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Unformatted text preview: Economic Costs
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) A. Explicit costs are payments the firm must make for inputs to nonowners of the firm to attract them away from other employment,
for example, wages and salaries to its employees. L6: L6: The Theory and Estimation of Cost (Chapter 8) B. Implicit costs are nonexpenditure costs that occur through the use of self-owned, self-employed resources,
for example, the salary the owner of a firm forgoes by operating his or her own firm and not working for someone else. forgone interest, forgone rent, forgone wages, and forgone entrepreneurial income.
Principles of Microeconomics,SP 2010 Economic Costs
The explicit costs of going to college are the tuition costs, the cost of books, and the extra costs of living away from home (if applicable). The implicit costs are the income forgone and the hard grind of studying. Economic Costs
C. Normal profits are considered an implicit cost because they are the minimum payments required to keep the owner’s entrepreneurial abilities self-employed. D. Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit). Economists classify normal profits as costs, since in the long run the owner of firm would close it down if long run the owner of a firm would close it down if a normal profit were not being earned.
Since a normal profit is required to keep the entrepreneur operating the firm, a normal profit is a cost. Economic profits are not costs of production since the entrepreneur does not require the gaining of an economic profit to keep the firm operating.
Principles of Microeconomics,SP 2010 In economics, costs are whatever is required to keep a firm operating. Principles of Microeconomics,SP 2010 1 Short Run vs Long Run
E. The short run is the time period that is too brief for a firm to alter its plant capacity.
The plant size is fixed in the short run. Short-run costs, then, are the wages, raw materials, etc., used for production in a fixed plant. F. The long run is a time period long enough for a firm to change the quantities of all resources employed, including the plant size.
Long-run costs are all costs, including the cost of varying the size of the production plant. Normal Profits • Treated as a cost • Required to attract & retain resources retain resources
Economic Profit Total Revenue ECONOMIC COSTS Economic or Pure Profits
Economic Cost Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 Profit
Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72 $72,000. Calculate accounting profits and economic profits for Calculate accounting profits and economic profits for Gomez’s pottery.
Explicit costs: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials). Implicit costs: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship). Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs); Economic profit = $13,000 (= $72,000 - $37,000 of explicit costs $22,000 of implicit costs). Principles of Microeconomics,SP 2010 Profit
Suppose Suppose that Daniel and Gordon have opened a delicatessen delicatessen in a building that they own in a shopping mall;
have have invested $60,000 of their own financial capital in it; and and consider its management to be their full-time jobs. full-time The income statement that might be prepared by an economist is illustrated as follows. econom ill
Note that we subtracted amounts for the firm’s owners’ implicit implicit opportunity costs from accounting profit.
Estimated Estimated rental income that the firm’s owners’ could have earned on the the building by leasing it to another business, The The monthly salary that Daniel and Gordon could expect to make if they worked for someone else, and An expected return on the $60,000 capital if invested elsewhere (with equal risk).
Principles of Microeconomics,SP 2010 2 Profit
Total Revenue (sales) Less Cost of Goods Sold Gross profit Less Operating Expenses Operating (Business or Operating (Business or Accounting Profit) Net Income Income (-) Implicit Rental Income Implicit Salary Income Implicit Interest Income Economic Profit $5,400 12,000 600 18,000 $12,000 $140,000 60,000 $80,000 50,000 $30,000 The Production Function
For For simplicity we will often consider a production function function of two inputs: Q=f(X, Y) Q: output output X: Labor Y: Capital Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 The Production Function
The shortThe short-run production function shows the maximum shows quantity of good or service that can be produced by a set of inputs, assuming the amount of at least one of the inputs used remains remains unchanged. The lon The long-run production function shows the maximum shows quantity of good or service that can be produced by a set of inputs, assuming the firm is free to vary the amount of all the inputs inputs being used. ShortShort-Run Analysis of Total, Average, and Marginal Product
Alternative terms in reference to inputs
Inputs Factors Factors of production Resources Alternative terms in reference to outputs
Output Quantity (Q) Total product (TP) Product Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 3 ShortShort-Run Analysis of Total, Average, and Marginal Product
Law Law of Diminishing Returns: As additional units of a variable input are combined with a fixed input, at some point the additional additional output (i.e., marginal product) starts to diminish.
Nothing Nothing says when diminishing returns will start to take effect, when diminishing only only that it will happen at some point. All All inputs added to the production process are exactly the same in individual individual productivity SHORT-RUN PRODUCTION RELATIONSHIPS
A. Short-run production reflects the law of diminishing returns that states that as successive units of a variable resource are added to a fixed resource, beyond some point the product attributable to each additional resource unit will decline. Table 1 in the book presents a numerical example of the law of diminishing returns law of diminishing returns.
Total product (TP) is the total quantity, or total output, of a particular good produced. Marginal product (MP) is the change in total output resulting from each additional input of labor. Average product (AP) is the total product divided by the total number of workers.
Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 SHORT-RUN PRODUCTION RELATIONSHIPS
The following figure illustrates the law of diminishing returns graphically and shows the relationship between marginal, average, and total product concepts.
a. When marginal product begins to diminish, the rate of increase in total product stops accelerating and grows at a diminishing rate. b. The average product declines at the point where the marginal product slips below average product. c. Total product declines when the marginal product Principles becomes negative. of Microeconomics,SP 2010 SHORT-RUN PRODUCTION RELATIONSHIPS
B. The law of diminishing returns assumes all units of variable inputs—workers in this case—are of equal quality. Marginal product diminishes not because successive workers are inferior but because more workers are being used relative to the amount of plant and equipment available. Principles of Microeconomics,SP 2010 4 Average Product, AP, and Marginal Product, MP Quantity of Labor Average Product, AP, and Marginal Product, MP rising. If MP < AP then AP is falling. MP=AP MP=AP when AP is maximized. maximized. Total Product Total Product, TP Total Product, TP SHORT-RUN PRODUCTION RELATIONSHIPS If If MP > AP Law of Diminishing Returns then AP is
Increasing I i Marginal Returns
Average Product Marginal Product SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns
Total Product Quantity of Labor Diminishing Marginal Returns
Average Product Marginal Product Principles of Microeconomics,SP 2010 Quantity of Labor Principles of Microeconomics,SP 2010 Quantity of Labor Total Product, TP SHORT-RUN PRODUCTION RELATIONSHIPS Law of Diminishing Returns
Total Product The The Relationship Between Production Production and Cost
Cost Cost function is simply the production function expressed expressed in monetary rather than physical units. Assume Assume the firm is a “price taker” in the input market. market. Average Product, AP, and Marginal Product, MP Quantity of Labor Negative Marginal Returns
Average Product Marginal Product Principles of Microeconomics,SP 2010 Quantity of Labor Principles of Microeconomics,SP 2010 5 The Short-Run Cost Function ShortStandard variables in the short-run cost function: shortQuantity Quantity (Q): the amount of output that a firm can produce in in the short run. Total Total fixed cost (TFC): the total cost of using the fixed input, input, capital (K). Total fixed costs are those costs whose total does not vary with changes in short vary with changes in short-run output. output. Total Total variable cost (TVC): the total cost of using the variable variable input, labor (L) Costs that change with the level of output. They include payment for materials, fuel, power, transportation services, most labor, and similar costs. Total Total cost (TC): the total cost of using all the firm’s inputs, L and K. and TC = TFC + TVC
Principles of Microeconomics,SP 2010 The Short-Run Cost Function ShortStandard variables in the short-run cost function: shortAverage fixed cost (AFC): the average per-unit cost of per-unit using using the fixed input K. The total fixed cost divided by the level of output =AFC = TFC/Q It will decline as output rises. will decline as output rises Average variable cost (AVC): the average per-unit cost of per-unit using using the variable input L. AVC = TVC/Q Average total cost (AC) is the average per-unit cost of per-unit using using all the firm’s inputs. AC = AFC + AVC = TC/Q Marginal Marginal cost (MC): the change in a firm’s total cost (or total total variable cost) resulting from a unit change in output. MC MC = TC/ Q = TVC/ Q TC/ TVC/
Principles of Microeconomics,SP 2010 SHORT-RUN PRODUCTION RELATIONSHIPS
The marginal cost is related to AVC and ATC.
These average costs will fall as long as the marginal cost is less than either average cost. SHORT-RUN PRODUCTION RELATIONSHIPS
Cost curves will shift if the resource prices change or if technology or efficiency change. Which of the following are short-run and which are long-run adjustments?
(a) Wendy’s builds a new restaurant; (b) Acme Steel (a) Wendy builds new restaurant; (b) Acme Steel Corporation hires 200 more production workers; (c) A farmer increases the amount of fertilizer used on his corn crop; and (d) An Alcoa plant adds a third shift of workers. As soon as the marginal cost rises above the average, the average will begin to rise. average will begin to rise
You can think of your grade-point averages with the total GPA reflecting your performance over your years in school, and your marginal grade points as your performance this semester. If your overall GPA is a 3.0, and this semester you earn a 4.0, your overall average will rise, but not as high as the marginal rate from this semester.
Principles of Microeconomics,SP 2010 (a) Long run, (b) Short run, (c) Short run, (d) Short run
Principles of Microeconomics,SP 2010 6 SHORT-RUN COSTS GRAPHICALLY
Total Total variable cost (TVC) changes with output. Total fixed coast (TFC) is independent of the the level of output. The total cost (TC) at any output is the vertical sum of the fixed cost and variable cost at that point. Costs (dollars) Total Cost Variable Cost TFC
Quantity Costs (dollars) Combining TVC With TFC to get Total Cost TC TVC
Fixed Cost The marginal-cost (MC) curve cuts through the average-total-cost marginalaverage-total-cost (ATC) (ATC) curve and the average-variable-cost (AVC) curve at their average-variable-cost minimum minimum points
When When MC is below average total cost, ATC falls falls When When MC is above average total cost ATC total cost, ATC rises rises When When MC is below average variables cost, AVC AVC falls When When MC is above average variable cost, AVC AVC rises MC Plotting Average and Marginal Costs ATC AVC AFC
Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 The Short-Run Cost Function ShortImportant Observations
AFC declines steadily over the range of production. When MC = AVC, AVC is at a minimum. When MC < AVC, AVC is falling. When MC > AVC, AVC is rising. The The same three rules apply for average cost (AC) as for for AVC. The Short-Run Cost Function ShortA reduction in the firm’s fixed cost would cause the reduction average average cost line to shift downward. A reduction in the firm’s variable cost would cause reduction all all three cost lines (AC, AVC, MC) to shift. Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 7 The Long-Run Cost Function LongIn In the long run, all inputs to a firm’s production function may be be changed. Because there are no fixed inputs, there are no fixed costs. The The long run production process is described by the concept of returns to scale returns to scale. The firm’s long run marginal cost pertains to returns to scale. First, increasing returns to scale. As As firms mature, they achieve constant returns, then ultimately ultimately decreasing returns to scale. The Long-Run Cost Function LongWhen a firm experiences increasing returns to scale:
A proportional increase in all inputs increases output proportional by by a greater proportion. As As output increases by some percentage, total cost of production increases by some lesser percentage. Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 The Long-Run Cost Function LongEconomies of Scale: situation where a firm’s longlongrun run average cost (LRAC) declines as output increases. increases. Diseconomies Diseconomies of Scale: situation where a firm’s LRAC increases as output increases. In general, the LRAC curve is u-shaped. u- The Long-Run Cost Function LongReasons for long-run economies longSpecialization in the use of labor and capital. Prices Prices of inputs may fall as the firm realizes volume discounts discounts in its purchasing. Use of capital equipment with better price-performance price-performance ratios ratios. Larger Larger firms may be able to raise funds in capital markets at at a lower cost than smaller firms. Larger firms may be able to spread out promotional costs. Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 8 The Long-Run Cost Function LongReasons for Diseconomies of Scale
Scale Scale of production becomes so large that it affects the total market market demand for inputs, so input prices rise. Transportation costs tend to rise as production grows. Handling Handling expenses, insurance, security, and inventory costs costs affect transportation costs. LONG-RUN PRODUCTION COSTS
In the long run, all production costs are variable, i.e., long-run costs reflect changes in plant size, and industry size can be changed (expand or contract).
The following figure illustrates different short-run cost curves for five different plant sizes. long curve shows the least per unit cost at The long-run ATC curve shows the least per unit cost at which any output can be produced after the firm has had time to make all appropriate adjustments in its plant size. Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 Economies or diseconomies of scale exist in the long run. LONG-RUN PRODUCTION COSTS
1. Economies of scale or economies of mass production explain the downward-sloping part of the long-run ATC curve, i.e., as plant size increases, long-run ATC decrease.
Labor and managerial specialization is one reason for this. The ability to purchase and use more efficient capital goods also may explain economies of scale. Other factors may also be involved, such as design, development, or other “start up” costs such as advertising and “learning by doing.” LONG-RUN PRODUCTION COSTS
Both economies of scale and diseconomies of scale can be demonstrated in the real world.
Larger corporations at first may be successful in lowering costs and realizing economies of scale. To keep from experiencing diseconomies of scale, they may decentralize decision making by utilizing smaller production units. 2. Diseconomies of scale may occur if a firm becomes too large, as illustrated by the rising part of the long-run ATC curve.
For example, if a 10 percent increase in all resources result in a 5 percent increase in output, ATC will increase. Some reasons for this include distant management, worker alienation, and problems with communication and coordination. The concept of minimum efficient scale defines the smallest level of output at which a firm can minimize its average costs in the long run.
1. The firms in some industries realize this at a small plant size: apparel, food processing, furniture, wood products, snowboarding, and small-appliance industries are examples. 2. In other industries, in order to take full advantage of economies of scale, firms must produce with very large facilities that allow the firms to spread costs over an extended range of output.
Examples would be automobiles, aluminum, steel, and other heavy industries. This pattern also is found in several new information technology industries.
Principles of Microeconomics,SP 2010 3. Constant returns to scale will occur when ATC is constant over a variety of plant sizes.
Principles of Microeconomics,SP 2010 9 LONG-RUN PRODUCTION COSTS LONG-RUN PRODUCTION COSTS Unit Costs Output
Principles of Microeconomics,SP 2010 Unit Costs Output
Principles of Microeconomics,SP 2010 LONG-RUN PRODUCTION COSTS
The long-run ATC just “envelopes” all of the short-run ATC curves. LONG-RUN PRODUCTION COSTS Unit Costs Unit Costs long-run ATC Output
Principles of Microeconomics,SP 2010 Output
Principles of Microeconomics,SP 2010 10 ECONOMIES AND DISECONOMIES OF SCALE
Economies of scale ECONOMIES AND DISECONOMIES OF SCALE
Economies of scale Constant returns to scale Unit Costs long-run ATC
Output Unit Costs long-run ATC
Output Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 ECONOMIES AND DISECONOMIES OF SCALE ECONOMIES AND DISECONOMIES OF SCALE
Where economies of scale are scale are quickly exhausted long-run ATC
Output Unit Costs long-run ATC
Output Principles of Microeconomics,SP 2010 Unit Costs Where extensive economies of scale exist Principles of Microeconomics,SP 2010 11 Economies of Scope
Economies Economies of Scope: reduction of a firm’s unit cost by producing two or more goods or services jointly rather rather than separately. Closely related to economies of scale. LONG-RUN PRODUCTION COSTS
Applications and illustrations. 1. The terrorist attacks on September 11, 2001, have led to rising insurance and security costs. Some of these costs are fixed (insurance premiums and security cameras), while others are variable (number of security guards). Both have resulted in an upward shift of the ATC curves. 2. Recently there have been a number of start-up firms that have been able to take advantage of economies of scale by spreading product development costs and advertising costs over larger and larger units of output and by using greater specialization of labor, management, and capital. Newspapers can be produced for low cost and thus sold for low price 3. Newspapers can be produced for a low cost and thus sold for a low price because publishers are able to spread the cost of the printing equipment over an extremely large number of units each day. 4. The aircraft assembly and ready-mixed concrete industries provide extreme examples of differing MESs.
Economies of scale are extensive in manufacturing airplanes, especially large commercial aircraft. As a result, there are only two firms in the world (Boeing and Airbus) that manufacture large commercial aircraft. The concrete industry exhausts its economies of scale rapidly, resulting in thousands of firms in that industry. Principles of Microeconomics,SP 2010 Principles of Microeconomics,SP 2010 Sunk Costs
Sunk Costs Sunk costs should be disregarded in decision making. 1. The old saying “Don’t cry over spilt milk” sends the message that if there is nothing you can do about it, forget about it. 2. A sunken ship on the ocean floor is lost, it cannot be recovered. It is what economists’ call a “sunk cost.” 3. Economic analysis says that you should not take actions for which marginal cost exceeds marginal benefit. 4. Suppose you have purchased an expensive ticket to a football game and you are sick the day of the game; the price of the ticket should not affect your decision to attend. In making a new decision, you should ignore all costs that are not affected by the decision. 1. A prior bad decision should not dictate a second decision for which the marginal benefit is less than the marginal cost. 2. Suppose a firm spends a million dollars on R&D only to discover that the product sells very poorly. The loss cannot be recovered by losing still more money in continued production. 3. If a cost has been incurred and cannot be partly or fully recouped by some other choice, a rational consumer or firm should ignore it. 4. Sunk costs are irrelevant! Don’t cry over spilt milk!
Principles of Microeconomics,SP 2010 Sources
Paul G. Keat and Philip K.Y. Young, Managerial Economics, 5th Edition, Prentice Hall, 2006. Mark Hirschey, Managerial Economics, 10th Edition, South-Western, 2003. McConnell and Stanley Brue McConnell and Stanley Brue, Microeconomics, 16th 16th edition, 2006. R. Glenn Hubbard and Anthony P. O'Brien, Microeconomics,1st edition 2006. Principles of Microeconomics,SP 2010 12 ...
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This note was uploaded on 04/15/2010 for the course ECON 2306 taught by Professor Bailiff during the Spring '08 term at UT Arlington.
- Spring '08