Lecture Outlines

Overview:

• Costs and Profit
• Short-Run Production Costs and Cost Formulas
• Marginal Cost Relationships
• Long-Run Production Costs
• Different Scales of Production

Except for not-for-profit entities such as the North Coast Co-op, the motivation for business decisions is profit maximization. Profit maximization helps explain why managers or firms choose a particular level of output or price.

The total opportunity cost of a business is the sum of explicit costs and implicit costs.

• Explicit costs: Payments to non-owners of a firm for their resources. For example, wages, rent, utilities, etc.
• Implicit costs: The opportunity costs of using resources owned by the firm. No actual payment is made to outsiders.

There are three definitions for profit -- everyday, Accounting, and Economic.

1. "Profit" in everyday use is defined as:

Profit = total revenue - total cost

 

2. Economists call this "Accounting Profit." They define it as:

Accounting profit = total revenue - total explicit cost

Accounting practice tends to overstate profit, however, because implicit costs are not included.

 

3. In order to include both explicit and implicit costs, economists use "Economic Profit." It is defined as:

Normal Profit: The minimum profit necessary to keep a firm in operation. A firm that earns normal profit earns total revenue equal to its total opportunity cost.

Economists distinguish short-run and long-run time horizons based on the ability to vary the quantity of inputs or resources used in production. There are two type of inputs to be considered:

1. Fixed Input: Any resource for which the quantity cannot change during the period of time under consideration.
2. Variable Input: Any resource for which the quantity can change during the period of time under consideration.

Short-Run: A period of time so short that there is at least one fixed input.

Long-Run: A period of time so long that all inputs are variable.

Production Function: The relationship between the maximum amounts of output a firm can produce and various quantities of inputs. It is assumed in this model that the level of technology is fixed.

Marginal Product: The change in total output produced by adding one unit of a variable input, with all other inputs used being held constant.

Law of Diminishing Returns: The principle that beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor. This law determines the shape of the product curve.

• Increasing marginal returns: Each additional worker adds more to total output than the previous worker.
• Diminishing marginal returns: Each additional worker adds less to total output than the previous worker.

There are two "families" of relationships between short-run costs and output: total cost curves and average cost curves.

• Total Fixed Cost (TFC): Costs that do not vary as output varies and that must be paid even if output is zero. These are payments that the firm must make in the short run, regardless of the level of output.
• Total Variable Cost (TVC): Costs that are zero when output is zero and vary as output varies.

• Average Fixed Cost (AFC): Total fixed cost divided by the quantity of output produced. As output increase, AFC decreases.

• Average Variable Cost (AVC): Total variable cost divided by the quantity of output produced. The AVC curve is U-shaped.

• Average Total Cost (ATC): Total cost divided by the quantity of output produced. The ATC curve is also U-shaped.

• Marginal Cost (MC): The change in total cost when one additional unit of output is produced. The MC curve is J-shaped.

Marginal-Average Rule: The rule links the marginal cost curve with the average cost curve. The rule states:

• When marginal cost is below average cost, average cost falls.
• When marginal cost is above average cost, average cost rises.
• When marginal cost equals average cost, average cost is at its minimum point.

The connection between the marginal product (MP) curve and the marginal cost (MC) curve: The shape of the MC curve is the mirror reflection of the shape of the marginal MP curve.

The marginal cost declines as the marginal product of a variable input rises if the wage rate is constant. Beginning at the point of diminishing returns, the marginal cost rises as the marginal product of a variable input declines.

Important point: Diminishing marginal returns ==> increasing marginal costs.  

Recall the definition of long-run: a period of time so long that all inputs are variable.

Long-Run Average Cost (LRAC) Curve: The curve that traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size.

• There are a large number of possible plant sizes from which a manager can choose in the long run.
• The LRAC Curve is made up of the low points on each of the various short-run average cost curves.
• The LRAC curve is usually thought to be U-shaped. Minimum efficient scale is the lowest output level at which the LRAC is minimized. Firms in the long run in a competitive market can only survive if they produce at minimum LRAC.

Usually a young firm will start small and increase plant size as it matures. As the scale of operation expands, the LRAC curve can follow three different patterns.

• Large firms can increase the division of labor and use of specialization. This idea is clearly illustrated by the assembly line.
• Efficiency of capital. Larger firms can afford to invest in more expensive machines that have greater efficiency.

• Increased chain of command and increased bureaucracy.
• Increased management layers, with little increase in actual output.