McConnell 22nd edition

1. CHAPTER 9
Businesses and the Costs of Production

2. Economic Costs
Short-Run Production Relationships
Short-Run Production Costs
Long-Run Production Costs
Applications and Illustrations
9-2
Chapter Contents

3. Economic Costs
• Economic cost: The payment that must be made to
obtain and retain the services of a resource.
• Explicit costs: Monetary outlay.
• It does not include any payment to owner(s) of firm.
• Implicit costs: Opportunity cost of using self-owned
resources.
• Value of next-best use of resource
• Includes a normal profit.
LO9.1 9-3

4. Accounting Profit and Normal Profit
• Accounting profit = Revenue – Explicit Costs
• Economic profit = Revenue – Economic costs
= Revenue – Explicit costs – Implicit costs
= Accounting Profit – Implicit Costs
LO9.1 9-4

5. Explicit
costs
Accounting costs
(explicit costs only)
Implicit costs (including
a normal profit)
Economic
profit
Accounting profit
Economic
(opportunity)
costs
TotalrevenueLO9.1
Economic Profit Versus Accounting Profit
9-5

6. Economics Profit Example
• Michael can mow the lawn for $40 per hour. He spends $5 on
gasoline and uses $10 worth of equipment (depreciation).
• Michael’s accounting profit: $40 - $15 = $25
• Instead, Michael can work at Home Depot as salesclerk and earn
$10 per hour.
• Michael’s economic profit: $40 - $15 - $10 = $15
• If Michael can earn only $25 per hour to mow the lawn, which job
should he choose?
• If Michael can earn only $20 per hour to mow the lawn, which job
should he choose? 9-6

7. Zero Economic Profit
• Accounting profit is a monetary payment to owner of firm.
• If an accounting profit is positive, the owner of firm may or may not
continue the business, depending on what other opportunities he/she
may have.
• Economic profit is an extra-payment that owner of firm can earn over
payment that the owner can earn from the next best opportunity.
• If an economic profit is positive, the owner of firm will definitely
continue the business since he/she earn more than he/she can make
from his/her next best opportunity.
• If an economic profit is negative, the rational owner of firm will
definitely quit the business and take his/her next best opportunity
which will pay more. 9-7

8. Short Run and Long Run
• Short run:
• Some variable inputs.
• Fixed plant.
• Long run:
• All inputs are variable.
• Firms can adjust plant size as well as enter and exit
industry.
• Actual time periods (months, years) of short run and
long run depend on business.
LO9.1 9-8

9. Short-Run Production Relationships
• Total product (TP): Total quantity of output for given inputs
• Marginal product (MP)
• Average product (AP)
LO9.2 9-9
Marginal product change in total product
change in labor input
=
Average product total product
labor input
=

10. Marginal Return
• Increasing marginal returns occur when the marginal product
of an additional variable input exceeds the marginal product
of the previous input.
• Diminishing marginal returns occur when the marginal
product of an additional variable input is less than the
marginal product of the previous input.
9-10

11. Total, Marginal, and Average Product
• MP is a slope of TP curve. When TP is rising, MP is
positive. When TP is falling, MP is negative.
• When MP curve is above AP curve, AP curve is increasing.
• When MP curve is below AP curve, AP curve is decreasing.
9-11
LO9.2
AP
Increasing
marginal
returns
Diminishing
marginal
returns
Negative
marginal
returns
20
10
Marginalproduct,MP
TP
0 1 2 3 4 5 6 7 8 9
Totalproduct,TP
Quantity of labor
(a)
Total product
0 1 2 3 4 5 6 7 8 9
Quantity of labor
(b)
Marginal and average product
MP
75
50
25
Total, Marginal, and Average Product: The Law of Diminishing Returns

12. Law of Diminishing Returns
• Law of diminishing returns:
• Resources are of equal quality.
• Technology is fixed.
• Variable resources are added to fixed resources.
• At some point, marginal product will fall, because not
enough fixed resources for too many variable resources.
• Example: Too many chefs with limited numbers of oven
LO9.2 9-12

13. Short-Run Production Costs
• Fixed costs (TFC)
• Costs that do not vary with output
• Costs associated with fixed input
= Quantity of fixed input x Price of fixed input
• Variable costs (TVC)
• Costs that do vary with output
• Costs associated with variable input
= Quantity of variable input x Price of variable input
• Total cost (TC)
• Sum of TFC and TVC: TC = TFC + TVC
LO9.3 9-13

14. Short-Run Cost Schedules
Total Cost Data
(1)
Total Product
(Q)
(2)
Total Fixed
Cost (TFC)
(3)
Total Variable
Cost (TVC)
(4)
Total Cost (TC)
TC = TFC + TVC
0 $100 $ 0 $ 100
1 100 90 190
2 100 170 270
3 100 240 340
4 100 300 400
5 100 370 470
6 100 450 550
7 100 540 640
8 100 650 750
9 100 780 880
10 100 930 1,030
LO9.3 9-14

15. Short-Run Cost Curves
Costs
0 1 2 3 4 5 6 7 8 9 10 Q
$1,100
1,000
900
800
700
600
500
400
300
200
100
TFC
TC
TVC
Total
cost Variable
cost
Fixed cost
See the table “Short-Run Cost Schedules” on the previous slide.
• TFC curve is a horizontal
straight line because it is
constant.
• Total cost is the sum of
total fixed cost and total
variable cost.
• A vertical distance
between TC curve and
TVC curve is equal to FC.
Since FC is constant, TC
curve can be found by
shifting TVC curve by an
amount of FC.
LO9.3 9-15

16. Per-Unit, or Average, Costs
• Average fixed cost (AFC) = TFC/Q
• Average variable cost (AVC) = TVC/Q
• Average total cost (ATC) = TC/Q
• Marginal cost (MC) = ΔTC/ΔQ
LO9.3 9-16

17. Short-Run Cost Schedules
Total Cost Data Average Cost Data Marginal Cost
(1)
Total Product
(Q)
(2)
Total Fixed
Cost (TFC)
(3)
Total Variable
Cost (TVC)
(4)
Total Cost (TC)
TC = TFC + TVC
(5)
Average
Fixed Cost
(AFC)
AFC = TFC/Q
(6)
Average
Variable
Cost (AVC)
AVC = TVC/Q
(7)
Average
Total Cost
(ATC)
ATC = TC/Q
(8)
Marginal
Cost
(MC)
MC = ΔTC/ΔQ
0 $100 $ 0 $ 100
1 100 90 190 $100.00 $90.00 $190.00 $ 90
2 100 170 270 50.00 85.00 135.00 80
3 100 240 340 33.33 80.00 113.33 70
4 100 300 400 25.00 75.00 100.00 60
5 100 370 470 20.00 74.00 94.00 70
6 100 450 550 16.67 75.00 91.67 80
7 100 540 640 14.29 77.14 91.43 90
8 100 650 750 12.50 81.25 93.75 110
9 100 780 880 11.11 86.67 97.78 130
10 100 930 1,030 10.00 93.00 103.00 150
LO9.3 9-17

18. The Average Cost Curves
• Average total cost is
the sum of average
fixed cost and
average variable
cost.
• A vertical distance
between ATC curve
and AVC curve is
equal to AFC.
Costs
0 1 2 3 4 5 6 7 8 9 10 Q
$200
150
100
50
AFC
ATC
AVC
AVC
AFC
LO9.3 9-18

19. Marginal Cost
LO9.3 9-19
Costs
0 1 2 3 4 5 6 7 8 9 10 Q
$200
150
100
50
AFC
MC
ATC
AVC
Quantity
The relationship of the marginal-cost curve to the average-total-cost and average-variable-cost curves
• When MC curve is below
ATC curve, ATC curve is
decreasing.
• When MC curve is above
ATC curve, ATC curve is
increasing.
• At the point where MC
curve intersects ATC
curve, ATC is lowest.

20. Marginal Cost and Marginal Product
LO9.3 9-20
• Figure illustrates the
relationship between the
marginal product curve and
marginal cost curve.
• If marginal product rises,
marginal cost falls.
• If marginal product is a
maximum, marginal cost is a
minimum.

21. Average Variable Cost and Average Product
LO9.3 9-21
• A firm’s average variable
cost curve is linked to its
average product curve.
• If average product rises,
average variable cost falls.
• If average product is a
maximum, average variable
cost is a minimum.

22. Marginal Cost and Marginal Product
LO9.3 9-22
The relationship between productivity
curves and cost curves
• At small outputs,
• MP and AP rise and
• MC and AVC fall.
• At intermediate outputs,
• MP falls and MC rises and
• AP rises and AVC falls.
• At large outputs,
• MP and AP fall and
• MC and AVC rise.

23. Technology Change
• A technological change that increases productivity shifts
the TP curve upward. It also shifts the MP curve and the AP
curve upward.
• With a better technology, the same inputs can produce
more output, so an advance in technology lowers the
average and marginal costs and shifts the short-run cost
curves downward.
9-23

24. Change in Prices of Factors of Production
• An increase in the price of a factor of production increases
costs and shifts the cost curves.
• No effect on production curves.
• But how the cost curves shift depends on which resource
price changes.
• If prices of fixed inputs increase, both the average fixed cost
curve and the average total cost curve increase. However, there
will be no change in the average variable cost or marginal cost
curves.
9-24

25. LO9.3 9-25
RELATIVE MANUFACTURING COSTS, SELECTED NATIONS, 2018
Global Perspective 9.1

26. Long-Run Production Costs
• The firm can change all input amounts, including plant size.
• All costs are variable in the long run.
• Long-run average total cost (LATC): the lowest short-run
average total cost at which it is possible to produce each
output when the firm has had sufficient time to change
both its plant size and labor employed.
• Compare short-run ATC with different plant sizes (different
levels of fixed input) at each level of output, then choose the
lowest one.
LO9.4 9-26

27. Firm Size and Costs
• At less than 20 units of output,
ATC-1 (short-run ATC with 1 unit
of fixed input) provides the
lowest ATC.
• Between 20 and 30 units of
output, ATC-2 (short-run ATC with
2 units of fixed input) provides
the lowest ATC.
• Between 30 and 50 units of
output, ATC-3 (short-run ATC with
3 units of fixed input) provides
the lowest ATC.
LO9.4 9-27
Averagetotalcosts
ATC-1
ATC-2
ATC-3
ATC-4
ATC-5
Output
0 20 30 50 60 Q
The long-run average-total-cost curve: five possible plant sizes

28. Long-Run Cost Curve
• Long-run average total
cost (ATC) curve traces
the lowest points of all
short-run average total
cost (ATC) curves.
LO9.4 9-28
Long-run
ATC
Averagetotalcosts
Output0 Q
The long-run average-total-cost curve: unlimited number of plant sizes

29. Economies of Scale
• Economies of scale (Increasing return to scale): when a
firm increases its plant size and labor employed by the same
percentage, its output increases by a larger percentage and
average total cost decreases.
• Labor specialization
• Managerial specialization
• Efficient capital
• Other factors
LO9.4 9-29

30. Constant Return to Scale
• Constant returns to scale: if when a firm increases its plant
size and labor employed by the same percentage, its output
increases by the same percentage and average total cost
remains constant.
• A firm can replicate its existing production facility including its
management system.
9-30

31. Diseconomies of Scale
• Diseconomies of scale (Decreasing return to scale): when
a firm increases its plant size and labor employed by the
same percentage, its output increases by a smaller
percentage and average total cost increases.
• Control and coordination problems
• Communication problems
• Worker alienation
• Shirking
LO9.4 9-31

32. Long-Run ATC and Returns to Scale
• ATC = TC of Input/Output Quantity
• Under IRS (Increasing returns to scale), a
long-run ATC (average total cost) curve is
decreasing.
Input ↑↑TC↑↑/Output↑↑↑ATC↓
• Under CRS (Constant returns to scale), a
long-run ATC curve is flat.
Input ↑↑TC↑↑/Output↑↑ATC→
• Under DRS (Decreasing returns to scale), a
long-run ATC curve is increasing.
Input ↑↑TC↑↑/Output↑ATC↑
9-32
Output
(a)
Averagetotalcosts
Long-run
ATC
Economies
of scale
Constant returns
to scale
Diseconomies
of scale
q1 q20

33. Minimum Efficient Scale
• Minimum efficient scale (MES)
• Lowest level of output at which long-run average costs
are minimized.
• Can determine the structure of the industry.
• Natural monopoly:
• Long-run costs are minimized when only one firm
produces the product.
LO9.4 9-33

34. MES and Industry Structure
A few large-scale firms in industry.
LO9.4 9-34
Output
(a)
Averagetotalcosts
Long-run
ATC
Economies
of scale
Constant returns
to scale
Diseconomies
of scale
q1 q20
Averagetotalcosts
Long-run ATC
0 Output
(b)
Averagetotalcosts
Output
(c)
Long-run
ATC
0
Many firms in same size in industry.
Firms of many different sizes in industry.

35. Applications and Illustrations
• Rising gasoline prices
• Successful start-up firms
• Verson stamping machine
• Newspaper companies
• Aircraft and concrete plants
LO9.5 9-35

36. Last Word: 3D Printers
• First industrial revolution began in 1700s.
• Mass production led to mass affordability.
• Second industrial revolution began in late 1800s.
• Mass sales were necessary to spread R&D costs.
• Third industrial revolution beginning now.
• Affordable mass customization with zero transportation
costs.
9-36