Chapter 22 – The Costs of Production
Economic Costs
The Economic/Opportunity cost of an object is the value or worth of the resources as produced in their best alternative use
Explicit and Implicit Costs
From a firms standpoint these are the payments a firm must make or incomes it must provide to attract the resources it needs away from alternative production opportunities
Explicit Costs – monetary payments for resources
Implicit costs – opportunity costs of using its self-owned, self-employed resources
Normal Profit as a (implicit) cost – You forgo other applications of your entrepreneurial talent
Economic Profit or Pure Profit
Economic profit is total revenue less any economic costs (Explicit, Implicit, Normal)
Short Run Production Relationships – since plant size is fixed, we will be focusing on labor-output relationship
Total Product (TP) – total quantity or total output of a particular good produced
Marginal Product (MP) – extra output or added product associated with adding a unit of a variable resource to the production process
Average Product (AP) – total products/units of labor
Law of diminishing returns – at a certain point, the amount you get out will start decreasing relative to the amount you put in
Short Run Production Costs
Fixed Costs – don’t depend on quantity produced, ie rent
Variable Costs – Change with the level of output, ie labor, fuel, etc
Total Cost – Sum of fixed and variable costs
Per-Unit or average costs
AFC – average fixed cost is found by dividing total fixed costs by quantity
AVC - average variable cost is total variable cost divided by quantity (declines initially, has a minimum where it is most efficient, then increases)
ATC – Average total cost is the Total Cost/quantity
Marginal Cost – the cost of producing the last item, also the cost saved by not producing one more, Firm decides whether or not to produce more
Relation of MC to AVC to ATC
MC curve intersects AVC and ATC curves at their minimum points
When the marginal cost per unit is less than average, ATC will fall
As long as MC lies below ATC, ATC will fall and when it is above ATC will increase, thus it intersects at the lowest point
Shifts of the Cost Curves
At each level of output, AFC is greater (and thus ATC would increase)
A change in labor/resource costs would affect ATC and AVC
Long-Run Production Costs
Firm Size and Costs – at first it will cost ATC to decrease (greater efficiency) but eventually it will cause ATC to increase if there are too many plants
Cost Curve – At certain intervals of quantity the firm should increase production capabilities
Economies and diseconomies of scale – Law of diminishing returns does not apply in the long run, (diminishing returns assumes one resource is fixed), assume long-run ATC curve is U shaped
Economies of Scale – As plant size increases, a number of factors will for a time lead to a lower average costs of production
Labor specialization – more efficient
Managerial Specialization - Managers should be overseeing as many people as they can
Efficient Capital – many of the most efficient machines are too large and expensive to afford on the small scale
Diseconomies of Scale
The difficulty of managing and controlling a firms operations as it becomes a large-scale producer
More Red Tape
Constant Returns to Scale - a period between economy of scale and diseconomy of scale where regardless of the scale, the ATC is the same
Minimum Efficient Scale and Industry Structure – MES – lowest level of output at which a firm can minimize long-run average costs
Given consumer demand, efficient production will be achieved with a few large-scale producers
When economies of scale are few and diseconomies come into play quickly, the minimum efficient scale occurs at a lower level of output
When economies of scale extend beyond the market size, natural monopolies are formed
Preferred stock – get benefits before others, get better dividends
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