A firm’s actual cash payments for its inputsA firm’s actual cash payments for its inputs

IMPLICIT COSTSIMPLICIT COSTS• Opportunity costs of non-purchased inputs such as the Opportunity costs of non-purchased inputs such as the

entrepreneur’s time and money.entrepreneur’s time and money.– opportunity cost of something is what you sacrifice to opportunity cost of something is what you sacrifice to

get it.get it.• Opportunity cost of the entrepreneur’s time:Opportunity cost of the entrepreneur’s time:

Time given up to operate a firm;Time given up to operate a firm;• Opportunity cost of funds:Opportunity cost of funds:

Money given up to set up and run a business.Money given up to set up and run a business.

EXPLICIT COSTSEXPLICIT COSTS

Economic CostEconomic Cost

• The sum of explicit and The sum of explicit and implicit costs.implicit costs.

• The economic cost is higher The economic cost is higher because the economist because the economist includes implicit costs but includes implicit costs but the accountant does not.the accountant does not.

Accounting versus Economic CostAccounting versus Economic Cost

Explicit CostExplicit Cost(Purchased Inputs)(Purchased Inputs) $60,000$60,000 $60,000$60,000

Implicit CostImplicit Cost(Opportunity cost of (Opportunity cost of $30,000$30,000

entrepreneur)entrepreneur)(Opportunity cost of(Opportunity cost of $10,000$10,000

funds)funds)-------------------------- --------------------------

Total CostTotal Cost $60,000$60,000 $100,000$100,000

AccountingAccounting EconomicEconomic ApproachApproach ApproachApproach

• SHORT RUNSHORT RUN

A period of time over which at least one input to production A period of time over which at least one input to production is fixed. For most firms, the fixed input is capital: firm is fixed. For most firms, the fixed input is capital: firm cannot modify production facility or build a new facility.cannot modify production facility or build a new facility.

• LONG RUNLONG RUN

A period of time over which a firm is perfectly flexible in its A period of time over which a firm is perfectly flexible in its choice of inputs.choice of inputs.

In the long run, a firm can build a new production facility In the long run, a firm can build a new production facility (factory,store, office or restaurant) or modify an existing (factory,store, office or restaurant) or modify an existing facility, hire a workforce, and buy raw materials. facility, hire a workforce, and buy raw materials.

TIME PERIODSTIME PERIODS

Time Period DecisionsTime Period Decisions

• Short RunShort Run

How much output to produce;How much output to produce;

• Long RunLong Run

What type of production facility What type of production facility to build;to build;

Principle of Diminishing Principle of Diminishing ReturnsReturns

• Suppose an output is produced with Suppose an output is produced with two or more inputs, and we increase two or more inputs, and we increase one input while holding the other one input while holding the other inputs fixed. Beyond some point -- inputs fixed. Beyond some point -- called the point of diminishing returns called the point of diminishing returns -- output will increase at a decreasing -- output will increase at a decreasing rate.rate.

Computer Chip ManufacturingComputer Chip Manufacturing• As firm packs more and more As firm packs more and more

workers into factory, total output workers into factory, total output increases, but at a decreasing rate.increases, but at a decreasing rate.

------------flipping this around-------------------------flipping this around-------------

• As the firm steadily increases its As the firm steadily increases its output, the firm requires more and output, the firm requires more and more workers to increase its output more workers to increase its output by a single chip.by a single chip.

Diminishing Returns and Increasing Marginal CostDiminishing Returns and Increasing Marginal Cost

For One More ChipFor One More ChipQuantity of Additional Additional Additional MarginalQuantity of Additional Additional Additional Marginal

ChipsChips Labor Time Labor Cost Material Cost Labor Time Labor Cost Material CostCostCost

Small: 100Small: 1002 hours2 hours $16$16 $10$10 $26 $26

Medium: 300Medium: 3006 hours6 hours $48$48 $10$10 $58 $58

Large: 400Large: 400 10hours10hours $80$80 $10$10 $90 $90

Short-Run Marginal CostShort-Run Marginal Cost

The change in total cost The change in total cost resulting from a one-unit resulting from a one-unit increase in the output of increase in the output of an existing production an existing production facility.facility.

Short-Run Marginal and Average Cost Curves

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100 300 400

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short-run average total cost curve (SATC)

short-run marginal cost curve (SMC)

MarginalorAverageCost$$$

Quantity of Chips produced per hour

QUANTITY SMC SATC 100 26 90 300 58 58 400 90 68

Short-Run Average Total Cost Short-Run Average Total Cost (SATC)(SATC)

• Equals the total cost divided by the Equals the total cost divided by the quantity of output, or the cost per quantity of output, or the cost per unit output.unit output.

• Total cost is the sum of the fixed Total cost is the sum of the fixed cost per chip, the labor cost per cost per chip, the labor cost per chip, and the material cost per chip.chip, and the material cost per chip.

• U-shaped.U-shaped.

Short-Run Average Total CostShort-Run Average Total Cost QUANTITY OF QUANTITY OF

CHIPSCHIPS SMALL MEDIUM SMALL MEDIUM

LARGE LARGE

Number of ChipsNumber of Chips 100 100 300 300 400400

Fixed Cost / Chip($)Fixed Cost / Chip($) 72 72 24 24 18 18

Labor HoursLabor Hours 100 100 900 900 2,0002,000

Labor Cost ($)Labor Cost ($) 800 800 7,200 7,200 16,00016,000

Labor Cost / Chip ($) 8 Labor Cost / Chip ($) 8 24 24 4040

Material Cost / Chip ($)Material Cost / Chip ($) 10 10 10 10 1010

Total Cost / Chip ($)Total Cost / Chip ($) 90 90 58 58 6868

Short-Run Average Total CostShort-Run Average Total Cost QUANTITY QUANTITY

OF CHIPSOF CHIPS

SMALL SMALL MEDIUM LARGEMEDIUM LARGE

Number of ChipsNumber of Chips 100 100 300 300 400400

Fixed Cost ($)Fixed Cost ($) 7,200 7,200 7,200 7,200 7,2007,200

Fixed Cost / Chip($)Fixed Cost / Chip($) 72 72 24 24 18 18

Labor HoursLabor Hours 100 100 900 900 2,0002,000

Labor Cost ($)Labor Cost ($) 800 800 7,200 7,200 16,00016,000

Labor Cost / Chip ($) 8 Labor Cost / Chip ($) 8 24 24 4040

Material Cost ($)Material Cost ($) 1,000 3,000 1,000 3,000 4,0004,000

Material Cost / Chip ($)Material Cost / Chip ($) 10 10 10 10 1010

Total Cost ($)Total Cost ($) 9,000 17,400 9,000 17,400 27,20027,200

Total Cost / Chip ($)Total Cost / Chip ($) 90 90 58 58 68 68

Average CostsAverage Costs• As production increases:As production increases:

Fixed cost per chip decreases from Fixed cost per chip decreases from $72 to $24 to $18;$72 to $24 to $18;

Labor cost per chip increases from Labor cost per chip increases from $8 to $24 to $40;$8 to $24 to $40;

Material cost per chip doesn’t changeMaterial cost per chip doesn’t change$10.$10.

• Cost is lowest ($58) at the medium level of Cost is lowest ($58) at the medium level of production.production.

Marginal & Average-Total Cost Marginal & Average-Total Cost RelationshipRelationship

• Short-run average total cost is at its Short-run average total cost is at its minimum value where average total minimum value where average total cost and marginal cost are equal. cost and marginal cost are equal. Average total cost slope = 0.Average total cost slope = 0.

• If marginal cost is less than average If marginal cost is less than average total cost, average total cost is total cost, average total cost is decreasing -- has a negative slope.decreasing -- has a negative slope.

• If marginal cost is greater than average If marginal cost is greater than average total cost, average total cost is total cost, average total cost is increasing -- has a positive slope.increasing -- has a positive slope.

Quantity SATC SAVC AFCQuantity SATC SAVC AFC 100100 90 90 18 7218 72 300300 58 58 34 2434 24 400400 68 68 50 1850 18

SHORT-RUN AVERAGE COST CURVESSHORT-RUN AVERAGE COST CURVES

Average Average cost percost perchip ($)chip ($)

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100 300 400

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Short-runShort-runaverageaveragetotal costtotal cost(SATC)(SATC)

Short-runShort-runaverageaveragevariable costvariable cost(SAVC(SAVC))

Average Fixed Average Fixed CostCost

Quantity of Chips per HourQuantity of Chips per Hour

SATC = SAVC + AFCSATC = SAVC + AFC

LONG-RUN AVERAGE COSTLONG-RUN AVERAGE COST• Total cost divided by the Total cost divided by the

quantity of output when the quantity of output when the firm can choose a production firm can choose a production facility of any sizefacility of any size

• The long-run average cost The long-run average cost curve is L-shaped, initially the curve is L-shaped, initially the result of economies of scale.result of economies of scale.

Economies of Scale Economies of Scale Cost saving associated with scaling up -- Cost saving associated with scaling up --

adding more capital, labor and materials to adding more capital, labor and materials to produce more output may be caused by produce more output may be caused by either of two effects:either of two effects:

• • Indivisible inputs;Indivisible inputs;

• • SpecializationSpecialization

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1.601.60

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0.500.50 1.001.00 1.501.50 2.002.00 2.502.50

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LONG-RUN AVERAGE COST CURVELONG-RUN AVERAGE COST CURVE FOR ALUMINUM PRODUCTION FOR ALUMINUM PRODUCTION

Long-run average cost curveLong-run average cost curve

Average costAverage cost$ per pound$ per pound

Millions of Pounds of Aluminum per yearMillions of Pounds of Aluminum per year

Indivisible InputsIndivisible Inputs Inputs which cannot be scaled down to Inputs which cannot be scaled down to

produce a small quantity of output. produce a small quantity of output. Examples:Examples:

• Railroad track between two cities cannot be Railroad track between two cities cannot be scaled from two to one track.scaled from two to one track.

• An industrial mold must be complete to An industrial mold must be complete to produce many copies or a single copy.produce many copies or a single copy.

SpecializationSpecialization• In a small operation with just a few workers, In a small operation with just a few workers,

each performs a wide variety of tasks.each performs a wide variety of tasks.

• In a large operation with many workers, In a large operation with many workers, each worker specializes in one or two tasks, each worker specializes in one or two tasks, and is more productive because:and is more productive because:

• • Repetition increases productivity;Repetition increases productivity;

• • Workers spend less time switching Workers spend less time switching from task to task.from task to task.

Minimum Efficient ScaleMinimum Efficient Scale

The output at which the long-The output at which the long-run average cost curve run average cost curve becomes horizontal.becomes horizontal.

INDUSTRIES EXPERIENCING MINIMUM INDUSTRIES EXPERIENCING MINIMUM EFFICIENT SCALEEFFICIENT SCALE

INDUSTRYINDUSTRY MINIMUM EFFICIENT SCALEMINIMUM EFFICIENT SCALE

British Sulfuric Acid British Sulfuric Acid 1 million tons1 million tons

British Steel British Steel 9 million tons9 million tons

U.S. AutomobilesU.S. Automobiles 200,000 to 400,000 per year 200,000 to 400,000 per year

Large U.S. BreweriesLarge U.S. Breweries 4.5 million barrels 4.5 million barrels

DISECONOMIES OF SCALEDISECONOMIES OF SCALE

• Increase in output leads to increases Increase in output leads to increases in the average cost of production: in the average cost of production: higher costs accompany scaling up.higher costs accompany scaling up.

• Diseconomies may occur for two Diseconomies may occur for two reasons:reasons:

• • Coordination problems;Coordination problems;

• • Increasing input costs.Increasing input costs.

CoordinationCoordination Problems Problems

• Large organizations require several Large organizations require several layers of management (a layers of management (a bureaucracy) to coordinate the bureaucracy) to coordinate the activities of the different parts of the activities of the different parts of the organization. This leads to a organization. This leads to a positively sloped average-cost positively sloped average-cost curve.curve.

Increasing Input CostsIncreasing Input Costs

• As a firm increases its output, it will As a firm increases its output, it will demand more of each of its inputs, demand more of each of its inputs, which may lead to higher prices for which may lead to higher prices for some inputs. some inputs.

• Higher prices increases the average Higher prices increases the average cost of production, resulting in a cost of production, resulting in a positively sloped average-cost curve.positively sloped average-cost curve.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Perfect Competition Perfect Competition ------

A market with a very large number of A market with a very large number of firms, each of which produces the firms, each of which produces the same standardized product and same standardized product and takes the market price as given.takes the market price as given.

A price-taking firm.A price-taking firm.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS

• Perfect CompetitionPerfect Competition

EXAMPLESEXAMPLES

• • The wheat farmer,The wheat farmer,

• • The average stock investorThe average stock investor

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Monopolistic Competition Monopolistic Competition ------

There are many firms, each sells a There are many firms, each sells a differentiated product. Because products differentiated product. Because products sold by different firms are not perfect sold by different firms are not perfect substitutes, each firm has some control substitutes, each firm has some control over price. There are no barriers to over price. There are no barriers to entering the market. entering the market.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Monopolistic competition Monopolistic competition ------

EXAMPLESEXAMPLES

• • restaurants,restaurants,

• • retail stores,retail stores,

• • gas stations,gas stations,

• • clothingclothing

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• Oligopoly --- There are just a few Oligopoly --- There are just a few

firms in the market, a result of two firms in the market, a result of two sorts of barriers to entry:sorts of barriers to entry:

• • economies of scale,economies of scale,

• • government may limit number government may limit number of firms in the marketof firms in the market

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• OligopolyOligopoly

EXAMPLESEXAMPLES

• • automobiles,automobiles,

• • airline travel,airline travel,

• • breakfast cerealsbreakfast cereals

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• MonopolyMonopoly --- ---

A single firm serves the entire market. A single firm serves the entire market. A monopoly occurs when the A monopoly occurs when the barriers to entry are very strong, barriers to entry are very strong, which could result from very large which could result from very large economies of scale or a government economies of scale or a government limit on the number of firms.limit on the number of firms.

FOUR TYPES OF MARKETSFOUR TYPES OF MARKETS• MonopolyMonopoly --- ---

EXAMPLESEXAMPLESlarge scale economieslarge scale economies::

• • local phone service,local phone service,

• • electric power generation,electric power generation,

established by government policyestablished by government policy::

• • drugs covered by patents,drugs covered by patents,

• • concessions in National Parksconcessions in National Parks

Characteristics of Different Types of MarketsCharacteristics of Different Types of Markets Perfect Perfect MonopolisticMonopolistic OligopolyOligopoly MonopolyMonopoly Competition Competition

CompetitionCompetition

NumberNumber very large very large many many few few one one

of firmsType of standardized differentiated std or diff. uniqueproductControl none slight considerable considerableover price if not

regulatedEntry no barriers no barriers large largeconditions barriers barriersExamples wheat restaurants automobiles local phone soybeans retail stores air travel and electric

clothing breakfast patentedcereal drugs

TOTAL REVENUETOTAL REVENUE

• The money the firm gets from selling its The money the firm gets from selling its product and is equal to price times quantity product and is equal to price times quantity sold:sold:

Total Revenue = price Total Revenue = price ** quantity quantity

ECONOMIC PROFITECONOMIC PROFIT

Total revenue - total economic costTotal revenue - total economic cost Total economic cost Total economic cost

= explicit costs= explicit costs

( firm’s actual cash payments for inputs ) ( firm’s actual cash payments for inputs )

+ implicit costs + implicit costs

( opportunity costs of non-purchased inputs, ( opportunity costs of non-purchased inputs, such as such as entrepreneur’s time or money )entrepreneur’s time or money )