Chapter 8 Production and Cost Introduction to Economics (Combined Version) 5th Edition

Chapter 8Production and Cost

Introduction to Economics (Combined Version) 5th Edition

Costs and ProfitsMicroeconomic theory

is based on the assumption that firms are in business to maximize profit.

• Profit is the difference between the revenue a firm earns by selling its output and the opportunity costs of producing that output.

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Explicit Costs Explicit costs are opportunity

costs that take the form of explicit payments to suppliers of factors of production and intermediate goods.

Examples: workers’ wages managers’ salaries salespeople’s commissions interest payments to banks and

other creditors fees for legal advice and other

services payments for energy and raw

material


Players’ salaries are an explicit cost for a professional football team.

Implicit Costs Implicit costs are opportunity

costs of using resources contributed by the firm’s owners (or owned by the firm itself as a legal entity) that are not obtained under contracts calling for explicit payments.

Examples: Labor of a small-business owner Opportunity cost of small-

business owners’ own savings invested in a business

Opportunity cost of capital invested by corporate shareholders


The opportunity cost of the time of a small-business owner who works without a salary is an example of an implicit cost.

Normal Profit Table shows the implicit and

explicit costs of the imaginary firm Fieldcom, Inc.

Total revenue minus explicit costs equals accounting profit.

Subtracting implicit costs from this quantity yields pure economic profit.

The opportunity cost of capital contributed by the owners can also be called normal profit.

Total Revenue $600,000Less explicit costs:

Wages and salaries 300,000Materials and other 100,000

_________Equals accounting profit $200,000Less implicit costs:

Owners’ forgone salary 160,000 80,000Opportunity cost

of capital 20,000_________

= pure economic profit $ 20,000


Fixed and Variable Costs• Variable costs: Costs of

inputs whose quantities can be changed easily in the short run

Fixed costs: Costs of inputs whose quantities can be changed only in the long run by increasing or decreasing the size of the firm’s plant

Sunk costs: One-time costs which, once made, cannot be recovered if the firm goes out of business

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The costs of owning a warehouse are a fixed cost for a trucking firm.

Marginal Physical Product Marginal physical product of labor is the amount by which total

output increases or decreases when the quantity of labor increases by one unit.


Law of Diminishing ReturnsAccording to the law of

diminishing returns, as the amount of one variable input is increased while the amounts of all other inputs remain fixed, a point will be reached beyond which the marginal physical product of the input will decrease.


Range of Diminishing

Returns

Marginal CostMarginal Cost is the amount by which total variable costs (labor

costs, in this example) increase or decrease when the quantity of output increases by one unit.


Family of Cost Curves

• TC = TVC + TFC• ATC = TC/Q• AVC = TVC/Q• AFC = TFC/Q• MC = ΔTC/ ΔQ


Marginal-Average Rule The marginal cost curve intersects the minimum points of the

average total cost and average variable cost curves.


Long- and Short-Run Average Cost Curves The position of the short-run average total cost curve for a firm depends on

the size of the plant. Each plant size can be represented by a U-shaped short-run average total cost curve. The firm’s long-run average cost curve is the “envelope” of these and other possible short-run average total cost curves; that is, it is a smooth curve drawn so that it just touches the short-run curves without intersecting any of them.


Economies and Diseconomies of Scale In any output range in which

long-run average cost decreases as output increases, the firm is said to experience economies of scale.

In any output range in which long-run average cost increases, the firm is said to experience diseconomies of scale.

If there is any range of output for which long-run average cost does not change as output varies, the firm is said to experience constant returns to scale in that range.


Appendix to Chapter Eight

Costs and Output with Two Variable Inputs


An Isoquant An isoquantity line, or isoquant

shows various ways of producing a given quantity of output.

Here, Points P, Q, and R represent various ways of growing the 200 bushels of corn.

A movement downward along the isoquant represents the substitution of fertilizer for land while output is maintained at 200 bushels per year.

As fertilizer is substituted for land, the isoquant becomes flatter because of diminishing returns.


Least-Cost Method of Production The price of fertilizer is assumed

to be $50 a ton and the rental price of land $50 per year.

A set of budget lines is drawn to represent various levels of spending on inputs. Line A ($400) does not provide

enough inputs to produce 200 bushels.

Line C ($625) provides enough inputs to grow 200 bushels of corn using methods P or R.

Line B ($500) permits the 200 bushels to be grown using method Q, which is the least-cost method given these input prices.


Effect of a Change in Input Price Assume the price of land increases from $50 to $200 and the price of fertilizer

remains fixed at $50 a ton. The $500 budget line shifts from position B to position C and now falls short of the 200-bushel isoquant. Increasing the amount spent on variable inputs to $1,000 shifts the budget line up to position D, where it just touches the isoquant at point R. Total variable cost of 200 bushels increases and fertilizer is be substituted for land, which is now relatively more costly.


From Isoquants to Cost Curve

Part (a) of this figure shows 100, 200, and 300 bushels isoquants.

Budget lines are based on input prices of $50 an acre for land and $50 a ton for fertilizer.

As output expands, the firm will move from T to Q and then to W along the expansion path.

Part (b) of the figure plots the amount of output and the total variable cost for each of these points, giving a total variable cost curve.


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Chapter 8 Production and Cost Introduction to Economics (Combined Version) 5th Edition