Understanding Economics

6th edition
by Mark Lovewell

Copyright 2012 by McGraw-Hill Ryerson

Limited. All rights reserved.
 Understanding Economics
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

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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

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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.

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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.

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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.

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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

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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

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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.

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Total, Marginal, and Average Products
Figure 4.2, Page 95 and Figure 4.3, Page 97

T-Shirts Produced per Day

300
Labour Total Marginal Average 250
TP
(L) Product Product Product 200
(q) (q/L) (q/L) 150
(workers (T-shirts (T-shirts (T-shirts 100
per day) per day) per day) per day)
50

0 0 -- 0 1 2 3 4 5 6
80 Number of Workers Employed per Day
1 80 80

T-Shirts Produced per Day

120 120 Diminishing
2 200 100 returns set in
50 100
3 250 83.3 80
20
4 270 67.5 60
10 40 AP
5 280 56
-10 20
6 270 45 0
-20 1 2 3 4 5 6
MP
Number of Workers Employed per Day

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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)

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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.

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Marginal Cost (b)
Figure 4.6, Page 100

12
MC
10

$ per T-Shirt 8

Diminishing
4 returns set in

0 50 100 150 200 250 300

Quantity of T-Shirts Produced Per Day

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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

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Short-Run Costs for Pure n Simple T-
Shirts
Figure 4.5, Page 99

Labour Total Marginal Fixed Variable Total Marginal Average Average Average
Product Product Costs Costs Cost Cost Fixed Costs Variable Cost
(L) (q) (MP) (FC) (VC) (TC) (MC) (AFV) Costs (AC)
(FC + VC) (TC/q) (FC/q) (AVC) (AFC + AVC)
(VC/q)
0 0 $825 $0 $825
80 140 $1.75
1 80 825 140 965 $10.31 $1.75 $12.06
120 160 1.33
2 200 825 300 1125 4.13 1.50 5.63
50 125 2.50
3 250 825 425 1250 3.30 1.70 5.00
20 110 5.50
4 270 825 535 1360 3.06 1.98 5.04
10 105 10.50
5 280 825 640 1465 2.95 2.29 5.24

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The Family of Short-Run Cost Curves
Figure 4.7, page 102

12
MC
10

8
$ per T-Shirt

6 AC

b
4
AFC

2 AVC

0 50 100 150 200 250 300

Quantity of T-Shirts Produced Per Day

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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.

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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.

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Costs in the Long Run (a)
Long-run average cost is the minimum short-
run average cost at every output.
The long-run average cost curve is saucer-

shaped 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

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Costs in the Long Run (b)
Figure 4.8, page 105
Long-Run Average Costs

AC1 AC4 Long-Run AC

$ per Magazine

AC2 AC3

Range A Range B Range C

Quantity of Magazines per Week

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Costs in the Long Run (b)
Figure 4.9, page 107
Possible Long-Run Average Costs

Extended Range of Extended Range of Extended Range of

Increasing Returns Constant Returns Decrease Returns
to Scale to Scale to Scale

Long-Run AC

Long-Run AC Long-Run AC

$ per Unit
$ per Unit
$ per Unit

Quantity of Output Quantity of Output Quantity of Output

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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

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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

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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.

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The Profit Game (OLC)
Income Statement
Income Statement
(for the year)

Total Sales $50 000

Expenses
Food $ 15 000
Fuel 3 500
Depreciation 1 000
Interest on loan 500
Total explicit costs $20 000

Total profit $ 30 000

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The Profit Game (OLC)
Calculating Economic Profit
Total Revenue $50 000

Explicit Costs
Food $ 15 000
Fuel 3 500
Depreciation 1 000
Interest on loan 500
Total explicit costs $20 000

Implicit Costs
Owners wage $ 25 000
Normal profit 3 000
Total implicit costs $28 000

Economic Profit $ 2 000

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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.
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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,
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Winnipeg,
All rights reserved. and Montreal.
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.
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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

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 Understanding Economics
6th edition
by Mark Lovewell

Chapter 4
The End
Copyright 2012 by McGraw-Hill Ryerson Limited. All rights reserved.