ECON 300 PPT CH - 04

Understanding Economics
6th edition
by Mark Lovewell
Copyright 2012 by McGraw-Hill Ryerson

Limited. All rights reserved.
6th edition
by Mark Lovewell
Chapter 4
Costs of Production
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.
Learning Objectives
After this chapter you will be able to:
1. identify economic costs (explicit and implicit) of
production and economic profit

2. recognize short-run (total, average, and marginal)
products, and the law of diminishing marginal
returns
3. derive short-run (total, average, and marginal)
costs
4. explain long-run results of production (increasing
returns to scale, constant returns to scale, and
decreasing returns to scale) and long-run costs

Types of Production
There are three main sectors in the economy:

the primary sector, which consists of industries
that extract or cultivate natural resources

the secondary sector, which consists of
industries that fabricate or process goods
the service sector, which consists of trade and
information industries

Productive Efficiency
Businesses can choose from different

production processes.
A labour-intensive process employs more labour
and less capital.

A capital-intensive process employs more
capital and less labour.
The lowest-cost process provides productive

efficiency.

Economic Costs
Economic costs include:

explicit costs, which are payments to resource
supplies outside a business

implicit costs, which are what owners give up
by being involved in a business
Economic profit is found by subtracting

economic costs (both explicit and implicit)
from total revenue.

Accounting versus Economic Profit

Accounting profit is total revenue minus
explicit costs.
Because accountants consider only explicit
costs, accounting profit always exceeds
economic profit by the amount of the
businesss implicit costs.

Production in the Short

Run (a)
In the short run:
some inputs (such as capital) are fixed

other inputs (such as labour) are variable
Inputs are combined to make total product.

Other product measures include:
average product, which is total product divided
by the number of workers

marginal product, which is the extra total
product associated with an additional worker
The Law of Diminishing Marginal

Returns
Short-run production is determined by the law

of diminishing marginal returns. According to
this law:
the addition of more variable input causes
marginal product to fall after some point

average product also falls after some point

Relating Average and Marginal

Values
Average and marginal values are related using

three rules:
If an average value is rising, then the marginal
value must be above the average value.

If an average value is falling, then the marginal
value must be below the average value.
If an average value stays constant, then the
marginal value must equal the average value.

Total, Marginal, and Average Products

Total
Product
(q)
(workers (T-shirts
per day) per day)
0
80
200
250
270
280
270
Marginal
Product
(q/L)
(T-shirts
per day)
80
120
50
20
10
-10
Average
Product
(q/L)
(T-shirts
per day)
80
100
83.3
67.5
56
45
300
250
TP
200
150
100
50
0
--
Number of Workers Employed per Day

T-Shirts Produced per Day
Labour
(L)
T-Shirts Produced per Day
Figure 4.2, Page 95 and Figure 4.3, Page 97
Diminishing
returns set in
120
100
80
60
AP
40
20
0
-20
MP
Number of Workers Employed per Day

Costs in the Short Run
Short-run costs include:

fixed costs (costs of all fixed inputs)
variable costs (costs of all variable inputs)
total cost (fixed costs + variable costs)

Marginal Cost (a)
Marginal cost is the extra cost of producing

another unit of output.
It equals the change in total cost divided by the
change in total product.
The marginal cost curve is shaped like a J

because of the law of diminishing marginal
returns.

Marginal Cost (b)

Figure 4.6, Page 100
12
MC
10
$ per T-Shirt
8
6
Diminishing
returns set in
4
2
50
100
150
200
250
300
Quantity of T-Shirts Produced Per Day

Per-Unit Costs
Per-unit costs include:

average fixed cost (fixed costs divided by total
product)
average variable cost (variable costs divided by
total product)
average cost
either total cost divided by total product
or average fixed cost + average variable cost

Short-Run Costs for Pure n Simple TShirts

Figure 4.5, Page 99
Labour
(L)
Total Marginal Fixed Variable

Product Product Costs Costs
(MP)
(q)
(FC)
(VC)
80
200
250
270
280
80
120
50
20
10
Average
Marginal Average
Average
Cost
Cost
Fixed Costs Variable
(AC)
(MC)
(AFV)
Costs
(AFC + AVC)
(TC/q)
(FC/q)
(AVC)
(VC/q)
Total
Cost
(TC)
(FC + VC)
$825
$0
$825
825
140
965
825
300
1125
825
425
1250
825
535
1360
825
640
1465
140 $1.75
160
1.33
125
2.50
110
5.50
105 10.50

$10.31
$1.75
$12.06
4.13
1.50
5.63
3.30
1.70
5.00
3.06
1.98
5.04
2.95
2.29
5.24
The Family of Short-Run Cost Curves

Figure 4.7, page 102
12
MC
$ per T-Shirt
10
8
AC
b
AFC
AVC
2
a
0
50
100
150
200
250
300
Quantity of T-Shirts Produced Per Day

Returns to Scale (a)
All inputs can be changed by the same

proportion in the long run.
Increasing returns to scale means the % change
in output > the % change in inputs.

Constant returns to scale means the % change
in output = the % change in inputs.
Decreasing returns to scale means the %
change in output < the % change in inputs.

Returns to Scale (b)

Increasing returns to scale are caused by the
division of labour, specialized capital, or
specialized management.
Constant returns to scale arise whenever
making more of a product means repeating
exactly the same tasks.
Decreasing returns to scale are caused by
management difficulties or limited natural
resources.

Costs in the Long Run (a)

Long-run average cost is the minimum shortrun average cost at every output.
The long-run average cost curve is saucershaped because of various ranges of returns
to scale:
an initial range of increasing returns to scale

a middle range of constant returns to scale
a final range of decreasing returns to scale

Costs in the Long Run (b)

Long-Run Average Costs
AC4
$ per Magazine
AC1
AC2
Range A
AC3
Range B
Quantity of Magazines per Week

Range C
Long-Run AC
Costs in the Long Run (b)

Possible Long-Run Average Costs

Extended Range of
Decrease Returns
to Scale
Extended Range of
Constant Returns
to Scale
Extended Range of
Increasing Returns
to Scale
Quantity of Output
Long-Run AC
Quantity of Output

$ per Unit
Long-Run AC
$ per Unit
$ per Unit
Long-Run AC
Quantity of Output
Critic of the Modern

Corporation
John Kenneth Galbraith:

suggested that ownership and control are
separated in large corporations

argued that shareholders (the owners) give up
control to managers
held out the possibility that managers are more
interested in maximizing sales than in
maximizing profit

The Profit Game (OLC)

Economists and accountants differ in the way
they measure business performance.

For accountants, there are two main business
records:
a balance sheet shows a businesss assets, or
items that it owns. It also lists a businesss

liabilities, or items that it owes, as well as
owners equity, which is the owners stake in
the business

The Profit Game (OLC) (b)

An income statement shows a businesss
activities in a given time period, incorporating

total sales (or revenue) and total expenses,
which are its explicit costs.
One important explicit cost is depreciation, or
the reduction in the value of a businesss

durable assets.
For these assets (excluding land), an annual
depreciation charge is included in the income

statement as an expense.

Income Statement
Income Statement
(for the year)
Total Sales
Expenses
Food
Fuel
Depreciation
Interest on loan
Total explicit costs
$50 000
$ 15 000
3 500
1 000
500
Total profit

$20 000
$ 30 000

Calculating Economic Profit
Total Revenue
$50 000
Explicit Costs
Food
Fuel
Depreciation
Interest on loan
Total explicit costs
$ 15 000
3 500
1 000
500
Implicit Costs
Owners wage
Normal profit
Total implicit costs
$ 25 000
3 000
$20 000
Economic Profit

$28 000
$ 2 000
Markets in Motion (OLC) (a)

While bonds are a form of marketable form of
interest-bearing debt, stocks provide their

holders with the opportunity for dividends and
stock price appreciation.
Stocks have a book value and market value,
which often differ widely. Participants in stock
markets look at P/E ratios, which relate a
stocks market price to the companys latest
reported earnings. Stocks with high P/E ratios
are considered to be expensive.
Markets in Motion (OLC) (b)

The Toronto Stock Exchange (the TSX) is the
third largest in North America, behind the New

York Stock Exchange (NYSE) and NASDAQ
(originally the National Association of
Securities Dealers Automated Quotations
system). The TSX concentrates on shares of
relatively large companies in Canada.
All junior equities (i.e. shares of smaller
companies) in Canada trade on the TSX
Venture Exchange, with headquarters in
Calgary, Alberta, and with offices in Toronto,
All rights reserved. and Montreal.
Vancouver,Limited.
Winnipeg,
Markets in Motion (OLC) (c)

All derivatives in Canada trade on the
Montreal Exchange.
There are two main types of derivatives:
Future contracts represent agreements to
exchange an underlying at some future time.

So-called hedgers and speculators participate in
the futures market, the first group in order to
protect themselves from changes in the price of
the underlying item and the second to make a
profit. Price variations in futures markets can be
significant.
Markets in Motion (OLC) (d)

Options allow their holders to buy or sell an
underlying item during a given time period.

There are two types of options. Call options
allow the holder to buy, and put options to sell,
the underlying item. Both are traded by
hedgers and speculators for the same reasons
as futures contracts. Option premiums contain
two elements: an intrinsic value and a time
value

6th edition
by Mark Lovewell
Chapter 4
The End
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.

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Understanding Economics

Copyright 2012 by McGraw-Hill Ryerson

1. identify economic costs (explicit and implicit) of

production and economic profit

Copyright 2012 by McGraw-Hill Ryerson

There are three main sectors in the economy:

that extract or cultivate natural resources

Copyright 2012 by McGraw-Hill Ryerson

Businesses can choose from different

and less capital.

The lowest-cost process provides productive

Copyright 2012 by McGraw-Hill Ryerson

Economic costs include:

supplies outside a business

Economic profit is found by subtracting

Copyright 2012 by McGraw-Hill Ryerson

Accounting versus Economic Profit

Copyright 2012 by McGraw-Hill Ryerson

Production in the Short

In the short run:

some inputs (such as capital) are fixed

Inputs are combined to make total product.

by the number of workers

The Law of Diminishing Marginal

Short-run production is determined by the law

marginal product to fall after some point

Copyright 2012 by McGraw-Hill Ryerson

Relating Average and Marginal

Average and marginal values are related using

value must be above the average value.

Copyright 2012 by McGraw-Hill Ryerson

Total, Marginal, and Average Products

Number of Workers Employed per Day

T-Shirts Produced per Day

Figure 4.2, Page 95 and Figure 4.3, Page 97

Number of Workers Employed per Day

Copyright 2012 by McGraw-Hill Ryerson

Costs in the Short Run

Short-run costs include:

Copyright 2012 by McGraw-Hill Ryerson

Marginal Cost (a)

Marginal cost is the extra cost of producing

change in total product.

The marginal cost curve is shaped like a J

Copyright 2012 by McGraw-Hill Ryerson

Marginal Cost (b)

Quantity of T-Shirts Produced Per Day

Copyright 2012 by McGraw-Hill Ryerson

Per-unit costs include:

Copyright 2012 by McGraw-Hill Ryerson

Short-Run Costs for Pure n Simple TShirts

Total Marginal Fixed Variable

Copyright 2012 by McGraw-Hill Ryerson

The Family of Short-Run Cost Curves

Quantity of T-Shirts Produced Per Day

Copyright 2012 by McGraw-Hill Ryerson

Returns to Scale (a)

All inputs can be changed by the same

in output > the % change in inputs.

Copyright 2012 by McGraw-Hill Ryerson

Returns to Scale (b)

Copyright 2012 by McGraw-Hill Ryerson

Costs in the Long Run (a)