Chapter 7

Production and Cost

in the Firm

© 2009 South-Western/Cengage Learning

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Cost for the firm

• All costs are opportunity costs– the true measure of doing something is

its full opportunity cost

• Explicit costs– cost of market purchased inputs

• Implicit costs – cost of owner-owned resources

Profit

• Economic profit– Total revenue minus total costs

• Includes full opportunity cost of all resources

• Accounting profit– Total revenue minus explicit costs

• Can see positive accounting profit where zero or negative economic profit exists

3

Profit

• Normal profit– that level of accounting profit necessary

to pay all resources their full opportunity cost• A normal profit implies zero economic profit

• Any accounting profit in excess of a normal profit is economic profit

• Firm’s goal is to maximize profit4

Exhibit 1Wheeler Dealer Accounts, 2007

5

Total revenue $105,000

Less explicit costs:Assistant’s salaryMaterial and equipment

- $21,000- $20,000

Equals accounting profit $64,000

Less implicit costs:Wanda’s forgone salaryForgone interest on savingsForgone garage rental

-$50,000- $1,000- $1,200

Equals economic profit $11,800

Planning horizons matter

• 2 planning horizons

• Short run– period of time where at least 1 resource

is fixed

• Long run – period of time where all resources vary

6

Decisions made

• Short Run decision making revolves around choosing those inputs that can vary

• Long Run decision making revolves around choosing the scale of operation

• Both types of decisions are being made simultaneously

7

Short Run

• Choosing our variable inputs• Total Product

– total output as a function of our variable input

• Marginal product– change in total product for a change in

the variable input• MPL = ∆TPL / ∆L

8

Law of Diminishing Returns

• As we increase the use of 1 input only, eventually output increases at a decreasing rate– eventually MP falls

9

Costs in the Short Run

• Fixed cost FC– cost of hiring the fixed resources

• Variable cost VC– cost of hiring the variable resourcesFull opportunity costs are being included in FC and VC

• Total cost TC = FC + VC• Marginal cost MC = ∆TC/∆q

– change in TC to produce one more unit of output

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Costs in the Short Run

• Changes in MC– Reflect changes in marginal productivity

• Increasing marginal returns– MC falls

• Diminishing marginal returns– MC increases

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More SR Costs

Average Cost

AC = TC / q

= (FC + VC) / q

= FC/q + VC/q

Average Fixed Cost

AFC = FC/q

Average Variable Cost

AVC = VC/q12

Average Cost in the Short Run

AC = TC/q

When MC < ACAC is falling

When MC > AC AC is rising

When MC = ACAC is minimum

U-shape of average cost curves reflects the law of diminishing returns

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Costs in the Long Run

• All resources can be varied– maybe not all are but they can be

• Decision here involves choosing the scale of operation– how large of a business?

– what should be our optimal level of output?

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Costs in the Long Run

• U-shaped long-run average cost curve– LRAC = TC/q (when all inputs can vary)

• Economies of scale– LRAC falls as output expands

• Diseconomies of scale– LRAC increases as output expands

• Constant returns to scale– LRAC remains unchanged as output expands– LRAC is at minimum

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Exhibit 8Short-run ATC curves form the LRAC curve

16

Cos

t pe

r un

it

0 q qa q’ Output per periodqb

S

S’

M M’

L

L’SS’, MM’, LL’ are short run ATC curves

Long run ATC curve: SabL’

a b

ATC1

ATC2

Exhibit 9Many short-run ATC curves form firm’s LRAC curve

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0 q q’ Output per period

Many possible plant sizes

Cos

t pe

r un

it

$11

10

9

b

ATC3

ATC4

ATC5

ATC6

ATC7

ATC8

ATC9

ATC10

Long-run

average cost

c

a

Each short-run curve is

tangent to the long run

average cost curve

Each point of tangency represents the least cost way of producing that

level of output

Sources of Economies of Scale

• Specialization of inputs lowers costs• Better technology available at higher

levels of production• Some financial expenditures are spread

out• Multi-plant operations save costs

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Sources of Diseconomies of Scale

• Organizational– large bureaucracy can result in increased

costs• cost of decision making• cost of management

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Exhibit 10A firm’s long-run average cost curve

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Cos

t pe

r un

it

0 A Output per periodB

Economies

of scale

Long-run

average cost

Diseconomies

of scale

Constant

average cost

LRAC

• Minimum Efficient Scale– level of output where constant returns to

scale is achieved• lowest q where LRAC is minimized

– All economies of scale have been taken advantage of and diseconomies of scale have not kicked in yet• economies of scale balance out

diseconomies of scale21

Review on Costs

• Short Run Costs– MC and AC are U-shaped due to law of

diminishing returns

• Long Run Costs– AC is U-shaped due to economies and

diseconomies of scale

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