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21 CHAPTER TWENTY-TWO THE COST OF PRODUCTION INSTRUCTIONAL OBJECTIVES After completing this chapter, students should be able to: 1. Distinguish between explicit and implicit costs, and between normal and economic profits. 2. Explain why normal profit is an economic cost, but economic profit is not. 3. Explain the law of diminishing returns. 4. Differentiate between the short run and the long run. 5. Compute marginal and average product when given total product data. 6. Explain the relationship between total, marginal, and average product. 7. Distinguish between fixed, variable and total costs. 8. Explain the difference between average and marginal costs. 9. Compute and graph AFC, AVC, ATC, and marginal cost when given total cost data. 10. Relate average product to average variable cost, and marginal product to marginal cost. 11. Explain what can cause cost curves to rise or fall. 12. Explain the difference between short-run and long-run costs. 13. State why the long-run average cost is expected to be U-shaped. 14. List causes of economies and diseconomies of scale. 15. Indicate relationship between economies of scale and number of firms in an industry. 16. Define and identify terms and concepts listed at the end of the chapter. LECTURE NOTES I. Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those resources away from their best alternative production opportunities. Payments may be explicit or implicit. (Recall opportunity-cost concept in Chapter 2.) A. Explicit costs are payments to nonowners for resources they supply. In the text’s example this would include CD cost, clerk’s salary, and utilities, for a total of $65,000. B. Implicit costs are the money payments the self-employed resources could have earned in their best alternative employments. In the text’s example this would include forgone interest, forgone rent, forgone wages, and forgone entrepreneurial income, for a total of $31,000. C. Normal profits are considered an implicit cost because they are the minimum payments required to keep the owner’s entrepreneurial abilities self-employed. This is $5,000 in the example. D. Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit). Figure 22-1 illustrates the difference between
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The Cost of Production accounting profits and economic profits. The economic profits are $24,000 (after $65,000 + $31,000 are subtracted from $120,000). On Board Example: Presently earns $20,000 as CD sales rep Has $20,000 in savings earning $1,000 per year Owns space in the Mall, now rents for $5,000 per year Decides to open own store in the Mall, hires Clerk at $20,000/year Year 1 Statement: Total sales revenue $120,000 Cost of CD’s $40,000 Clerk’s Salary 20,000 Utilities 5,000 Total Explicit Costs 65,000 Accounting Profit $55,000 Foregone : Interest $1,000 Rent $5,000 Wages $20,000 Entrepreneurial Cost $ 5,000 Total Implicit Costs $31,000 Economic Profit
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