chapter6A-D-1

# chapter6A-D-1 - Chapter 6: Economic Costs and Profit....

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19 Chapter 6: Economic Costs and Profit. Computing the firm’s cost. We have already learned (twice) that the firm’s cost is determined by the cost formula: Cost = (x×P x ) + (y×P y ) + (z×P z ) + . .. (etc.). x, y, z, etc., represent the quantities of different inputs that the firm consumes. For example, suppose that a manager wants to know the cost of producing 10,000 pairs of jeans. The inputs might include labor, sewing machinery, denim, thread, dye, etc. If she knows the price of each input, then she can use the production function to figure out how much of each input she needs to produce 10,000 jeans efficiently (as we learned in Chapter 5). Then she can substitute all of these prices and quantities into the cost formula and compute the total cost of producing the jeans. A complication: using the correct prices for inputs. One problem in calculating the cost of production is that the true “prices” of inputs are sometimes unclear. The next section discusses this issue, which affects many practical business decisions. A. Opportunity cost and sunk cost. The cost of using inputs that are already owned. If production would use up a resource that the firm already owns, then it may be unclear what is the true current “cost” of using up that resource. It may be quite different from whatever price the firm originally paid for that resource. It is important to evaluate such costs rationally, because they have an important effect on production decisions and on the firm’s profitability. Valuing inputs correctly can even change the firm’s shutdown decision. (In reality, “shutting down” does not necessarily mean shutting down the whole firm; it might mean dropping one product, or closing one plant.) Opportunity cost. To determine the cost of using inputs that the firm already owns, economists use the concept of opportunity cost . The opportunity cost of an already-owned input, for producing some good “G,” is the value that the firm could get from that input in its next best use, if it did not produce G . The “next best use” of an input might be using it to produce some alternative good (not G), or to return it to the original supplier, or to sell it in the open market. Among all of these choices, the next best use is whichever alternative gets the most value from the unused input. By using the input to produce G, the firm loses the opportunity to get value from the input in its next best use; that is why we call this value the opportunity cost . The best way to explain opportunity cost is through examples. Example 1: The hours that a businessman spends working for himself. No one has to pay for his or her own labor -- since he or she is born with it -- but it still has value. When a businessman uses his own labor to run his store, he loses the opportunity to use that valuable labor in a different activity. The opportunity cost of using his labor in his store is whatever he could earn from his labor in its next best use. That might be working for himself in a different

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## This note was uploaded on 01/31/2009 for the course ECON 200 taught by Professor Cramer during the Spring '07 term at Arizona.

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chapter6A-D-1 - Chapter 6: Economic Costs and Profit....

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