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Production Costs
Lesson 8


The Business Firm

  1. Business firm
    • Purchase resources from other firms and households
    • Transform resources into products
    • Sell products to consumers
  2. All countries have business firms
    • Differ by freedom for decision making
    • Socialist countries have less freedom
  3. Firm owners have strong incentive to produce at low cost
    • If business is doing well, the owners earn profits
    • If business is doing badly, the owners earn a loss
  4. Organizing workers
    • Contracting - owner contracts with individual workers who work independently
      • Takes time, planning, and has high transaction costs
      • Example: Building a house or office building
    • Team production - workers are hired by a firm to work together under supervision
      • Reduces transaction costs
      • Employees are monitored
      • Prevent shirking
      • Shirking - employees working at less than normal rate of productivity
        • Examples: Long coffee & bathroom breaks

Economic Costs

1. Explicit costs - when a firm makes a monetary payment, using cash or a bank transfer

  • Salaries for labor
  • Tax payments
  • Interest payments
  • Buying resources

2. Implicit costs - a cost imposed on the firm, but does not involve a payment

  • Accountants use depreciation of machines and equipment
    • Accountants recognize that machines wear out and is an expense to the firm
  • Opportunity costs - the highest valued option that the decision maker expects to give up as the result of a choice
    • Economist include opportunity costs but accountants do not
    • A proprietor's opportunity cost is working for his business and earning salary
    • Look forward
    • Include all production costs
    • If company could use resources to make a more valuable product, then it would make that product

3. Sunk costs - historical costs associated with past decisions that cannot be changed

  • Requires three things
    • Firm paid a cost in the past, or historical costs
    • Firm cannot undo the decision
    • Firm cannot sell or salvage
  • Examples
    • Firm pays for a government license that it cannot resell
    • Firm pays for special machines and equipment with little salvage value
    • Person pays for a ticket to enter a cinema and the movies is bad
  • Provide information
  • Not relevant to current choices
  • Example: Henderson State University buys a printing machine to publish a magazine
    • Machine costs $20,000 and will be depreciated over 10 years
      • Depreciation expense is $2,000 per year
    • In Year 3, subscription revenue is $3,000
    • Depreciation expense is $2,000
    • Paper/ink costs $2,000
      • University earns a $1,000 loss
  • What should the university do?
  • Economists - in Year 1, if the administration knew this would be the outcome, then the machine should of not been purchased.
    • In Year 3, the machine cost is sunk cost
    • Revenue is $3,000
    • Paper/ink cost is $2,000 for paper/ink
    • Keep the machine operating and minimize the loss
      • Activity is contributing $1,000

Economic profit = total revenue - explicit costs - implicit costs (all costs)

Accounting profit = total revenue - explicit costs - implicit costs (i.e. depreciation)

Accounting profit > Economic profit

Blue Arrow Firms earning zero economic profit are earning a normal rate of return. If economic profit is zero, then accounting profit is positive.

If economic profit < 0, then firms are not using resources efficiently.

Someone quit his job (earning $20,000) and used his savings $5,000 to open a business His savings was earning 10%. The first year income statement is below:

Lemonade Stand at the Mall
1st year income statement

Total Revenue (30,000 lemonades @$1) $30,000
Costs (explicit)  
     Lemons, sugar, paper cups, etc. $10,000
     Taxes $2,000
     Labor - employees $5,000
     Leasing space $3,000
     Accounting profit $10,000
Costs (Implicit)  
     Salary $20,000
     Interest foregone $500
     Economic profit ($10,500)
Blue ArrowHe is not using all of his resources efficiently.
Note: There is a non-monetary benefit of being your own boss.


Output and Costs in the Short Run

1. Short run - a period of time so short that at least one factor of production is fixed, usually the physical capital, like structures, machines, and equipment.

  • Total Fixed Costs (TFC) - the costs do not change when production level changes
    • Insurance premiums
    • Property taxes
    • Loans or bonds on factory building or machines
    • Overhead from administration
  • Average Fixed Costs (AFC) - fixed costs per good produced
    • As production level increases, AFC will get smaller and smaller
      • "Spreading the overhead"
    • The fixed costs is spread out over more units

AFC = TFC / Output

Total Fixed Cost Average Fixed Cost
Costs Per-Unit Costs
Total Fixed Costs Average Fixed Costs
Output/Quantity Output/Quantity
  • Total Variable Costs (TVC) - the costs that varies when the production level changes.
    • Labor costs
    • Raw material costs
    • Utilities like electricity, water, etc.
  • Average Variable Cost (AVC) - variable costs per unit of a good produced

AVC = TVC / Output

Total Variable Costs Average Variable Costs
Costs Per-Unit Costs
Total Variable Costs Average Variable Costs

2. Marginal Cost (MC) - the increase in cost as production increases by one unit.

  • MC will decline initially, reach a minimum, and then rise
  • Example: A factory starts with 0 workers
    • Specialization of labor
      • Production gains
      • MC decreases
        • 1 worker - output is 10 units (10 units per worker)
        • 2 workers - output is 30 units (15 units per worker)
        • 3 workers - output is 60 units (20 units per worker)
    • Law of Diminishing Returns
      • Output increases by a smaller and smaller amount as more labor (variable resource) is added to a factory (fixed resource)
      • Production inefficiency
      • Exists only in the short run
        • 50 workers - output is 1,000 units (20 units per worker)
        • 51 workers - output is 1,100 units (18.3 units per worker)
Marginal Cost
Cost per unit
Marginal Costs

3. The Total Costs and Average Curves.

Total Cost (TC) = Total Fixed Cost + Total Variable Cost


Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost.

ATC = AFC + AVC = TC / Output

  • Relationship between marginal cost and total variable costs
    • MC < ATC, then ATC is decreasing
    • MC > ATC. then ATC is increasing
    • MC intersects ATC at its minimum point
    • Example: Student's score is 80% and student took 2 tests
      • 3rd test (i.e. marginal)
      • Scores 90%, average increases
      • Scores 70%, average decreases


Total Cost Curves Average Cost Curves
Total cost Per-unit cost
Total Costs Average Cost Curves
Output/Quantity Output/Quantity

4. Product curves - Do not worry about the shape of these curves

  • Total product - total output of a good associated with different levels of a variable input (e.g. labor).
  • Marginal product - change in total product with a one more unit of a variable input (e.g. labor).
  • Average product - total product divided by the number of the units of the variable input (e.g. labor).
Cost Curves Average Costs Curves Product Curves
TC, TVC, TFC ATC, AFC, AVC, MC Total Product, Marginal Product, Average Product
Total costs for output Per-unit costs for output Output for a resource input
All curves are related to each other! However, the Average Costs Curves are the most important, because we can derive the supply curve.


Output and Costs in the Long Run

1. Long run - is a period of time sufficient for the firm to alter all factors of production.

  • Firms can enter and exit the industry.
  • Long run differs by industry.
    • Examples: Long run for an automobile factory using lots of machines may be 7 years.
    • The long run for an internet company may be 1 year.
  • Long-Run ATC - shows the minimum average cost of producing each output level when a firm is able to vary all production resources, including factory size.
    • Allow the firm to vary among 3 factory sizes: ATC1, ATC2, ATC3. Which factory size should the firm produce at?
Long Run ATC
Per-Unit Cost
Long-run Average Total Costs
Blue arrow

ATC2 will give the factory the lowest per unit costs in the long run. The firm will be able to recuperate all its total costs, when:

Market price (P*) > = minimum of long-run ATC

2. Why unit costs differ in the long run.

Long Run ATC
Per-Unit Cost
Long-run Average Total Costs
  • Economies of scale - per-unit costs fall as output (plant size) expands
    • Mass production - large amounts of capital and machines
    • Specialization of labor - adding more labor allows workers to specialize in task that they are good at
    • Management specialization - departments can specialize in finance, personnel, and marketing
    • Examples
      • Automobile
      • Electricity
      • Natural gas
      • Telecommunications including internet services
      • Computer chips
  • Constant returns to scale - per-unit costs are constant as plant size is changed.
    • Small firms can be just as efficient as large firms.
      • Apparel
      • Food processing
      • Publishing
      • Lumber
      • Retailing
      • Wood products
  • Diseconomies of scale - per-unit costs rises as output (plant size) expands
    • Bureaucratic inefficiencies
    • More difficult to coordinate workers
    • Monitoring problems, such as workers shirking

Factors that Shifts Firm's Cost Curves

Everything that shifts a supply function will also shift the production function

  1. Prices of resources - if a price of a resource used in production increases, the cost curves shift higher.
    • Labor costs increase.
    • Example: Price of steel increases for automobile industry.
      • Supply decreases.
  2. Taxes - increasing taxes on businesses.
    • Supply decreases.
  3. Regulations - increasing regulations on businesses. Firm has to hire compliance specialists, gather data and information, and submit reports. This can be a large cost.
    • Environmental regulations
    • Health & safety regulations
    • Labor regulations
      • Supply decreases.
  4. Technology - allows firms to produce more output while using the same level of resources.
    • Microprocessor - compressed millions of transistors onto one chip. Uses less silicone wafers, less labor, less wires, uses less energy, etc.
      • Supple increases.
Decrease in Production Costs Increase in Production Costs
Per-unit cost Per-unit cost
Firm's production costs decrease Firm's production costs increase
Output/Quantity Output/Quantity


  • business firm
  • contracting
  • team production
  • shirking
  • principal-agent problem
  • explicit costs
  • implicit costs
  • opportunity costs
  • sunk costs
  • normal rate of return
  • economic profit
  • short run
  • total fixed costs
  • average fixed costs (AFC)
  • total variable costs
  • average variable cost (AVC)
  • marginal costs (MC)
  • law of diminishing returns
  • specialization of labor
  • total cost
  • average total cost (ATC)
  • long run
  • long-run average total costs (ATC-LR)
  • economies of scale
  • diseconomies of scale
  • constant returns to scale

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