Chaper 8 Notes ( 8.3 - 8.9 )

Economic Role of Costs

  • The demand for a product represents the voice of consumers telling firms to produce a good

  • A firms cost represents the desire of consumers not to sacrifice good that could be produced if the same resources were employed elsewhere

  • (Demand is the benefit of making a product, while cost is the hidden sacrifice of what could have been made instead.)


Calculating Economic Costs and Profits

Profit: Total Revenue - Total Costs

Total Product (output): Total quantity of output produced with a given amount of resources

Marginal Product of Labor (MPL) =▵Q/▵X

                        I.E.

                        Remaining Blanks: 10,15,20,10,0,-15

# difference of pizzas made/ #cooks

Explicit Costs: Payments by a firm to purchase the services of productive resources

  •         Fixed: Costs that don’t change with the amount of output produced

    •  i.e. rent, purchases of land, etc.

  •         Variable: Costs that change with the amount of output produced   

    •  i.e. # of workers, inputs to the good, etc.

Implicit Costs: Hidden opportunity cost of using resources you already own instead of using them for their next best alternative


Economic & Accounting Profits

Accounting Profit: Revenue - Explicit Costs

Economic Profit: Revenue - Explicit + Implicit Costs

            I.E.

Accounting Profits: 8,000-7500 = 500

Economic Profits: 8,000-8200 = -200


  • Average Costs: The cost per unit of output

    • Average fixed costs (AFC) = Fixed costs / Quantity

    • Average variable costs (AVC) = Variable costs / Quantity

    • Average total costs (ATC) = Total Costs / Quantity = (FC+VC)/Q


  • Marginal Cost (MC): The additional cost associated with 1 more unit of production; ▵TC/▵Q

    • When MC is below AVC, AVC must be decreasing

    • When MC is above ATC, ATC must be increasing

    • MC will cross AVC AND ATC directly at their minimum

  • Opportunity Cost of Equity Capital: Rate of return that must be earned by investors to induce them to supply financial capital to the firm  


Short-Run & Long-Run Time Periods

Short Run: The time period in which at least one input of production cannot be changed

Long Run: The time period in which all inputs of production can be changed


Categories of Costs

  • Total fixed cost (TFC): sum of the costs that do not vary with output; will remain unchanged when output rises or falls in the short run

  • Average fixed cost (AFC): TFC/ # of units produced; always ↓ as output ↑

  • Total variable cost (TVC): sum of the costs that rise as output increases

  • Average variable cost (AVC): TVC/ # of units produced

  • Total cost (TC): sum of fixed and variable costs

  • Average total cost (ATC): TC/ # of units produced; also called per-unit cost; also = to sum of AFC & AVC

  • Marginal Cost (MC): ▵TC required to produce an additional unit of output


Diminishing Returns & Production in the Short Run

Law of diminishing returns: Adding more of one input while keeping other inputs fixed will eventually lead to smaller and smaller increases in output

Total Product: total output of a good that is associated with each alternative utilization rate of a variable input

Marginal Product: Extra output gained by adding one more unit of an input while keeping all other inputs the same

Average Product: Total product/ # of units of the variable input required to produce that output level


As units of labor are added to a fixed input total products will ↑, first at an ↑ rate and then a ↓ rate.     

This will cause both marginal and average product curves to ↑ at first and then ↓.


Economies & Diseconomies of Scale

  • 3 reasons why planning a larger volume of output usually reduces (initially) unit costs

    • Economies accompanying the use of mass production

      • Typically economical only when large volumes of output are planned because they tend to involve larger development and setup costs

      • Once production methods are established, marginal costs are low

      • High-volume methods typically require high fixed costs and cause unit costs to be far higher for low volumes of production

    • Higher productivity as a result of specialization (“learning by doing”)

    • Economies in promotion and purchasing

Economic theory explains why initially larger firms have lower unit costs than comparable smaller firms

Economies of Scale: cost of making each individual item goes down as a company produces more of them

Diseconomies of Scale: a company grows so much the AC to produce each unit goes up


Alternative Shapes of the LRATC