1. Chapter 8
The Costs of
Production
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Chapter Objectives
• Explicit and implicit costs
• Law of diminishing returns
• Fixed and variable costs
• Total, average, and marginal
costs
• The firm’s size in the long run
8-2

3. Economic Costs
• Opportunity costs
• Explicit + implicit costs
• Explicit costs
–Monetary payments
• Implicit costs
–Value of next best use
–Self-owned resources
–Self-employed resources
8-3

4. Profit
• Accounting profit
–Total revenue less explicit cost
• Economic or pure profit
–Total revenue less economic cost
8-4

5. Profits Compared
Economic Accounting
Economic
Profit Accounting
Total Revenue
Implicit Costs Profit
(Opportunity)
(Including a
Economic
Normal Profit)
Costs
Accounting
Explicit
Costs (Explicit
Costs Costs Only)
8-5

6. Short and Long Run
• The short run
–Fixed plant capacity
–Variable intensity of plant use
–Variable output
• The long run
–Variable plant capacity
–Firms enter and exit
8-6

7. Production Relationships
• Total product (TP)
• Marginal product (MP)
Change in Total Product
Marginal Product =
Change in Labor Input
• Average product (AP)
Total Product
Average Product = Units of Labor
8-7

8. Law of Diminishing Returns
• Fixed technology
• Add variable resource to fixed
resource
• Marginal product will decline
–Beyond some point
• Rationale
8-8

9. Law of Diminishing Returns
(3) (3)
(1) Marginal Product Average
Units of the (2) (MP), Product
Variable Resource Total Product Change in (2)/ (AP),
(Labor) (TP) Change in (1) (2)/(1)
0 0 -
1 10
] 10 Increasing
10.00
2 25
] 15 Marginal
Returns 12.50
3 45
]
4 60
]
5 70
]
75
]
6
]
7 75
]
8 70
8-9

10. Law of Diminishing Returns
(3) (3)
(1) Marginal Product Average
Units of the (2) (MP), Product
Variable Resource Total Product Change in (2)/ (AP),
(Labor) (TP) Change in (1) (2)/(1)
0 0 -
1 10
] 10 Increasing
10.00
2 25
] 15 Marginal
Returns 12.50
3 45
] 20
15.00
4 60
] 15
Diminishing 15.00
5 70
] 10 Marginal
14.00
75
] 5 Returns
12.50
6
] 0 Negative
7 75 10.71
] -5 Marginal
Returns
8 70 8.75
8-10

11. Law of Diminishing Returns
Total Product, TP
30
TP
20
10
0
1 2 3 4 5 6 7 8 9
Marginal Product, MP
Increasing Diminishing Negative
Marginal Marginal Marginal
20 Returns Returns Returns
10 AP
1 2 3 4 5 6 7 8 9
MP
8-11

12. Law of Diminishing Returns

13. Short-Run Production Costs
• Fixed Costs
–Do not vary with output
• Variable Costs
–Materials, most labor
• Total Cost
–TC = TFC + TVC
8-13

14. Per-Unit Production Costs
• Average fixed cost
AFC = TFC/Q
• Average variable cost
AVC = TVC/Q
• Average total cost
ATC = TC/Q = TFC/Q + TVC/Q
ATC = AFC+AVC
• Marginal cost
MC = change in TC/change in Q
8-14

15. Cost for Individual Firm

16. Short-Run Production Costs
$1100
1000 TC
900
TVC
800
700
Costs
600
Fixed
500 Cost
400
300 Total Variable
Cost Cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q
8-16

17. Short-Run Production Costs
$200
MC
Costs 150
ATC
100
AVC
AFC
50
AVC
AFC
0 1 2 3 4 5 6 7 8 9 10 Q
8-17

18. Production Relationships
• Marginal cost and diminishing returns
• Marginal cost and marginal product
• Marginal cost and average variable
cost
• Marginal cost and average total cost
• Production curves and cost curves
• Shifts in cost curves
8-18

19. Graphical Relationships
Production Curves
Average Product and
Marginal Product
AP
MP
Quantity of Labor
MC
AVC
Cost (Dollars)
Cost Curves
Quantity of Output
8-19

20. Long-Run Production Costs
• Choose your plant size
• Minimize ATC
• Different ATC curves
–Short run
• Long run ATC
–Envelope of short run ATC
8-20

21. Long-Run ATC Curve
Average Total Costs
ATC-1
ATC-5
ATC-2
ATC-3 ATC-4
Output
Any number of short-run optimum
size cost curves can be constructed
8-21

22. Long-Run ATC Curve
Average Total Costs
ATC-1
ATC-5
ATC-2
Long-Run
ATC-3 ATC-4
ATC
Output
The long-run ATC curve just
“envelopes” the short run ATCs
8-22

23. Long Run Production Cost
• Economies of Scale
–Labor specialization
–Managerial specialization
–Efficient capital
• Diseconomies of Scale
• Constant Returns to Scale
8-23

24. Long-Run ATC Shapes
Economies Constant Returns Diseconomies
Average Total Costs Of Scale To Scale Of Scale
Long-Run
ATC
q1 q2
Output
Long-run ATC curve where economies
of scale exist
8-24

25. Long-Run ATC Shapes
Economies Diseconomies
Average Total Costs Of Scale Of Scale
Long-Run
ATC
Output
Long-run ATC curve where costs are
lowest only when large numbers are
participating
8-25

26. Long-Run ATC Shapes
Economies Diseconomies
Average Total Costs Of Scale Of Scale
Long-Run
ATC
Output
Long-run ATC curve where economies
of scale exist, are exhausted quickly,
and turn back up substantially
8-26

27. Key Terms
• economic (opportunity) • variable costs
cost • total cost
• explicit costs • average fixed cost (AFC)
• implicit costs • average variable cost
• normal profit (AVC)
• economic profit • average total cost (ATC)
• short run • marginal cost (MC)
• long run • economies of scale
• total product (TP) • diseconomies of scale
• marginal product (MP) • constant returns to scale
• average product (AP) • minimum efficient scale
• law of diminishing returns (MES)
• fixed costs • natural monopoly
8-27

28. Next Chapter Preview…
Pure
Competition
8-28