Types of cost

• Opportunity cost - that which is forgone to produce another good or service

• Explicit cost - the "out of pocket" or cash expenditures a firm makes to outsiders to supply resources

• Implicit cost - the money payments the self-employed resources could have earned in their best alternative employment.

  • Normal profit - the cost necessary to keep entrepreneurial talents engaged in a certain enterprise. (normal profit is an implicit cost)

Types of Profit

• Accounting profit - firm's total revenue less its explicit costs

• Economic profit - total revenue less than all costs (implicit and explicit)

 If a firm's total revenue exceeds its economic costs, any residual goes to the entrepreneur.  This is called an economic, or pure profit 

Economic Profit = total revenue - opportunity cost of all inputs 

NOTE: keep in mind that even if economic profit is zero, you are still covering normal profit

Short Run and Long Run 

The Short Run is a period of time too brief for an enterprise to alter its plant capacity.  This means that you can change the intensity at which the fixed plant is used.

The Long Run is extensive enough for firms to change quantities of all resources employed.  The means that you can change capacity and intensity.  

Short-Run Production Costs

The Law of Diminishing Returns states that at the beginning of production, you get increasing returns per input, where as successive units of a variable resource are added to a fixed resource, you will get smaller and smaller increases of output.

Graphical portrayal

• total product is the total output at various levels of labor input
• marginal product - change in output associated with each additional input of labor
• average product - output per worker (also "labor productivity")

 When marginal product > average product

• average product is rising

When marginal product < average product

• average product is declining

When marginal product = average product

• average product is at its maximum

Fixed, Variable, and Total Costs

• Fixed costs - costs which in total do not vary with changes in output

1. Interest on debt
2. Rental payments
3. Insurance premiums
4. Salaries to top management
5. Depreciation on equipment

• Variable costs - costs which change with the level of output

1. Materials
2. Fuel
3. Power
4. Transportation services

• as production begins, variable costs increase by a decreasing amount
• as production is greater, variable costs increase by an increasing amount

Why?

• near the beginning of production, increasing returns for each input

• near the end, diminishing returns for each input - therefore, more input is needed to get same output

  Key Points

• total cost = fixed cost + variable cost
• variable costs can be changed in the short run
• fixed costs cannot be changed in the short run

Per Unit, or Average, Costs

Average Fixed Cost (AFC)

• AFC = TFC / Q = total fixed cost / output
• Continuously declining because fixed cost is fixed at each output

 Average Variable Cost (AVC)

AVC = TVC / Q = total variable cost / output

• Declines initially, reaches a minimum, and increases again (U-shaped).  Initially, you have diminishing returns, and you need more VC per output.  NOTE: Average Product and Average Variable Cost are mirror images.

1. When average product is high, AVC is low
2. When average product is low, AVC is high
3. When average product is at a max, AVC is at a min

Average Total Cost (ATC)

-ATC = TC / Q = AFC + AVC

Marginal Cost

MC = ?TC / ?Q

• Diminishing returns causes increasing marginal cost.

NOTE: Marginal Product and Marginal Cost are mirror images

• MC intersects ATC and AVC at their minimums

• Determinants of the Cost Curves

1. Changes in resource prices or quality

2. Greater technology

3. More productivity

Long Run Production Costs

• 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 appropriate adjustments.

The long run ATC curve is made by summing up an infinite number of short run ATC curves

Economies and Diseconomies of Scale

Economies of scale

Economies of scale have a down-sloping long run ATC curve

as plant size increases, a number of factories will lead to lower average costs

increase in resources causes an even larger increase in output

Characteristics of Economies of Scale

• Labor specialization

1. hiring more workers means more jobs can be divided and subdivided

2. each worker has fewer tasks (specialization)

•   Managerial Specialization

    better management because fewer workers and services each has to manage

•   Efficient capital

    larger firms can get more efficient equipment

• By-products

    larger producers can better use by-products

• Other factors

1. start up costs irrespective of projected sales
2. for bigger producers, this cost is smaller proportion

Diseconomies of Scale

• managerial problems in efficiently controlling and coordinating a firm's operations as it becomes a large-scale producer
• large hierarchies promote miscommunication, bad coordination, etc, therefore, impaired efficiency causes rising average total costs
• workers may feel isolated from job
• increase in resources causes a smaller increase in output

Constant Returns to Scale

• long run average cost is constant

• an increase in resources causes a similar increase in output

Miscellaneous Facts

• minimum efficient scale (MES) - the smallest output at which a firm can minimize long-run average costs

• natural monopoly - market situation where unit costs are minimized by having one firm produce the particular good or service

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