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Costs of Production. Chapter 20. Economic Costs. Economic costs are the costs faced when deciding how to use resources They can be obvious costs like wages or rents – explicit costs Or hidden – such as interest income lost when money from savings is used – implicit costs. Profits.

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economic costs
Economic Costs
  • Economic costs are the costs faced when deciding how to use resources
  • They can be obvious costs like wages or rents – explicit costs
  • Or hidden – such as interest income lost when money from savings is used – implicit costs
  • Accounting Profits are the monies received from revenue after all explicit costs have been paid
  • Economic profit is the monies received from revenue after all explicit and implicit costs have been covered
short and long run
Short and Long Run
  • Firms profits often depend upon how quickly they respond to changes in demand
  • Depends upon how fast resource use can be adjusted
  • Variable resources are easy to adjust – work labor longer, buy more materials
  • Fixed resources are much harder to adjust and take time – size of the building, machinery available
short run
Short Run
  • Short Run is a time period to small to adjust size of capital resources but long enough to adjust how it is used
  • Example – machines can be worked longer, more workers can be added to shifts, more materials used in the plant
  • In the short run plant capacity is fixed
long run
Long Run
  • Long run is the time period where firms can adjust plant capacity – all resources can be adjusted now
  • Build a new plant, buy more equipment
  • Firms can also arrange to leave or enter the industry as needed
  • Known as a variable plant period
short run production
Short Run Production
  • Production costs depend upon the prices of resources and the amount of resources needed to produce the desired quantity of goods
  • Labor output relationship – how much is produced per worker
  • Total Product – total quantity produced
  • Marginal Product – additional output produced when an extra unit of a VARIABLE resource is added to the production process
    • change in total product/change in labor input
  • Average Product – measures labor productivity – output per unit of labor
    • Total product/units of labor
law of diminishing marginal returns
Law of Diminishing Marginal Returns
  • Assumes technology is fixed so methods of production do not change
  • As additional units of variable resources are added to fixed resource, at some point the additional (marginal) product (output) from that extra variable resource will decline
  • In other words: as you add more labor to a fixed resource, the output rises by smaller and smaller amounts
  • The logic is simple – overcrowding will eventually take place
  • At first, adding an additional worker to a plant can help – they can help create division of labor and specialization
  • Each worker becomes more efficient as they focus on one task
  • Eventually though too many workers create delays and people have to wait to use equipment which causes slow downs in production
  • Slow downs mean the additional workers create less additional production than the people before them did
total marginal and average product
Total, Marginal and Average Product
  • The law of diminishing marginal returns affects total, marginal and average product
  • Total product goes through 3 stages based on the changes in marginal product
    • Marginal product is the slope of total product
    • Total will increase, at an increasing rate, when marginal is rising
    • Total will increase, but at a decreasing rate, when marginal is positive but falling
    • Total will be maximized when marginal is zero
    • Total will fall when marginal goes negative
Average product will follow the same tendencies (given it is simply total divided by quantity)
  • It will increase, reach a maximum and then begin to fall as more variable inputs are added
  • If marginal exceeds average, average product rises
  • If marginal is less than average, average product will fall
  • Because of this, marginal and average intersect where average is at it’s maximum
  • You must look at the math to understand this – if you add a number larger than average to the average, average will rise. If you add a number smaller than average to the average, average falls.





production costs
Production Costs
  • Fixed Costs – cost that do not change with output so exist even if production is 0
    • Rent, interest payments, depreciation of equipment
  • Variable Costs – cost that changes with production due to increased use of variable inputs
    • Wages, material costs, utility payments
    • As production increases, variable will increase as well
      • At first it will increase in decreasing amounts, then it will begin to increase in increasing amounts
variable why
Variable – why?
  • This change in variable costs is due to the shape of the marginal product curve
  • As marginal product rises, it does not take much of an increase in variable resources to increase production
    • One additional worker can increase production by a lot if they contribute to specialization and efficient use of resources
    • Small units of additional variable resources mean small increases in costs
  • As marginal product begins to fall, it will take more and more variable resources to produce increasing quantities
    • As overcrowding takes place, it will take larger amounts workers just to see an increase in production
Total Cost: sum of fixed and variable costs
  • At 0 production there will still be a total cost equal to fixed cost
  • As production increases and variable resources are added, total will increase by the amount of variable costs
Average Costs: per unit cost of production
  • Useful in making comparisons with price per unit for a good
  • Average fixed cost: total fixed cost / quantity
    • AFC declines as quantity rises since it never changes and is spread over larger production numbers
  • Average Variable Cost: total variable cost / quantity
    • AVC declines initially, reaches a minimum and then increases again because VC originally increase by smaller amounts, then begin to increase by increasing amounts
Again this is due to diminishing marginal returns
  • AVC will decline initially because it does not take much additional variable resources to increase production
    • Firms are inefficient and costly at first but as output increases specialization makes it more efficient and cheaper to run
  • It will hit its minimum point when marginal product is at its maximum
  • After that as overcrowding takes place, larger numbers of variable resources are needed to increase production so variable costs (total and average) begin to rise
Average Total Cost: total cost / quantity
  • Graphically it is the AFC and AVC curves added together so the distance between ATC and AVC represents the AFC






marginal cost
Marginal Cost
  • The additional cost of producing one more unit of output
    • Reflection of changes in VARIABLE costs
  • Change in total cost / change in quantity
  • These are the costs that can be controlled immediately – should we produce another unit? YES – costs are incurred. NO – costs are not incurred
Production decisions are usually marginally based
  • Combined with marginal revenue (additional revenue received from one more sale) it tells firms if they should produce the additional unit – will it be profitable?
  • Marginal cost curves decline sharply, reach a minimum and then begin rising rapidly
  • Reflects the fact that variable costs increase by decreasing amounts, reach a minimum and then begin rising
mc and mp
MC and MP
  • MC curve shape is reflection of law of diminishing marginal returns
  • As MP is rising, MC of labor is falling (remember don’t need a lot of extra labor to get that additional output so costs rise at a decreasing rate)
    • Can see this if you divide the constant cost (assume all workers are hired at same wage rate) of a worker by their marginal product
  • Once diminishing returns kicks in, MP begins to fall and MC begins to rise
  • MC and MP are opposites – when MP is rising, MC is falling; when MP is at it’s peak, MC is at it’s minimum; when MP begins to fall, MC is rising
mc atc and avc
  • MC will intersect ATC and AVC at their minimum points
  • When the marginal cost added is less than the average, average will fall
  • When the marginal cost added is greater than the average, average will rise
  • MC and ATC intersect where ATC has ceased to fall but has not yet begin rising – the minimum point on the ATC curve (MC reacts faster and more sharply than ATC)
  • MC also crosses AVC at the minimum point for the same reason
  • MC is not affected by AFC because marginal is a reflection of change and TFC do not change







Q of labor

Q of output

Comparing Curves

what causes the curves to shift
What causes the curves to shift?
  • Changes in resource prices or technology
  • Changes in costs will change the curves
  • If fixed costs increase, AFC will shift up and ATC will move up – AVC and MC will NOT move because both are based on variable resources
  • If variable costs increase, AVC, ATC and MC will all shift upward
  • More efficient technology that increases productivity will lower costs
long run production costs
Long Run Production Costs
  • In the long run ALL resources can be adjusted
    • Different amounts of variable resources can be used, more/equipment can be owned, plant size can change
  • Therefore, in the long run, ALL costs become variable so we only really look at TOTAL costs
firm size and costs
Firm Size and Costs
  • What is the relationship between the plant size of a firm and the costs they face?
  • At first, larger plant sizes may actually result in falling ATC but eventually, larger and larger plants will result in rising ATC







Dashed lines tell you where a firm needs to move to a new plant size.

At this point, a new larger plant can produce at lower ATC than the existing plant

Average Total Costs






At outputs of 20 or less, plant size 1 is best.
  • At 21 – 30 it gets lower ATC with plant size 2
  • At 31 – 50 plant size 3 is best
  • 51 – 60 plant size 4
  • 61+ plant size 5 is best
  • Each plant will have higher total costs than the one before it BUT ATC (per unit costs) will be lower
  • Each individual curve represents a short run production for different plants. Together they make up the Long Run ATC curve for the firm
  • LRATC shows the lowest ATC at which any output level can be produced as firms have time to make adjustments in plant size
economies of scale
Economies of Scale
  • Why is LRATC u-shaped?
  • NOT due to law of diminishing marginal returns – it does is short run only; does not apply in the long run
  • Economies of Scale (economies of mass production): reductions in the average total cost of production as a firm expands plant size in the long run
why economies of scale lead to downsloping long run atc curves
Why Economies of Scale lead to downsloping long run ATC curves
  • Labor Specialization: as plants increase in size labor is able to become more specific and specialized in their job
    • There is more room and ability to divide workers up into single specific tasks
    • Focusing on one task makes a worker better and more efficient at their job
    • No more production time loss from switching jobs
Managerial Specialization: greater specialization of managers
    • Individual group managers who can work with certain tasks and small groups rather than a single plant manager who has to supervise multiple tasks and hundreds of workers
    • Leads to greater efficiency
  • Efficient Capital: more efficient equipment, more efficient use of current equipment
  • Other Factors: per unit design and development costs, advertising costs fall as production increases, experience and therefore efficiency rises as production rises
  • As inputs rise, production rises by large amounts, ATC falls
diseconomies of scale
Diseconomies of Scale
  • Rising ATC as firms increase expands production in the long run
  • Mainly due to difficulty in controlling and managing a large operation
  • As plant size increases, personnel size increases and more managers get involved.
  • Key executives move further away from hands on understanding and more people are needed to understand and absorb all details of production.
  • Delegation leads communication and cooperation problems. Efficiency falls and costs rise.
  • Also easier for workers to slack off and drop in efficiency as workers feel more isolated. More management is needed to watch them and so costs rise.
  • Increases in inputs lead to a small increase in production so ATC rises
constant returns to scale
Constant Returns to Scale
  • Production range where ATC does not change as production increases
  • Increases in inputs have a proportionate increase in production size
minimum efficient scale
Minimum Efficient Scale
  • Lowest level of output at which a firm can minimize long run average costs
  • Some industries can only support one or a few firms who can produce efficiently to meet consumer demand – these industries lead to natural monopolies or oligopolies
  • LRATC shape is determined by technology and economies/diseconomies of scale
    • Industries can have firms of different plant sizes who all operate on the same portion of a LRATC curve
  • The shape of the ATC curve determines the number of firms in an industry