Microeconomics: COST OF PRODUCTION

ECONOMIC COSTS

economic costs encompass both explicit and implicit costs. Explicit costs are the direct out-of-pocket payments that a firm makes to acquire resources. Implicit costs represent the opportunity cost of using resources a firm already owns.

EXPLICIT COSTS

Monetary payments for resources. (eg. wages, rent, materials)

IMPLICIT COSTS

The value of the next best use of self-owned resources (eg. forgone salary, forgone rent)

EXPLICIT AND IMPLICIT COST EXAMPLE

A BUSINESS OWNER USES ITS OWN BUILDING FOR ITS COMPANY. THE EXPLICIT COSTS ARE THE BILLS THAT THEY PAY, WHILE IMPLICIT COSTS ARE THE RENT THEY COULD HAVE EARNED BY LEASING THE BUILDING TO SOMEONE ELSE.

NORMAL PROFITS AS A COST

Normal profit is the MINIMUM level of profit needed to keep a firm operating in a particular industry. It is significant because it represents the opportunity cost of an entrepreneur’s time and investment.

ECONOMIC PROFIT

TOTAL REVENUE MINUS TOTAL COSTS (INCLUDING EXPLICIT AND IMPLICIT COSTS)

• EP= TR - TC (E+I)

ECONOMIC OR PURE PROFIT

Economic profit is the profit earned above and beyond normal profit. It represents the return that exceeds what is necessary to keep resources employed in their current use.

ECONOMIC PROFIT > 0

The firm is earning more than its opportunity cost.

ECONMIC PROFIT = 0

The firm is earning just enough to cover its opportunity cost (normal profit).

ECONOMIC PROFIT < 0

The firm is earning less than its opportunity cost (economic loss).

SHORT RUN AND LONG RUN DISTINCTION

The distinction between the short run and the long run is:

• The short run has some inputs fixed

• The long run all inputs are variable.

SHORT RUN (Shawty 🎶= short run is the melody in my head)

A period where at least one input is fixed (eg. plant size)

LONG RUN (run boy run 🎶= long run, run)

A period long enough for the firm to adjust all inputs ( including plant size)

LAW OF DIMINISHING RETURNS (PRODUCTION COST IN THE SHORT RUN)

The law of diminishing returns states that as successive units of a variable input are added to a fixed input, beyond a certain point, the marginal product of the variable input will decrease.

MARGINAL PRODUCT (MP) (krusty krab pizza 🎶🎵= Marginal product is the product for you and me)

The additional output produced by adding one more unit of variable input.

DIMINISHING RETURNS (Divorce babes, divorce = Diminishing returns, babes, Diminishing)

MP eventually decreases as more variable input is added.

EXAMPLE OF THE LAW OF DIMINISHING RETURNS (praise to the law)

adding more workers to a fixed amount of machinery will eventually lead to smaller increases of output.

Fixed costs, Variable costs, And Total costs. (read like dr.suess)

These are the fundamental cost categories in the short run. Fixed costs do not vary with output, variable costs do, and total cost is the sum of the two.

FIXED COSTS (NOT ON MY WATCH!)

costs that do not change with the level of output. (eg. rent, insurance)

VARIABLE COSTS (Ayeeee)

costs that vary with the level of output.

TOTAL COSTS (IF FIXED AND VARIABLE HAD A BABY)

The sum of fixed and variable costs.

Formula: TC= FC + VC

PER UNIT OR AVERAGE COSTS ( goes around the world nanananana🎶)

Average costs are calculated by dividing total costs by the quantity of output. They provide a per-unit measure cost.

AVERAGE FIXED COST (AFC easy as 123)

Fixed cost divided by the quantity of output.

AVERAGE VARIABLE COSTS (AVC easy as 123)

Variable cost divided by the quantity of output.

AVERAGE TOTAL COST (ATC easy as 123)

Total cost divided by quantity of output.

MARGINAL COST (MC)

Is the additional cost of producing one more unit of output. it is a crucial concept for making production decisions.

• The change in total cost from producing one more unit of output.

• Formula: MC= TC/Q

RELATIONSHIP TO MP ( when i was 13 I had my first luv 🎶)

MC is inversely related to MP. when MP is increasing, MC is decreasing and vise versa.

SHIFTING THE COST CURVES (“but they say when you shift your perspective”- kevin gates)

Cost curves can shift due to changes in input prices, technology or other factors.

• Example: An increase in the price of raw materials will increase variable costs, shifting the AVC, ATC, and MC curves upward.

INPUT PRICES ( to the moon 🚀 )

An increase in input prices will shift the cost curves upward.

TECHNOLOGY (womp womp)

Technological improvements can shift the cost curves downward. (womp womp)

ECONOMIES AND DISECONOMIES OF SCALE:

Economies of scale occur when long-run average total cost decreases as output increases. Diseconomies of scale occur when long-run average total cost increases as output increases.

ECONOMIES OF SCALE

factors that cause ATC to decrease as output increases (eg., specialization, efficient capital.)

DISECONOMIES OF SCALE:

FACTORS THAT CAUSE ATC TO INCREASE AS OUTPUT INCREASES. (eg management difficulties, communication problems).

CONSTANT RETURNS TO SCALE

ATC remains constant as output increases.

MINIMUM EFFICIENT SCALE (MES)

is the lowest level of output at which a firm can minimize its long-run average total cost. The MES can influence the structure of an industry.

INDUSTRY STRUCTURE

The MES can determine whether an industry is dominated by a few large firms or many small firms.

• example if the MES is a large percentage of the total market, the industry is likely to be dominated by a few large firms.