COSTS OF PRODUCTION

LECTURE NOTES

Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to
attract those resources away from their best alternative production opportunities. Payments may be
explicit or implicit.
A. Explicit costs are payments to nonowners for resources they supply.
B. Implicit costs are the money payments the selfemployed resources could have earned in their best alternative
employments.
C. Normal profits are considered an implicit cost because they are the minimum payments required to keep the
owner’s entrepreneurial abilities selfemployed.
D. Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit).
E. The short run is the time period that is too brief for a firm to alter its plant capacity. The plant size is fixed in
the short run. Shortrun costs, then, are the wages, raw materials, etc., used for production in a fixed plant.
F. The long run is a period of time long enough for a firm to change the quantities of all resources employed,
including the plant size. Longrun costs are all costs, including the cost of varying the size of the production
plant.
Short-Run Production Relationships
A. Shortrun production reflects the law of diminishing returns that states that as successive units of a variable
resource are added to a fixed resource, beyond some point the product attributable to each additional resource
unit will decline.
1. Total product (TP) is the total quantity, or total output, of a particular good produced.
2. Marginal product (MP) is the change in total output resulting from each additional input of labor.
3. Average product (AP) is the total product divided by the total number of workers.
4. law of diminishing returns shows the relationship between marginal, average, and total product concepts.
a. When marginal product begins to diminish, the rate of increase in total product stops accelerating and
grows at a diminishing rate.
b. The average product declines at the point at which the marginal product slips below average product.
c. Total product declines when the marginal product becomes negative.
B. The law of diminishing returns assumes all units of variable inputs—workers in this case—are of equal
quality. Marginal product diminishes not because successive workers are inferior but because more workers
are being used relative to the amount of plant and equipment available.
Short Run Production Costs
A. Fixed, variable and total costs are the shortrun classifications of costs;
1. Total fixed costs are those costs whose total does not vary with changes in shortrun
output.
2. Total variable costs are those costs that change with the level of output. They include payment for
materials, fuel, power, transportation services, most labor, and similar costs.
3. Total cost is the sum of total fixed and total variable costs at each level of output
B. Per unit or average costs
1. Average fixed cost is the total fixed cost divided by the level of output (TFC/Q). It will decline as output
rises.
2. Average variable cost is the total variable cost divided by the level of output (AVC = TVC/Q).
3. Average total cost is the total cost divided by the level of output (ATC = TC/Q), sometimes called unit
cost or per unit cost. Note that ATC also equals AFC + AVC
C. Marginal cost is the additional cost of producing one more unit of output (MC = change in TC/change in Q).
1. Marginal cost can also be calculated as MC = change in TVC/change in Q.
 2. Marginal decisions are very important in determining profit levels. Marginal revenue and marginal cost
are compared.
3. Marginal cost is a reflection of marginal product and diminishing returns. When diminishing returns
begin, the marginal cost will begin its rise .
4. The marginal cost is related to AVC and ATC. These average costs will fall as long as the marginal cost
is less than either average cost. As soon as the marginal cost rises above the average, the average will
begin to rise.
D. Cost curves will shift if the resource prices change or if technology or efficiency change.
In the longrun, all production costs are variable, i.e., long-run costs reflect changes in plant size and
industry size can be changed (expand or contract).
A. The longrun ATC curve shows the least per unit cost at which any output can be produced after the firm has
had time to make all appropriate adjustments in its plant size.
B. Economies or diseconomies of scale exist in the long run.
1. Economies of scale or economies of mass production explain the downward sloping part of the longrun
ATC curve, i.e. as plant size increases, long-run ATC decrease.
a. Labor and managerial specialization is one reason for this.
b. Ability to purchase and use more efficient capital goods also may explain economies of scale.
c. Other factors may also be involved, such as design, development, or other “start up” costs such as
advertising and “learning by doing.”
2. Diseconomies of scale may occur if a firm becomes too large as illustrated by the rising part of the
longrun ATC curve. For example, if a 10 percent increase in all resources result in a 5 percent increase in
output, ATC will increase. Some reasons for this include distant management, worker alienation, and
problems with communication and coordination.
3. Constant returns to scale will occur when ATC is constant over a variety of plant sizes.
C. Both economies of scale and diseconomies of scale can be demonstrated in the real world. Larger
corporations at first may successful in lowering costs and realizing economies of scale. To keep from
experiencing diseconomies of scale, they may decentralize decision making by utilizing smaller production
units.
D. The concept of minimum efficient scale defines the smallest level of output at which a firm can minimize its
average costs in the long run.
1. The firms in some industries realize this at a small plant size: apparel, food processing, furniture, wood
products, snowboarding, and small-appliance industries are examples.
2. In other industries, in order to take full advantage of economies of scale, firms must produce with very
large facilities that allow the firms to spread costs over an extended range of output. Examples would be:
automobiles, aluminum, steel, and other heavy industries. This pattern also is found in several new
information technology industries.

Don’t Cry over Sunk Costs

A. Sunk costs are irrelevant in decision-making.
1. The old saying “Don’t cry over spilt milk” sends the message that if there is nothing you can do about it,
forget about it.
2. A sunken ship on the ocean floor is lost, it cannot be recovered. It is what economists’ call a “sunk cost.”
3. Economic analysis says that you should not take actions for which marginal cost exceeds marginal
benefit.
4. Suppose you have purchased an expensive ticket to a football game and you are sick the day of the game;
the price of the ticket should not affect your decision to attend.
B. In making a new decision, you should ignore all costs that are not affected by the decision.
1. A prior bad decision should not dictate a second decision for which the marginal benefit is less than
marginal cost.
2. Suppose a firm spends a million pesos on R&D only to discover that the product sells very poorly. The
loss cannot be recovered by losing still more money in continued production.
3. If a cost has been incurred and cannot be partly or fully recouped by some other choice, a rational
consumer or firm should ignore it.
4. Sunk costs are irrelevant! Don’t cry over spilt milk or sunk costs!