Chapter 9Businesses and the Costs of

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9-2

Economic Costs

• The payment that must be made to obtain and retain the services of a resource

• Explicit costs• Monetary outlay

• Implicit costs• Opportunity cost of using self-owned

resources• Value of next-best use• Includes a normal profit

LO1

9-3

Accounting Profit and Normal Profit

• Accounting profit

= Total revenue – explicit costs• Economic profit

= Accounting profit – implicit costs• Economic profit (to summarize)

= Revenue – economic cost

= Revenue – explicit costs – implicit costs

LO1

9-4

Explicitcosts

Accounting costs (explicit costs

only)

Implicit costs (including a

normal profit)

Economicprofit

Accounting profit

Econ

omic

(o

ppor

tuni

ty)

cost

s

Tota

l rev

enue

LO1

Economic Profit

9-5

Short Run and Long Run

• Short run• Some variable inputs• Fixed plant

• Long run• All inputs are variable• Firms can adjust plant size as well as enter

and exit industry

LO2

9-6

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

=

9-7

Law of Diminishing Returns

• Law of diminishing returns• Resources are of equal quality• Technology is fixed• Variable resources are added to fixed

resources• At some point, marginal product will fall

• Rationale

LO2

9-8

Total, Marginal, and Average Product: The Law of Diminishing Returns

(1)Units of the Variable

Resource (Labor)

(2)Total Product (TP)

(3)Marginal Product

(MP)Change in (2)/ Change in (1)

(4)Average Product

(AP),(2)/(1)

0 0 -

1 10 10 Increasingmarginalreturns

10.00

2 25 15 12.50

3 45 20 15.00

4 60 15Diminishing

marginalreturns

15.00

5 70 10 14.00

6 75 5 12.50

7 75 0 10.71

8 70 -5 Negativemarginalreturns

8.75

7-8

The Law of Diminishing Returns

9-9

The Law of Diminishing Returns

TP

MP

AP

IncreasingMarginalReturns

DiminishingMarginalReturns

NegativeMarginalReturns

1 2 3 4 5 6 7 8 90

10

20

30To

tal p

rodu

ct, T

P

1 2 3 4 5 6 7 8 9

20

10

Mar

gina

l pro

duct

, MP

LO2

9-10

Short Run Production Costs

• Fixed costs (TFC)• Costs that do not vary with output

• Variable costs (TVC)• Costs that do vary with output

• Total cost (TC)• Sum of TFC and TVC• TC = TFC + TVC

LO3

9-11

Cost

s

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

Totalcost

Variablecost

Fixedcost

LO3

Short-Run Production Costs

9-12

Per-Unit, or Average, Costs

• Average fixed cost AFC = TFC/Q• Average variable cost AVC = TVC/Q• Average total cost ATC = TC/Q• Marginal cost MC = ΔTC/ΔQ

LO3

9-13

Short-Run Production Costs

LO3

Total, Average, and Marginal Cost Schedules for an Individual Firm in the Short Run

Total Cost Data Average Cost Data Marginal Cost

(1)Total Product

(Q)

(2)Total Fixed Cost

(TFC)

(3)Total Variable

Cost(TVC)

(4)Total Cost (TC)

TC=TFC+TVC

(5)Average Fixed

Cost(AFC)

AFC = TFC/Q

(6)AverageVariable

Cost (AVC)

AVC=TVC/Q

(7)Average Total

Cost(ATC)

ATC = TC/Q

(8)Marginal Cost

(MC)MC =ΔTC/ΔQ

0 $100 $0 $100

1

100

90 190 $100.00 $90.00 $190.00 $90

2 100 170 270 50.00 85.00 135.00 80

3 100 240 340 33.33 80.00 113.33 70

4 100 300 400 25.00 75.00 100.00 60

5 100 370 470 20.00 74.00 94.00 70

6 100 450 550 16.67 75.00 91.67 80

7 100 540 640 14.29 77.14 91.43 90

8 100 650 750 12.50 81.25 93.75 110

9 100 780 880 11.11 86.67 97.78 130

10 100 930 1030 10.00 93.00 103.00 150

7-13

9-14

Per-Unit, or Average, Costs

Cost

s

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

ATCAVC

AVC

AFC

LO3

9-15

Marginal Cost

Cost

s

1 2 3 4 5 6 7 8 9 100 Q

50

100

150

$200

AFC

MC

ATCAVC

AVC

AFC

LO3

9-16

Marginal Cost and Marginal Product

MPAP

MCAVC

Quantity of output

Quantity of labor

Cost curvesLO3

9-17

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

9-18

Firm Size and CostsA

vera

ge to

tal c

osts ATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

LO4

9-19

The Long-Run Cost Curve

Long-runATC

Ave

rage

tota

l cos

ts ATC-1

ATC-2

ATC-3 ATC-4

ATC-5

Output

LO4

9-20

Economies of Scale

• Economies of scale• Labor specialization• Managerial specialization• Efficient capital• Other factors

• Constant returns to scale

LO4

9-21

Diseconomies of Scale

• Diseconomies of scale• Control and coordination problems• Communication problems• Worker alienation• Shirking

LO4

9-22

MES and Industry Structure

• Minimum efficient scale (MES)• Lowest level of output at which long run

average costs are minimized• Can determine the structure of the industry

• Natural monopoly• Long run costs are minimized when one

firm produces the product

LO4

9-23

MES and Industry Structure

Output

Ave

rage

tot

al c

osts

Long-runATC

Economiesof scale

Constant returnsto scale

Diseconomiesof scale

q1 q2

LO5

9-24

MES and Industry Structure

Output

Ave

rage

tot

al c

osts

Economiesof scale

Diseconomiesof scale

Long-runATC

LO5

9-25

MES and Industry Structure

Output

Ave

rage

tot

al c

osts

Long-runATC

Economiesof scale

Diseconomiesof scale

LO5

9-26

Applications and Il lustrations

• Rising gasoline prices• Successful start-up firms• Verson stamping machine• The daily newspaper• Aircraft and concrete plants

LO5

9-27

3D Printers and Mass Customization

• First industrial revolution began in 1700s• Mass production led to mass affordability• Second industrial revolution began late 1800s• Mass sales were necessary to spread R&D

costs• Third industrial revolution is beginning Now• Affordable mass customization with zero

transportation costs