EC 201 Lecture 8
Dr. Bresnock
EC 201
Cal Poly Pomona
Dr. Bresnock
Lecture 8
Opportunity Costs -- value of the next best alternative. (Remember production possibilities curve description.)
Explicit Costs -- monetary payments for resources that are external to the firm. i.e. payments for any labor, capital, land and/or entrepreneurial ability which are not owned by the firm. All explicit costs are opportunity costs.
Implicit Costs -- opportunity costs of self-owned, self-employed resources in their next best alternative use. i.e. If I hire myself to run my own business then the implicit cost for my self-employed labor is the salary that I will forgo in the next best alternative job if I were hired by another employer.
Note: Economists count all explicit and implicit costs prior to reporting a residual or “pure economic profit.” In other words, economists account for wages paid to labor, interest paid to capital, rent paid to land, and a “normal” profit paid to the entrepreneurial to cover risk, etc. Any residual revenue that remains after deducting these four categories of resource payments is the “pure economic profit.” Technically the “normal” profits that are the payment to the entrepreneurial are an implicit cost. Thus, since accountants count only explicit costs prior to determining their “profits,” accountants’ profit figures lump “normal” and “pure” economic profit together.
Diagram 1 Economic vs. Accounting Profits
Note: Production costs are distinguished between short-run and long-run costs. The short-run is defined as a time period too short to allow a firm to alter its plant capacity but long enough to allow for more or less intensive use of existing plant capacity. i.e. In the short-run, the existing plant capacity may be utilized at 60%, 85%, 100%, etc. capacity. In the long-run, new plants can be built. Thus, the long-run time period is long enough to allow for changes in the existing number of plants, and other changes that emerge from technological change.
Ex. “Footloose firms” like software developers – can move easily, can replace equipment easily – thus the short run may be very short, i.e. days. The auto industry uses lots of capital equipment in the form of factories, machinery, etc. Auto plants do not change location. Hence the short run for the auto industry may be very long indeed, i.e. 15 – 20 years.
Note: The concept of diminishing returns applies due to a fixed factor of production and is thus a short run concept. In the long run, there is no such thing as diminishing returns.
Production Costs in the Short-Run
In the short-run variable resources can be added to increase production or decrease production. The law of diminishing returns underlies the relationship between short-run costs and the physical production process.
Fixed Costs -- costs that do not change as output changes. These costs must be paid evenif output is zero. i.e. rent, insurance, salaries to top management, interest.
TFC = Total Fixed Cost. (Overhead Cost)
Graph 1 Total Fixed Cost
Variable Costs -- costs which increase with levels of output or decrease when output is decreased. i.e. materials, fuel, most labor.
TVC = Total Variable Cost.
Graph 2 Total Variable Cost
Note: Initially as variable costs increase the rate of change of these variable costs is decreasing. This growth pattern of variable costs can be tracked back to the production function where one will see that MP is increasing when the variable costs are increasing at a decreasing rate. Once the point of diminishing returns is reached, however, variable costs grow at an increasing rate and MP is declining at the same time. The connection between production costs and the production function is critical to understanding decision making by the firm.
Total Costs -- the sum of all fixed and variable costs. Thus,
TC = TFC + TVC
Graph 3 Total Cost
Average, or Per Unit, Costs -- these costs are determined at a particular level of output. They are most useful in quick comparisons.
Average Fixed Costs -- defined as
AFC = TFC/Q where Q represents units of output
Graph 4 Average Fixed Cost
Note: AFC declines as Q increases. In other words, the fixed cost is spread over more units of output, sometimes referred to as “spreading the overhead.”
Average Variable Costs -- defined as
AVC = TVC/Q
Graph 5 Average Variable Cost
Average Total Costs – defined as
ATC = TC/Q
Graph 6 Average Total Cost
Marginal Costs -- the extra, or additional, cost of producing one more unit of output.
MC = Change in TC = TC = TC2 – TC1
Change in Q Q Q2 – Q1
Marginal Cost may also be defined as:
MC = Change in TVC = TVC = TVC2 – TVC1
Change in Q Q Q2 – Q1
WHY?
Note: The relationship between: (a) TC, TVC and MC, (b) TP, MP and MC, and (c) relationship between AVC, ATC, and MC. The MC curve cuts the AVC and ATC curves at their minimum points.
Graph 7 Total Cost, Total Variable Cost, and Marginal Cost
Graph 8 Marginal Product and Marginal Cost
Graph 9 Marginal Cost, Average Total Cost and Average Variable Cost
Note: Practice calculating these costs by working out the first 8columns of “Additional Problem 4” Costs. Do not continue with the remaining portions of Additional Problem 4 until we have completed market structure lectures.
Production Costs in the Long Run
In the long run firm’s can adjust their plant size as the demand for their product grows over time. This adjustment is depicted below.
Graph 10 Constructing the Long Run Average Total Cost
Graph 11 Long Run Average Total Cost
Note: The Long Run Average Cost (LRAC) is also referred to as the “planning curve”. The LRAC is a locus, or collection, of points representing the least average total cost at each output level after the firm has had the time to make the necessary adjustments.
Economies of Scale = ing LRAC = shown as the declining, left portion of the U-shaped LRAC. This long run decline in unit costs may result from:
(a)Labor Specialization – division of labor, cost and time savings,
(b)Managerial Specialization – division of labor, efficiencies in time and costs,
(c)Efficient Capital – efficiencies in size of equipment that may be used, and
(d)Other Factors – spreading start-up costs, by-product development.
Diseconomies of Scale = ing LRAC shown as the inclining, right portion of the U-shaped LRAC. This long run increase in unit costs may result from:
(a)Inefficiencies – size “too large”,
(b)Worker Alienation
(c)Shirking Behavior
Some Applications
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