CHAPTER 6

Production costs

KEY POINTS

Costs and profit

Economic and accounting profit
Short run and long run
Constructing a production function
Defining short-run and long-run production costs
Cost of environmentally sensitive services
Explaining and identifying scales of production

COSTS AND PROFIT

Assumption: profit maximisation as the
motivation for business decisions.
Profit maximisation goal has been shown
to be a powerful way of explaining the
behaviour of managers of firms who are
responsible for making decisions about
the appropriate level of output or price.

ECONOMIC AND ACCOUNTING

PROFIT
Accounting profit only takes into consideration
explicit costs payments to non-owners of a
firm for their resources, e.g. wages, lease
payments, cost of materials, etc.
Economic profit includes explicit costs and
implicit costs which are the opportunity costs,
e.g. where owners have forgone a salary
elsewhere to start the firm.

ACCOUNTING PROFIT VERSUS

ECONOMIC PROFIT
Accounting Profit is:
Total Revenue Total Explicit
Costs
Economic Profit is:
Total Revenue Total
Opportunity Costs
Total Opportunity Cost is:
Explicit Costs + Implicit Costs

ACCOUNTING PROFIT VERSUS

ECONOMIC PROFIT EXAMPLE

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 costs.

So it still makes an accounting

profit

SHORT RUN VERSUS LONG RUN

Cost theory is the relationship between output
and costs.
Economists distinguish between the short-run
and the long-run.

Shortrun
Longrun

a period of time where there

is at least one fixed input
a sufficient period of time to
allow all inputs to be varied

FIXED AND VARIABLE INPUTS

10

A fixed
input is:

any resource where the

quantity used cannot
change during a specific
period of time

A
variable
input is:

any resource for which

the quantity used can
change during a specific
period of time

THE PRODUCTION FUNCTION

The
relations
hip
between:
A typical
productio
n
function:
11

the maximum amounts of

output a firm can produce
and various quantities of
inputs
shows how output rises
based on number of
people employed

THE SHORT-RUN PRODUCTION

FUNCTION

THE SHORT-RUN PRODUCTION

FUNCTION
Exhibit 6.2 shows:
the variable input as the number of
employees employed per day, and each
employee is presumed to have equal job
skills.
the amount of land, the number of vines, the
number of machines and all other inputs as
fixed inputs.

MARGINAL PRODUCT
Recall from Chapter 1, economists work
on the margins:
we measure the change in total output produced by
adding one unit of a variable input, with all other
inputs used being held constant (reinforcing ceteris
paribus)
it is a short-run concept.

MARGINAL PRODUCT CURVE

The law of diminishing returns explains

the shape of the marginal product
curve

THE LAW OF DIMINISHING

RETURNS
Beyond some point, the marginal product
decreases as additional units of a
variable factor are added to a fixed
factor.
Overall productivity (output per worker)
starts to falls after a certain number of
additional inputs.

SHORT-RUN COST FORMULAS

In the short run, the business makes
decisions based upon the cost of
producing various levels of output.
Economists distinguish between total
costs and average costs.

TOTAL COST CURVES

Total
Fixed
Costs

Total
Variable
Costs

Do not vary
as output
varies and
must be
paid even
if output is
zero

Are zero
when
output is
zero and
vary as
output
varies

Total
Cost
Is the sum
of total
fixed cost
and total
variable
cost at
each level
of output

SHORT-RUN COSTS CURVES:

TOTAL COST CURVES

AVERAGE COST CURVES

Average
fixed cost
Average
variable
cost
Average
total cost

MARGINAL COST
Marginal analysis asks how much it costs
to produce an additional unit of output
It is the change in total cost when one
additional unit of output is produced

SHORT-RUN COSTS CURVES:

AVERAGE AND MARGINAL COSTS

MARGINAL COST RELATIONSHIPS:

THE MARGINALAVERAGE RULE
When MC <
AC

AC falls

When MC >
AC

AC rises

When MC =
AC

AC is at its minimum
point

MC AND MP INVERSELY RELATED

Rising portion of the MP curve corresponds to the
declining portion of the MP curve and vice versa.
Maximum point of the MP curve corresponds to the
minimum point of the MC curve.

LONG-RUN PRODUCTION COSTS

In the long run, the quantity of all inputs
can be adjusted:
build a larger factory
expand onto new land
hire new staff.

The long-run allows greater planning for

the expected level of production.

LONG-RUN AVERAGE COST

CURVE
The curve traces
the lowest cost per
unit at which a firm
can produce any
level of output when
the firm is in a
position to build any
desired plant size.

DIFFERENT SCALES OF
PRODUCTION
LRAC is U-shaped
Economies
of scale
LRAC curve
declines as the
firm increases
output

Constant
returns to
scale
LRAC curve is
horizontal as
the firm
increases
output

Diseconomi
es of scale
LRAC curve
rises as the firm
increases
output

DIFFERENT SCALES OF
PRODUCTION

SCALES OF PRODUCTION

Economies of scale
When LRAC declines as the firm
increases output.
When:
the division of labour and the use of
specialisation are increased
more efficient use of capital equipment.

SCALES OF PRODUCTION
Constant returns to scale
When LRAC does not change as the
firm increases output.

SCALES OF PRODUCTION
Diseconomies of scale
When the LRAC rises as the firm
increases output.
When there:
is a bureaucracy
is an increased barrier to
communication
are management difficulties (lack of
coordination).