Lecture Notes Chapter 9: Businesses and the Costs 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 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 the graph AFC, AVC, ATC, and Marginal Cost when given total cost data.

10. Explain how AVC, ATC, and Marginal Cost relate to one another.

11. Relate average product to average variable cost, and marginal product to marginal cost.

12. Explain what can cause cost curves to rise or fall.

13. Explain the difference between short-run and long-run costs.

14. State why the long-run average cost is expected to be U-Shaped.

15. List causes of economies and diseconomies of scale.

16. Indicate relationship between economies of scale and number of firms in an industry.

17. Define and identify terms and concepts listed at the end of the chapter.

Lecture Notes

I. Learning Objectives - After reading this chapter, students should be able to:

1. Explain why economic costs include both explicit (Revealed and expressed) costs and implicit (Present but not obvious) costs.

2. Relate the law of diminishing returns to a firm’s short-run production costs.

3. Describe the distinctions between fixed and variable costs and among total average, and marginal costs.

4. Use economies of scale to link a firm’s size and its average costs in the long run.

5. Give business examples of short-run costs, economies of scale, and minimum efficient scale (MES).

II. Economic Costs

1. 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.

2. Explicit costs are payments to non-owners for resources they supply. in the text’s example this would include cost of the T-shirts, clerk’s salary, and utilities, for a total of $63,000.

3. 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 $33,000.

4. 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.

5. Economic or pure profits are total revenue less all costs (Explicit and implicit including a normal profit). The economic profits in the example are $24,000 (After $63,000 + $33,000 are subtracted from $120,000).

6. Economic profit steers resources in such a way that is allocatively efficient.

7. 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.

8. The long run is a period of time 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.

III. Short-Run Production Relationships

1. 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 will decline.

   1. Example: Consider This… Diminishing Returns from Study

      1. Success in a course depends on a variety of factors like course materials, intelligence, and study time, etc.

      2. Study time is the only factor that is variable, and at some point another hour of studying adds less to total learning than the previous hour.

   2. Total product (TP) is the total quantity, or total output, of a particular good or service produced.

   3. Marginal product (MP) is the change in total output resulting from each addition input of labor.

   4. Average product (AP) is the total product divided by the total number of workers.

   5. Figure 9.2 (Key Graph) illustrates the law of diminishing returns graphically and shows the relationship between marginal, average, and total product concepts.

      1. When marginal product begins to diminish, the rate of increase in total product stops accelerating and grows at a diminishing rate.

      2. The average product declines at the point at which the marginal product slips below average product.

      3. Total product declines when the marginal product becomes negative.

2. 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.

IV. Short-Run Production Costs

1. Fixed, variable and total costs are the short-run classifications of costs.

   1. Total fixed costs are those costs whose total does not vary with changes in short-run output.

   2. Total variable costs are those costs that change with the level of output. They include payment for materials, fuel, power, transportation services, most labor, and similar costs.

   3. Total cost is the sum of total fixed and total variables cost at each level of output.

2. Per unit or average costs are shown in Table 9.2, columns 5 to 7.

   1. Average fixed cost is the total fixed cost divided by the level of output (TFC/Q). It will decline as output rises.

   2. Average variable cost is the total variable cost divided by the level of output (AVC = TVC/Q).

   3. Average total cost is the total cost divided by the level of output (ATC = TC/Q), sometimes called unit cost or per unit cost. Note that ATC also equals AFC + AVC.

3. Consider This - Ignoring Sunk Costs

   1. “Sunk costs” are costs incurred in the past. That is, these are costs that you have already incurred and these costs should not affect your decision at the margin.

   2. Example: You purchase apples on a vacation stop and later down the road you find out the apples are bad. Do you force your family to eat them? No, you cannot undo the expenditure on apples, so your decision is to eat the apples or not eat the apples (Note that in either case you have paid for the apples). You choose the best option for your family, which is to not eat the apples.

4. Marginal cost is the additional cost of producing one more unit of output (MC = Change in TC / Change in Q).

   1. Marginal cost can also be calculated as MC = Change in TVC / Change in Q.

   2. Marginal decisions are very important in determining profit levels. Marginal revenue and marginal cost are compared.

   3. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise.

   4. 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. As soon as the marginal cost rises above the average, the average will begin to rise. Students can think of their grade-point averages with the total GPA reflecting their performance over their years in school, and their marginal grade points as their performance this semester. If their overall GPA is a 3.0, and this semester they earn a 4.0, their overall average will rise, but not as high as the marginal rate from this semester.

5. Cost Curves will shift if the resource prices change or if technology or efficiency change.

V. Long-Run Production Costs

1. All production costs are variable, i.e., long-run costs reflect changes in plant size, and industry size can be changed (Expand or contract).

2. 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.

3. Economies or diseconomies of scale exist in the long run.

   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 decreases.

      1. Labor and managerial specialization is one reason for this.

      2. Ability to purchase and use more efficient capital goods may also explain economies of scale.

      3. Other factors may also be involved, such as design, development, or other “start up” costs such as advertising and “learning by doing”.

   2. Diseconomies of scale may occur if a firm become too large, as illustrated by the rising part of the long-run ATC curve. For example, if a 10% increase in all resources results in a 5% increase in output, ATC will increase. Some reasons for this include distant management, worker alienation, and problems with communication and coordination.

   3. Constant returns to scale will occur when ATC is constant over a variety of plant sizes.

4. 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.

5. 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 is also found in several new information technology industries.

VI. Applications and Illustrations

1. As gas prices rise, it causes most firms’ short-run variable costs to also increase since most firms use gasoline to some extent, thereby increasing the AVC, MC, and ATC.

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.

3. In 1996, Verson (A firm located in Chicago) introduced a stamping machine the size of a house, weighing as much as 12 locomotives. This $30 million dollar machine enables automakers to produce in 5 minutes what used to take 8 hours. To justify use of this machine. The auto manufacturer has to be a large producer so that the fixed costs of the machine are spread over a large output.

4. With the Internet, there’s a decrease in news readership and advertising in newspapers. This results in a higher AFC (Fixed costs spread out over a smaller level of output) forcing newspaper companies to increase their prices, which causes a further reduction in news readership, resulting in many newspaper companies to go bankrupt.

5. 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.

VII. Last Word: 3-D Printers Are Poised to Replace Mass Production with Mass Customization

1. The reason why certain products that cost a large amount to develop are available at a low cost too all consumers is the result of mass production.

   1. Marginal cost is typically low for goods that are mass-produced (And sold). This result holds because the producer can spread the fixed cost over a large number of goods produced.

   2. This ability to spread fixed cost over a large number of goods is known as economies of scale.

2. Mass production and mass sales are not easy. This type of market became possible during the industrial revolution during the late 1700s.

   1. Along with mass production, the ability to transport these goods over a large area was also a requirement for economies of scale. The producer needed to reach a large number of consumers for mass sales.

   2. The mass sale requirement required (And still requires) a large investment by society to provide the transportation infrastructure needed for these mass sales (Cost to society).

3. Now a new type of technology promises to deliver a Third Industrial Revolution that will feature not only low cost but also zero transportation cost. The new technology is called additive manufacturing, and it creates objects using computer-controlled devices known as 3-D printers.

   1. These printers use lasers to construct 3-D objects that no longer require shipping.

   2. These objects can also be fully customized.

   3. The only major cost is the programming design for each object.