chapter NINE
The Costs of Production
This chapter develops a number of crucial cost concepts that will be employed in the succeeding three chapters to analyze the four basic market models. A firm’s implicit and explicit costs are explained for both short‑ and long‑run periods. The explanation of short‑run costs includes arithmetic and graphic analyses of both the total-, unit-, and marginal-cost concepts. These concepts prepare students for both total-revenue—total-cost and marginal-revenue — marginal-cost approaches to profit maximization, which are presented in the next few chapters.
The law of diminishing returns is explained as an essential concept for understanding average and marginal cost curves. The general shape of each cost curve and the relationship they bear to one another are analyzed with special care.
The final part of the chapter develops the long‑run average cost curve and analyzes the character and factors involved in economies and diseconomies of scale. The role of technology as a determinant of the structure of the industry is presented through several specific illustrations.
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 the 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 and 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 curve 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.
I. Economic costs are the 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. (Recall opportunity-cost concept in Chapter
2.)
A. Explicit costs are payments to nonowners 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.
B. 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.
C. 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.
D. Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit). Figure 22‑1 illustrates the difference between accounting profits and economic profits. The economic profits are $24,000 (after $63,000 + $33,000 are subtracted from $120,000).
E. 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.
F. The long run is a time period 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.
II. Short-Run Production
Relationships
A. 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 unit will decline.
1. Example: CONSIDER THIS … Diminishing Returns from
Study
2. Table 22-1 presents a numerical example of the law of diminishing returns.
3. Total product (TP) is the total quantity, or total output, of a particular good produced.
4. Marginal product (MP) is the change in total output resulting from each additional input of labor.
5. Average product (AP) is the total product divided by the total number of workers.
6. Figure 22-2 illustrates the law of diminishing returns graphically and shows the relationship between marginal, average, and total product concepts. (Key Question 4)
a. When marginal product begins to diminish, the rate of increase in total product stops accelerating and grows at a diminishing rate.
b. The average product declines at the point where the marginal product slips below average product.
c. Total product declines when the marginal product becomes negative.
B. 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.
III. Short Run Production
Costs
A. Fixed, variable, and total costs are the short‑run classifications of costs; Table 22-2 illustrates their relationships.
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 variable costs at each level of output (see Figure 22-3).
B. Per unit or average costs are shown in Table 22-2, 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 (see Figure 22‑4).
C. Marginal cost is the additional cost of producing one more unit of output (MC = change in TC/change in Q). In Table 22-2 the production of the first unit raises the total cost from $100 to $190, so the marginal cost is $90, and so on for each additional unit produced (see Figure 22-5).
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 (Figure 22-6 illustrates this).
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.
D. Cost curves will shift if the resource prices change or if technology or efficiency change.
IV. In the long run, all
production costs are variable, i.e., long-run costs reflect changes in plant
size, and industry size can be changed (expand or contract).
A. Figure 22-7 illustrates different short‑run cost curves for five different plant sizes.
B. 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.
C. 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 decrease.
a. Labor and managerial specialization is one reason for this.
b. The ability to purchase and use more efficient capital goods also may explain economies of scale.
c. 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 becomes too large, as illustrated by the rising part of the long‑run ATC curve. For example, if a 10 percent increase in all resources result in a 5 percent 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.
D. 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.
E. 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 also is found in several new information technology industries.
F. Applications and illustrations.
1. The terrorist attacks on September 11, 2001, have led to rising insurance and security costs. Some of these costs are fixed (insurance premiums and security cameras), while others are variable (number of security guards). Both have resulted in an upward shift of the ATC curves.
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 machine enables automakers to produce in 5 minutes what used to take 8 hours to produce.
4. Newspapers can be produced for a low cost and thus sold for a low price because publishers are able to spread the cost of the printing equipment over an extremely large number of units each day.
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.
V. LAST WORD: Irrelevancy of Sunk Costs
A. Sunk costs should be disregarded in decision making.
1. The old saying “Don’t cry over spilt milk” sends the message that if there is nothing you can do about it, forget about it.
2. A sunken ship on the ocean floor is lost, it cannot be recovered. It is what economists’ call a “sunk cost.”
3. Economic analysis says that you should not take actions for which marginal cost exceeds marginal benefit.
4. Suppose you have purchased an expensive ticket to a football game and you are sick the day of the game; the price of the ticket should not affect your decision to attend.
B. In making a new decision, you should ignore all costs that are not affected by the decision.
1. A prior bad decision should not dictate a second decision for which the marginal benefit is less than the marginal cost.
2. Suppose a firm spends a million dollars on R&D only to discover that the product sells very poorly. The loss cannot be recovered by losing still more money in continued production.
3. If a cost has been incurred and cannot be partly or fully recouped by some other choice, a rational consumer or firm should ignore it.
4. Sunk costs are irrelevant! Don’t cry over spilt milk!