2025-02-14 01-22

Businesses and the Costs of Production

Learning Objectives

• LO8.1: Understand that economic costs include explicit and implicit costs.

• LO8.2: Relate the law of diminishing returns to short-run production costs.

• LO8.3: Differentiate between fixed and variable costs, as well as total, average, and marginal costs.

• LO8.4: Connect economies of scale to firm size and average costs in the long run.

• LO8.5: Provide business examples relating to short-run costs, economies of scale, and minimum efficient scale (MES).

Chapter Focus

• Producer Behavior: This chapter examines producer behavior and foundational concepts regarding production and costs in market economies.

• Resource Payments: Businesses incur costs to obtain economic resources, including payments to resource owners and opportunity costs.

• Economic Efficiency: Analysis to show how firms compare revenues and costs, relating to economic efficiency.

Economic Costs (LO8.1)

• Definition: Economic costs are the payments made to acquire resources and the opportunity costs of using those resources.

• Explicit Costs: Monetary payments made to acquire resources not owned by the firm (e.g., wages, rent).

• Implicit Costs: Opportunity costs associated with resources owned by the firm (e.g., owner’s salary, use of owned capital).

• Total Economic Costs: Sum of explicit costs and implicit costs.

Example of Economic Costs

• Table-Making Firm:

  • Uses $5,000 cash (explicit cost) for labor and must account for the opportunity cost of the oak (implicit cost = $1,500).

  • Economic Costs: Explicit ($5,000) + Implicit ($1,500) = $6,500.

Profit Measurements

• Accounting Profit: Revenue minus explicit costs.

• Normal Profit: Implicit cost that represents an expected return from alternative investments.

• Economic Profit: Revenue minus total economic costs (explicit + implicit).

  • Positive economic profit indicates more success compared to alternative ventures.

Profit Example

• Retail T-Shirt Shop:

  • Total sales revenue: $120,000

  • Explicit costs (salaries, etc.): $63,000

  • Accounting profit: $57,000 (overstates success as it ignores implicit costs).

  • Economic profit calculation reveals a more accurate measure of success.

Short Run vs. Long Run (LO8.3)

Definitions

• Short Run: Time period in which a firm cannot change plant capacity; can adjust labor and materials.

• Long Run: Time period allowing changes to all resource inputs and plant capacity; fixed costs become variable.

Cost Classifications

1. Fixed Costs: Costs that do not change with output (e.g., rent, insurance).

2. Variable Costs: Costs that vary with output (e.g., materials, labor).

3. Total Cost: Sum of fixed and variable costs (TC = TFC + TVC).

4. Average Costs: Costs per unit (AFC = TFC/Q, AVC = TVC/Q, ATC = TC/Q).

5. Marginal Cost: Additional cost of producing one more unit (MC = change in TC/change in Q).

Diminishing Returns

• Law of Diminishing Returns: As more units of a variable resource are added to a fixed resource, marginal product at first increases then eventually decreases.

Long-Run Average Costs and Economies of Scale (LO8.4)

• Long-Run ATC Curve: U-shaped and derived from the lowest points of short-run ATC curves.

• Economies of Scale: Cost advantages that firms gain due to expansion.

• Diseconomies of Scale: Challenges and rising costs that can occur when firms grow too large and complex.

• Minimum Efficient Scale (MES): Lowest output at which a firm minimizes long-run average costs.

Example of Economies of Scale

• Boeing vs. Concrete Plants:

  • Large-scale aircraft manufacturing has high MES requiring few firms. Conversely, concrete mixing has low MES, allowing many small firms.

Business Examples (LO8.5)

• ** rising gasoline prices**: Raise AVC, MC, and ATC for firms reliant on fuel (e.g., FedEx).

• Start-Up Firms: Successful transitions to economies of scale (e.g., Starbucks, Google) leading to reduced costs as sales grow.

• The Verson Stamping Machine: An example of capital-intensive production requiring significant output for cost efficiency.

• Daily Newspapers: Facing rising fixed costs due to a decline in circulation and advertising revenue, exemplifying the average-fixed-cost death spiral.

Summary of Key Terms

• Economic Cost: Sum of explicit and implicit costs.

• Explicit/Implicit Costs: Definition and significance in calculating economic profit.

• Diminishing Returns: Concept relating to productivity in fixed-resource scenarios.

• Average and Marginal Costs: Definitions and implications for production decisions.

• Economies and Diseconomies of Scale: Characteristics influencing firm size and efficiency in production.