. Short-Run: Time period over which some inputs are variable (labour, materials) and some inputs are fixed (plant size).Long-Run: Time period over which all inputs are variable, including plant size.
Principles of Microeconomics : Ch.13 Second Canadian Edition
Short-Run Costs
Costs of production may be divided into two categories in the short-run:Fixed Costs:
–Those costs that do not vary with the amount of output produced.
Variable Costs:
–Those costs that do vary with the amount of output produced.
Principles of Microeconomics : Ch.13 Second Canadian Edition
Family of Total Costs...
Total Fixed Costs (TFC)Total Variable Costs (TVC)Total Costs (TC)
where: TC = TFC + TVC
Principles of Microeconomics : Ch.13 Second Canadian Edition
Family of Average Costs. . .
Average Costs: Specific Cost / Output LevelAverage Fixed Costs (AFC) = TFC / QAverage Variable Costs (AVC) = TVC / QAverage Total Costs (ATC) = TC / Q
Principles of Microeconomics : Ch.13 Second Canadian Edition
Marginal Cost: “How much does it cost to produce an
additional unit of output?”Marginal Cost (MC):
“The extra or additional cost of producing one more unit of output.”
MC is the addition to the cost of production that must be covered by additional revenue for profit maximization.
MC = TC ÷ Q
Principles of Microeconomics : Ch.13 Second Canadian Edition
Quick Quiz! If Ford’s total cost of
producing 4 cars is $225,000 and its total cost of producing 5 cars is $250,000. . .
...what is the average total cost and marginal cost of producing the fifth car?
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Shape of Short-Run Cost Curves
Short-run cost behaviour is based on the productivity of the inputs (resources).
As the firm continues to expand output,in a fixed plant-size situation, eventuallythe marginal product of each successive worker hired will decrease.
The diminishing marginal product causesthe marginal cost to increase in the short-run. This in turn affects the behaviour of average total cost.
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity of output
MC
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity of output
MCATC
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity of output
MCATC
AVC
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Shape of Typical Cost CurvesC
ost
($’
s)
Quantity of output
MCATC
AVC
AFC
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Shape of Typical Cost Curves
U-Shaped Average Total Cost (ATC):
– At low levels of output, as the firm expands production, ATC declines.
– At higher production levels, as output is increased, ATC increases.
– The bottom of the U-Shape occurs at the quantity that minimizes average total cost.
– This is called the Efficient Size of the firm.
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Relationship Between Marginal Cost and Average Total Cost
Why is ATC U - shaped?When marginal cost is less than average
total cost, average total cost is falling.
MC < ATC ATC When marginal cost is greater than average
total cost, average total cost is rising.
MC > ATC ATC
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Relationship Between Marginal Cost and Average Total Cost
The marginal-cost curve crosses the
average-total-cost at minimum ATC.
Why?
Principles of Microeconomics : Ch.13 Second Canadian Edition
The Relationship Between Marginal Cost and Average Total Cost
Co
st (
$’s)
Quantity
MCATC
The marginal cost curve always crossesthe average total costcurve at the minimum
average total cost!
Principles of Microeconomics : Ch.13 Second Canadian Edition
Overview
Types of Costs and ProfitShort-Run Cost BehaviourLong-Run Cost Behaviour
Principles of Microeconomics : Ch.13 Second Canadian Edition
Long-Run CostsHow do per unit costs behave as the firm
expands all inputs, even plant size or scale of operation?
The Long-Run Average Total Cost (LRATC) reflects the lowest possible unit cost related to different plant sizes and/or scales of operation.
The LRATC Curve is U-shaped as shown in the next slide.
Principles of Microeconomics : Ch.13 Second Canadian Edition
Long-Run Costs
Econ.of Scale
Disecon. of Scale
Constant Returns to Scale
LRATC Curve
$ PerUnit
Scale of Operation (Q)
Principles of Microeconomics : Ch.13 Second Canadian Edition
Long-Run Costs
There are three typical long-run cost situations:Economies of Scale: LRATC decreases as the scale of operation increases.Diseconomies of Scale: LRATC increases with the scale of operation.Constant Returns to Scale: LRATC stays constant as the scale of operation increases.
Principles of Microeconomics : Ch.13 Second Canadian Edition
Long-Run CostsPossible causes of Economies of Scale:
– volume discounts on purchases– manufacturing, warehousing,
transportation, and promotional economies
– larger firm can borrow at lower interest rates
Possible causes of Diseconomies of Scale
– management diseconomies...
Principles of Microeconomics : Ch.13 Second Canadian Edition
Overview
Types of Costs and ProfitShort-Run Cost BehaviourLong-Run Cost Behaviour