Chapter 7: Cost and Industry Structure

7.1 Explicit and Implicit Costs, and Accounting and Economic Profit

• Explicit costs

  • Out-of-pocket costs, payments for wages and salaries, rent, materials, etc.

• Implicit costs

  • Opportunity costs of resources owned by the firm and used in business (e.g., working in the business without a formal salary, using home space as a store).

  • Include depreciation of goods, materials, and equipment necessary for operation.

• Accounting profit

  • Defined as: \text{Accounting profit} = \text{Total Revenue} - \text{Explicit Costs}

  • Explicit costs include depreciation.

• Economic profit

  • Defined as: \text{Economic profit} = \text{Total Revenue} - \text{Total Cost} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})

• Example: Fred’s potential new practice

  • Revenue: 200{,}000

  • Explicit costs: Office rent 50{,}000 + Law clerk salary 35{,}000 = 85{,}000

  • Accounting profit: 200{,}000 - 85{,}000 = 115{,}000

  • Implicit cost: Foregone salary from current job = 125{,}000

  • Economic profit: 200{,}000 - 85{,}000 - 125{,}000 = -10{,}000

• Normal profit

  • Occurs when economic profit = 0; i.e., resources could not be used more profitably elsewhere.

  • In other words, implicit costs (opportunity costs) are embedded in the concept of normal profit.

• Quick takeaway

  • Accounting profit > economic profit because implicit costs are not deducted in accounting profit.

7.2 The Structure of Costs in the Short Run

• Fixed costs (FC)

  • Expenses that must be paid before production starts and do not change with output in the short run (e.g., rent on a retail space).

  • Other examples: cost of machinery/equipment, research and development costs.

• Variable costs (VC)

  • Costs that increase with the quantity produced (e.g., labor hours, raw materials, production supplies, electricity).

• Total cost (TC)

  • TC = FC + VC

  • At zero production, FC remains, so TC is not zero.

• Key cost measures

  • Average total cost (ATC): ATC = \dfrac{TC}{Q}

  • Average variable cost (AVC): AVC = \dfrac{VC}{Q}

  • Marginal cost (MC): MC = \dfrac{\Delta TC}{\Delta Q} (the additional cost of producing one more unit)

• Typical shapes and relationships

  • ATC and AVC are typically U-shaped.

  • MC is upward-sloping in the most common short-run context.

  • MC intersects ATC and AVC at their minimum points.

  • If MC < ATC, ATC is falling; if MC > ATC, ATC is rising.

  • AFC (average fixed cost) is always decreasing as output rises; this helps bring ATC and AVC curves closer.

• Short-run cost behavior with output

  • Total cost = FC + VC; as output increases, VC grows and TC changes accordingly.

• Shifting cost curves

  • If Fixed Costs change: AFC and ATC shift; MC and AVC do not change.

  • If Variable Costs change: MC, AVC, and ATC shift.

• Graphical note

  • MC, ATC, and AVC are costs per unit; TC, FC, and VC are total costs measured in dollars. It is not sensible to put all on one graph due to differing units.

7.3 The Structure of Costs in the Long Run

• Short run vs long run

  • Short run: the time period in which the plant size is fixed; some inputs are fixed.

  • Long run: all inputs are variable; no costs are fixed; firms can adjust plant size and other inputs.

• Production function (concept)

  • Production function shows how inputs translate into outputs.

  • General form: Q = f[NR, L, K, t, E] where inputs include labor (L), capital (K), raw materials (NR), time (t), and entrepreneurship/efficiency (E).

  • Example narrative (pizza making) illustrates inputs (flour, water, yeast, tomatoes, spices, oven, etc.) and outputs (pizza) and how input costs affect the cost of producing output.

• Stages of short-run production (with MP and AP)

  • Stage I: Increasing marginal returns (MP increasing; TP increasing; AP increasing to its maximum at end of Stage I).

  • Stage II: Decreasing marginal returns (MP decreasing; TP still rising but at a diminishing rate; MP intersects AP at AP’s maximum, after which AP falls).

  • Stage III: Negative marginal returns (MP < 0; TP falls; AP falls).

• Key definitions

  • Total Product (TP): Total output produced.

  • Marginal Product (MP): Change in TP from adding one more unit of labor: MP = ΔTP / ΔL.

  • Average Product (AP): TP per unit of labor: AP = TP / L.

• Summary relationships (MP and TP/AP)

  • MP represents the slope of TP.

  • When MP is increasing, TP increases at an increasing rate.

  • When MP is positive but decreasing, TP increases at a decreasing rate.

  • When MP is zero, TP is at a maximum.

  • When MP is negative, TP is decreasing.

  • MP crosses through the maximum of AP: when MP > AP, AP is rising; when MP < AP, AP is falling.

Long-Run Production Costs and Economies of Scale

• Economies of scale

  • Definition: When increasing the quantity of output leads to lower cost per unit (cost per unit declines as production scales up).

  • Intuition: Larger plants can exploit efficiencies (e.g., bulk purchasing, specialization, spreading fixed costs).

  • Example numbers (illustrative):

  • Small factory S: 1{,}000 units at $12 per unit.

  • Medium factory M: 2{,}000 units at $8 per unit.

  • Large factory L: 5{,}000 units at $4 per unit.

• Shapes of long-run average cost curves

  • Economies of scale: downward-sloping portion of the long-run average cost (LRAC) curve.

  • Constant returns to scale: flat portion of LRAC where increasing all inputs by a given proportion leaves average cost unchanged.

  • Diseconomies of scale: upward-sloping portion of LRAC when large scale leads to higher average costs per unit.

• Returns to scale (conceptual distinction)

  • If you double all inputs, output may:

  • Increase by more than double (Increasing Returns to Scale).

  • Double (Constant Returns to Scale).

  • Increase by less than double (Decreasing Returns to Scale).

  • Returns to scale concerns production capability; it is distinct from short-run diminishing marginal returns.

• Relation to short-run costs

  • Economies of scale (long run) contrast with diminishing marginal returns (short run) as they involve all inputs changing, not just one input (like labor).

Profit Maximization (MR = MC Rule)

• Profit maximization goal

  • Firms maximize profit by producing the quantity where marginal revenue equals marginal cost: MR = MC

• Example (price is $25)

  • Data:

  • Q = 1: MC = 15; TR = 25; MR = 25

  • Q = 2: MC = 8; TR = 50; MR = 25

  • Q = 3: MC = 17; TR = 75; MR = 25

  • Q = 4: MC = 25; TR = 100; MR = 25

  • Q = 5: MC = 31; TR = 125; MR = 25

  • Observations

  • MR is constant at 25 (price).

  • Profit-maximizing output occurs where MC first equals MR or where MC is just below MR before MC exceeds MR.

  • In this table, MC = MR at Q = 4, so the profit-maximizing output is 4 units.

• Important cost relations (recap from the cost framework)

  • TC = TVC + TFC

  • ATC = AFC + AVC

  • ATC = TC / Q

  • FC = TFC = AFC × Q

  • AVC = TVC / Q

  • TVC = AVC × Q

  • MC = ΔTC / ΔQ = (TC2 − TC1) / (Q2 − Q1)

• Additional profit measures

  • Average Profit (conceptual) = Average Revenue − Average Cost

  • A firm’s decisions connect price, cost, and output to determine profitability.

• Summary notes on cost curves and intersections

  • MC intersects ATC and AVC at their minimum points.

  • If MC is below ATC, ATC is falling; if MC is above ATC, ATC is rising.

  • MC intersects AFC indirectly by moving with TC and VC shapes; AFC always decreases as Q increases.

Practice Problems and Practice Questions

PRACTICE PROBLEM #1 ( Ruben’s restaurant vs teaching )

• Given:

  • Current teaching salary: 60{,}000

  • Expected revenue from restaurant: 350{,}000

  • Restaurant rent and bills: 100{,}000

  • Restaurant labor costs: 125{,}000

  • Restaurant ingredients costs: 50{,}000

• Calculations

  • Implicit cost (opportunity cost of teaching): 60{,}000

  • Explicit costs: 100{,}000 + 125{,}000 + 50{,}000 = 275{,}000

  • Total accounting profit: TR - Explicit = 350{,}000 - 275{,}000 = 75{,}000

  • Total economic profit: TR - (Explicit + Implicit) = 350{,}000 - (275{,}000 + 60{,}000) = 15{,}000

• Decision

  • Since economic profit > 0, Ruben should open the restaurant (all else equal).

  • Note: Other non-financial factors may also be relevant (risk, preferences, etc.).

PRACTICE PROBLEM #2 (Laszlo’s Lawn Rangers cost schedule)

• Given fixed costs: F C = 4{,}000

• Short-run cost schedule (Total Cost, TC, at various outputs) is provided:

  • 0 units: TC = 4{,}000

  • 10: TC = 10{,}000

  • 20: TC = 14{,}000

  • 30: TC = 23{,}000

  • 40: TC = 34{,}000

  • 50: TC = 47{,}000

  • 60: TC = 62{,}000

  • 70: TC = 88{,}000

• Questions and answers (with formulas)
  1) At Q = 50, AFC = \frac{TFC}{Q} = \frac{4{,}000}{50} = 80.
  2) At Q = 60, AVC = \frac{TVC}{Q}; TVC = TC − TFC = 62{,}000 − 4{,}000 = 58{,}000; AVC = \frac{58{,}000}{60} ≈ 966.67.
  3) Marginal cost of producing 40 instead of 30: MC = \frac{TC(40) − TC(30)}{40 − 30} = \frac{34{,}000 − 23{,}000}{10} = 1{,}100.
  4) Total variable cost of producing 70 units: TVC = TC − TFC = 88{,}000 − 4{,}000 = 84{,}000.
  5) Will AFC increase or decrease as more units are produced? AFC will decrease with higher output because fixed costs are spread over more units.

• Quick takeaway

  • These calculations illustrate how fixed costs, variable costs, and per-unit costs behave as output changes in the short run.

Key Terms (from the chapter)

• accounting profit

• average total cost (ATC)

• average variable cost (AVC)

• constant returns to scale

• diminishing marginal productivity

• diseconomies of scale

• economic profit

• economies of scale

• explicit costs

• fixed cost

• implicit costs

• long run

• marginal cost (MC)

• marginal product (MP)

• production

• production function

• short run

• total cost (TC)

• total revenue (TR)

• variable cost (VC)

Review Questions (for self-testing)

1) What are explicit and implicit costs?
2) What is the difference between accounting and economic profit?
3) What is the difference between a fixed input and a variable input?
4) What is the difference between fixed costs and variable costs?
5) How do we calculate each of the following: marginal cost, average total cost, and average variable cost?
6) What shapes would you generally expect each of the following cost curves to have: fixed costs, variable costs, marginal costs, average total costs, and average variable costs?
7) Are there fixed costs in the long-run? Explain briefly.
8) What are diminishing marginal returns as they relate to costs?
9) Which costs are measured on per-unit basis: fixed costs, average cost, average variable cost, variable costs, and marginal cost?
10) What is a long-run average cost curve?
11) What is the difference between economies of scale, constant returns to scale, and diseconomies of scale?
12) What shape of a long-run average cost curve illustrates economies of scale, constant returns to scale, and diseconomies of scale?

Additional Resources Mentioned

• Crash Course Economics #24: Revenue, Profits, and Price (link provided in material)

Practice Problems Answers (Reminders)

• 7.1 and 7.2: Use the formulas provided to compute profits, costs, and per-unit costs; compare accounting vs economic profit; interpret normal profit.

• 7.3: Use LRAC concepts to reason about economies/returns to scale and relate to stages of production.

• 7.4-7.5: Apply the MR = MC rule to decide optimal output in given price scenarios.