Chapter Twenty-

One
Production and Costs

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 Icebreaker
1. The class will be broken up into pairs of students.
2. Each pair of students will discuss the question.
− Scenario: You and your partner are going into business together by starting
a new restaurant. One person currently earns a higher salary than the other
person.
− Who is more likely to give up their current employment to work in the
business and why?
− What costs do you expect to pay when your restaurant is in operation?
3. Then one person from each pair will share a one sentence answer to the
class.
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 Chapter Objectives
By the end of this chapter, you should be able to:
• Calculate profit, given price, input costs, and production data.
• Compare economic profit and accounting profit, given data on total revenue,
implicit costs, and explicit costs.
• Classify a firm's costs as fixed or variable.
• Explain the shapes of the ATC, AVC, AFC, and MC curves.
• Given a graph of the average-total-cost curve in the long run, identify the regions
that represent economies of scale, constant returns to scale, and diseconomies of
scale.

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 Why Firms Exist

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 The Market and the Firm

• Business Firm: An entity that employs factors of production (resources) to

produce goods and services to be sold to consumers, other firms, or the
government.
• Market and the firm: Invisible hand vs visible hand
− Market Coordination: The process in which individuals perform tasks, such
as producing certain quantities of goods, based on changes in market
forces, such as supply, demand, and price.
− Managerial Coordination: The process in which managers direct
employees to perform certain tasks.

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 Two Answers

• The Alchian-and-Demsetz Answer

− Economists Alchian and Demsetz suggest that firms are formed when
benefits can be obtained from individuals working as a team.
▪ Sum of team production > sum of individual production
• The Coase Answer
− Firms exist either to economize on buying and selling everything or to
reduce transaction costs.

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 Team Production

• Problem with team production

− Shirking: The behavior of a worker who is putting forth less than the agreed-
to effort.
• Solution
− Monitor: A person in a business firm who coordinates team production and
reduces shirking.
− Residual Claimant: Persons who share in the profits of a business firm.

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 Exchanges in the Firm

• Economics is largely about trades or exchanges, market transactions

• In the theory of the firm, exchanges take place at two levels:
− At the level of individuals coming together to form a team
− At the level of workers choosing a monitor
• Because sum of team production > sum of individual production
− They trade some control over their daily behavior in order to receive a larger
absolute amount of the potential benefits of the team.

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 Knowledge Check 1a

According to Alchian and Demsetz, a firm is likely to be established when

A. the sum of what individuals can produce working alone is greater than what
they can produce as a team.
B. the sum of what individuals can produce as a team is greater than the sum of
what they can produce working alone.
C. money is important to everyone.
D. only labor is needed for production.

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 Answer 1a

• B. According to economists Alchian and Demsetz, a firm is formed when the

sum of team production is greater than the sum of individual production.

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 Knowledge Check 1b

According to Coase, a firm exists to

A. have the sum of team production equal to the sum of individual production.
B. have the sum of team production greater than the sum of individual production.
C. reduce transaction costs.
D. avert economic losses.

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 Answer 1b

• C. According to Coase, a firm exists to reduce transaction costs.

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 Knowledge Check 1c

One problem of team production is _____, which occurs when workers put forth
less than the agreed-to effort.

A. limited individual production

B. monitoring
C. transaction costs
D. shirking

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 Answer 1c

• D. One problem of team production is shirking, which occurs when workers put
forth less than the agreed-to effort.

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Two Sides to Every Business
Firm

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 Two Sides of Business
• Two sides to every business firm: revenue and cost
− Both sides can be seen by focusing on profit
• Profit: The difference between total revenue and total cost
▪ Profit = TR - TC
• Total revenue (TR) is equal to the price of a good multiplied by the quantity of
the good sold.
▪ TR = P x Q
• Total cost (TC) that a firm incurs is related to the production of the firm.

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 Costs and Profit
• Total Cost = explicit costs + implicit costs
− Explicit Cost: A cost incurred when an actual (monetary) payment is made
− Implicit Cost: A cost that represents the value of resources used in
production for which on actual (monetary) payment is made
• Accounting Profit: The difference between total revenue and explicit costs
▪ Accounting Profit = TR – TC (explicit costs)
• Economic Profit: The difference between total revenue and total cost,
including both explicit and implicit costs
▪ Economic Profit = TR – TC (explicit costs + implicit costs)

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 Normal Profit
• Normal Profit
▪ Normal Profit = Zero Economic Profit
− The level of profit necessary to keep
resources employed in a firm
− A firm that earns normal profit is earning
revenue equal to its total costs
▪ TR = TC (explicit costs plus implicit
costs)

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 Knowledge Check 2a

Consider the following information about a business, Erika’s, that opened last
year: price = $12, quantity sold = 150,000; implicit cost = $155,000; explicit cost =
$660,000. What was Erika's accounting profit last year?

A. $985,000
B. $1,140,000
C. $1,645,000
D. $1,295,000

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 Answer 2a

• B. Accounting profit is the difference between total revenue and explicit costs.
Total revenue is equal to price times quantity. In this problem, total revenue =
$12 ×150,000 = $1,800,000 and accounting profit = $1,800,000 – 660,000 =
$1,140,000.

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 Knowledge Check 2b

Consider the following information about a business, Erika’s, that opened last
year: price = $12, quantity sold = 150,000; implicit cost = $155,000; explicit cost =
$660,000. What was Erika's economic profit last year?

A. $985,000
B. $1,140,000
C. $1,645,000
D. $1,295,000

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 Answer 2b

• A. Economic profit is the difference between total revenue and explicit and
implicit costs. Total revenue is equal to price times quantity. In this problem, total
revenue = $12 ×150,000 = $1,800,000 and economic profit = $1,800,000 –
(660,000 + 155,000) = $985,000.

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 Knowledge Check 2c

_____ is the level of profit necessary to keep resources employed in a firm.

A. Implicit profit
B. Explicit profit
C. Accounting profit
D. Normal profit

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 Answer 2c

• D. Normal profit is another term for zero economic profit. Zero economic profit
occurs when total revenue is sufficient to cover all of the firm's costs, both
explicit and implicit. Zero economic profit is not as bad as it sounds, since the
firm is making enough revenue to cover not only its explicit costs, but also its
implicit costs.

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 Production

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 Inputs and Time
• Inputs in the production process
− Fixed Input: An input whose quantity cannot be changed as output changes.
− Variable Input: An input whose quantity can be changed as output changes.

• Periods of time
− Short Run: A period during which some inputs in the production process are
fixed.
− Long Run: A period during which all inputs in the production process can be
varied. (No inputs are fixed.)

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 Production in the Short Run
• Marginal Physical Product (MPP):
The change in output that results from
changing the variable input by one
unit, with all other inputs held fixed.
▪ MPPL = ΔQ / ΔL
• Law of Diminishing Marginal
Returns: As ever larger amounts of a
variable input are combined with fixed
inputs, eventually the marginal
physical product of the variable input
will decline.
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 Total Cost and Marginal Cost

• Fixed Costs: Costs that do not vary with output; the costs associated with fixed
inputs
• Variable Costs: Costs that vary with output; the costs associated with variable
inputs
• Total Cost (TC): The sum of fixed costs and variable costs
▪ TC = TFC + TVC
• Marginal Cost (MC): The change in total cost that results from a change in
output
▪ MC = ΔTC / ΔQ
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 MPP and MC

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 Productivity
• Inverse relationship between MPP
and MC
MPP Variable Cost W / MPP = MC
▪ MC = Wage / MPP (units) (Wage)
18 $20 20/18=$1.11
19 $20 20/19=$1.05
• When using the word productivity 20 $20 20/20=$1.00
− Usually referring to average 19 $20 20/19=$1.05
physical product 18 $20 20/18=$1.11
17 $20 20/17=$1.17
− Not MPP
16 $20 20/16=$1.25
▪ APL = Q / L

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 Knowledge Check 3a

If labor is the only variable input and the wage rate is constant, after diminishing
marginal returns have set in, then _____ as output increases.

A. marginal cost is falling

B. marginal cost is rising
C. average fixed cost is rising
D. average total cost is falling

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 Answer 3a

• B. Marginal physical product (MPP) is the change in output resulting from a one
unit change in variable input, with all other inputs held fixed. When labor is the
only variable input, marginal cost equals wage divided by marginal physical
product (MPP) of labor. After diminishing marginal returns have set in, MPP is
falling so marginal cost must be rising.

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 Knowledge Check 3b

The law of diminishing marginal returns is

A. the same concept as economies of scale.

B. another name for the law of diminishing utility.
C. relevant to the short run, but not the long run.
D. relevant to the production of services, but not goods.

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 Answer 3b

• C. The law of diminishing marginal returns states that as ever larger amounts of
a variable input are combined with fixed inputs, eventually the marginal physical
product of the variable input will decline. Since no inputs are fixed in the long
run, this law applies to the short run, but not the long run.

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 Knowledge Check 3c

As MPP of labor _____, MC _____.

A. rises; declines
B. declines; declines
C. rises; rises
D. declines; remains constant

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 Answer 3c

• A. MC is equal to W/MPP, so that if MPP rises, MC declines.

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 Costs of Production:
Total, Average, Marginal

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 Average Costs

• Average Fixed Cost (AFC): Total fixed cost divided by quantity of output
▪ AVC = TFC / Q
• Average Variable Cost (AVC): Total variable cost divided by quantity of output
▪ AVC = TVC / Q
• Average Total Cost (ATC): Total cost divided by quantity of output
▪ ATC = TC / Q
− Alternatively, ATC equals the sum of AFC and AVC
▪ ATC = AFC + AVC
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Calculating and Graphing Costs

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 Average and Marginal

• Average-marginal rule: When the

marginal magnitude is above the
average magnitude, the average
magnitude rises; when the marginal
magnitude is below the average
magnitude, the average magnitude
falls.
− MC > AVC or ATC, Average rises
− MC < AVC or ATC, Average falls
• MC intersects AVC and ATC at
minimum
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 Sunk Cost

• Short run period during which some inputs in the production process are fixed.
• One more cost concept
− Sunk Cost: A cost incurred in the past that cannot be changed by current
decisions and therefore cannot be recovered.
▪ Advice: Ignore sunk costs; a present decision can affect only the future,
never the past.
•Behavioral economics and sunk cost: It seems likely that the greater
the sunk cost, the more likely to not ignore sunk cost.

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 Knowledge Check 4a

_____ declines continuously as output is increased.

A. ATC
B. AVC
C. AFC
D. MC

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 Answer 4a

• C. It is AFC that continuously declines as output increases, since AFC is equal

to TFC divided by Q. TFC is constant as Q rises, so that AFC continuously
declines as Q rises.

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 Knowledge Check 4b

In the downward-sloping portion of the average variable cost curve, it is always

true that the

A. marginal cost curve is below the average variable cost curve.

B. marginal cost curve is downward sloping.
C. average fixed cost curve is upward sloping.
D. marginal cost curve is upward sloping.

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 Answer 4b

• A. As a result of the average-marginal rule, when marginal cost is below

average variable cost it causes the average variable cost to decline. Thus, when
the marginal cost curve is below the average variable cost curve, the average
variable cost curve is downward sloping.

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 Knowledge Check 4c

The _____ curve cuts the _____ curve at its lowest point.

A. AVC; MC
B. ATC; MC
C. MC; MPP
D. MC; AVC

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 Answer 4c

• D. The marginal cost curve cuts the average variable cost and average total
cost curves at their lowest point.

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Production and Costs in the
Long Run

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 Long-Run Average Total Cost

• Long run has no fixed inputs

• Long-Run Average Total Cost

(LRATC) Curve: A curve that shows
the lowest (unit) cost at which a firm
can produce any given level of
output.

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 Economies or Diseconomies of Scale

• Economies of Scale: Economies

that exist when inputs are increased
by some percentage and output
increases by a greater percentage,
causing unit costs to call.
• Diseconomies of Scale: The
condition when inputs are increased
by some percentage and output
increases by a smaller percentage,
causing unit costs to rise.

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 Constant Returns to Scale

• Constant Returns to Scale: The

condition when inputs are increased
by some percentage and output
increases by an equal percentage,
causing unit costs to remain constant.
• Minimum Efficient Scale: The
lowest output level at which average
total costs are minimized.
− Divide the MES as a percentage
of U.S. consumption into 100 as
MES varies by industry.
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 Reasons for Economics of Scale

• Economies of scale exist if unit costs fall as output increases.

▪ LRATC is falling
• Reasons
− Growing firms offer greater opportunities for employees to specialize.
− Growing firms (especially large ones) can take advantage of highly efficient
mass production techniques.

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 Reasons for Diseconomies of Scale
• Diseconomies of scale exist if unit costs rise as output increases.
▪ LRATC is rising
• Reasons
− Coordination problems
− Communication problems
− Monitoring problems
• There is also a monetary incentive to not operate at diseconomies of scale.
− Reorganizing, dividing operations, or other measures to reduce the
diseconomies of scale.

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 Shifts in Cost Curves
• Several factors shift cost curves
− Taxes: Taxes on the production of a good will increase the per-unit costs
▪ Shifts AVC, ATC, and MC
− Input prices: A rise or fall in variable input prices
▪ Causes a corresponding shift in AVC, ATC, and MC
− Technology: Technological change often brings the capability of using fewer
inputs to produce a good, or lower input prices.
▪ Lowers variable costs and so shift AVC, ATC, and MC downward

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 Knowledge Check 5a

Diseconomies of scale are said to exist when inputs are increased by some
percentage and output increases by a _____ percentage, causing unit costs to
_____.

A. greater; fall
B. smaller; fall
C. smaller; rise
D. greater; rise

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 Answer 5a

• C. Diseconomies of scale are said to exist when inputs are increased by

some percentage and output increases by a smaller percentage, causing unit
costs to rise.

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 Knowledge Check 5b

One reason why economies of scale occur is that

A. larger firms are less likely to use mass production techniques.

B. in very large firm's managers tend to find it difficult to coordinate work
activities.
C. larger firms are less likely to use machinery that requires large setup costs.
D. a growing firm has opportunities to engage in specialization of labor, which can
help to reduce unit costs.

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 Answer 5b

• D. Economies of scale exist when inputs increase by some percentage and

output increases by a greater percentage. For example, if inputs increase by 10
percent and output increases by 20 percent, then economies of scale exist and
unit costs are falling. One reason that economies of scale exist is that larger
firms tend to be able to employ specialization of labor which gives workers the
ability to produce more units at a lower cost per unit.

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 Knowledge Check 5c

When the firm experiences _____, its _____ is constant.

A. increasing returns to scale; SRATC

B. constant returns to scale; LRATC
C. decreasing returns to scale; LRATC
D. constant returns to scale; MC

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 Answer 5c

• B. When the LRATC is constant, the firm is experiencing constant returns to

scale.

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Exercise

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 Chapter Summary
Now that the lesson has ended, you should have learned how to:
• Calculate profit, given price, input costs, and production data.
• Compare economic profit and accounting profit, given data on total
revenue, implicit costs, and explicit costs.
• Classify a firm's costs as fixed or variable.
• Explain the shapes of the ATC, AVC, AFC, and MC curves.
• Given a graph of the average-total-cost curve in the long run, identify the
regions that represent economies of scale, constant returns to scale, and
diseconomies of scale.
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