1 A Tour of Block Five: Objectives and Introduction After working through Block Five of this course, you should be able to: |. Give examples of the role of input prices in the choice of technology. Explain the particular meaning of cost and profits in economics Distinguish the short run from the long run, Distinguish between historical and incremental costs. . Define the relationship between marginal cost and per unit costs. 2 3 4 5. Explain some implications of opportunity cost. 6 7. State some goods subject to (a) economies of scale and (b)diseconomies of scale. 8 Find the break-even level of output for a simple product. 1.1 Introduction Production is the process of transforming a set of resourees into a good or service that has economic value. The resources used in production are known as inputs. Recall that natural resources, capital resources, and human resources are the three economic resources used in Production. Inputs for most businesses include all three of these factors of production. Output is the result of this production, the quantity of a good or service that is produced. Businesses and the industries in which they operate fall into one of three sectors depending on the type of production: primary, secondary, or service (also known as tertiary"), The primary fector includes industries that extractor cultivate natural resources, such as mining, forestry, fishing, and agriculture. The secondary sector involves fabricating or processing goods, and includes manufacturing and construction, among other industries. Finally, the service sector includes trade industries (both retail and wholesale) such as banking and insurance, and the new information industries. Despite the differences among these three sectors, they all follow the same production principles. : 1.2 Choice of Technology 'm producing a certain good or service, businesses can typically choose from several processes, cach using a different combination of inputs. A labour-intensive process is one that employs more labour and less capital to produce a certain quantity of output. Conversely, a capital- intensive process uses more capital and less labour to produce the same quantity of output Suppose you have started a small company, “Simple Diapers,” with $100,000 you have saved. You rent a building to use as a factory, and buy a supply of materials. Before hiring workers or buying sewing machines, you discover that you can make 1,000 “Soft Diapers’ a day by using one of five possible production processes, each involving a different combination of workers and machines. 125The combinations of labour and capital employed in each process are shown in Figure 5-1, Five diferent techniques of producing 1,000 diapers are available. Technique A is most labour- sive since it requires more workers and fewer machines (10 units of labour and 2 units of capital} to produce 1,000 diapers per day. However, inputs can also be substituted for one sother. If labour becomes more expensive, firms can adopt labour-saving technologies: that is, they can substitute capital for labour. ‘They can automate assembly lines by replacing human eines with machines and can substitute capital for land when land is scarce. Techniques B. and ) are increasingly more capital- (and less labour-) intensive. Technique E is the most capital-intensive, requiring only 2 units of labour but 10 units of capital Table 6-1 Inputs Required to Produce 1,000 Diapers by means of Alternative Technologies Tae ee td a So tel Se Units of Units of Technique Capital (K) Labour (L) 2 10 B 3 6 a 4 4 D 6 3 i 10 2 Learning Tip You can think of units of labour as human hours and of capital as machine hours. To choose a production technique, the firm must look to input markets to figure out the current market prices of labour and capital low does a business decide which production process to use? Owners who want to eamn as much jvofitas possible should uy to maximize the business's productive efficiency, which means staking @ given quantity of output with the least costly mix of inputs. Selecting the most efficient srocess therefore depends both on the quantity of each input used and on the prices of these input 41.3 Practice Use the following information for the next two questions. Each technique produces the same amount of output. Technique Units of Capital Units of Labour A 2 15 B 5 8 Cc 9 3 D 14 1 : |. The price of both labour and capital is $1 per unit. What is the optimal production technique: A. B.C. or D? 126Answer: Technique C is best (least cost). The total cost is $12 2. Which production technique is the most labour intensive: A. B. C.or D? Answer: Technique A uses more units of labour than any of the other techniques 2 What Are Costs? Fo determine what a cost is, you must begin with the firm's objective. Let's find the seemingly obviots answer to what costs are by focusing on your diapers business. It is conceivable ther cou Started your firm because of an altruistic desire to provide nearby families of intants with diapers. More likely, however, you started your business to make money. Economists normally assume that the goal of a fitm is to maximize profit. and they find that this assumption works well in most cases, ‘What isa firm's profit? The amount thatthe firm receives for the sale of its output (diapers) is called its total revenue. The amount that your firm pays to buy inputs (fabric. absorber lille, Workers, sewing machines, etc.) is called its total cost. You get to keep any revenue that is not needed to cover costs. We define profit as a firm's total revenue minus its total cost, That ws Profit = Total revenue - Total cost. Your objective is to make your firm's profit as large as possible. To see how a firm goes abwout maximizing profit, we must consider fully how to measure its total revenue and its tolal evn Total revenue is the easy part: it equals the quantity of ouput the firm produces tinies the price at sshich it sells its output. If you produce 1,000 “Soft Diapers’ and sell them at $1.00 a dap. ve ‘otal revenue is $1,000. The measurement of your firm's total cost, hewever, is more challengin In the example given above, Figure 3-1. your total cost would depend on the choice of Fechnique (A t0 E). which in turn depends on the combination of the two inputs and the prices of the inputs. However, there is more to this than can be seen in the first instance 2.2 Opportunity Costs When measuring costs, economists always use the concept of opportunity cost, The cost of something is what you give up to get it. The opportunity cost of an item refers to all those things that must be forgone to acquire that item. When economists speak of a firm's cost of production, they include all the opportunity costs of making its output of goods and services, When you eloce down your business of making diapers for a week to go on a fishing trip, the amount of ineome that you forgo by suspending your operation temporarily would be a real cost to you, the opportunity cost. For economists, this cost is as real as the out-of: pocket expenses associated * witlf your fishing activities. Firmis face two types of costs: explicit costs and implicit costs, Explicit costs are payments made by a business to other businesses or people outside of it. Explicit costs are also referred to ax 127accounting costs because they include all the costs that appear in the business accounting records, These costs include such items as payments made for workers, buildings, machinery, and materials. In contrast, implicit costs are estimates of what owners give up by being involved with a business—the opportunity cost, in other words, of pursuing this course of action over another. Implicit costs relate to the resources provided by the owners. This distinction between explicit and implicit costs highlights an important difference between how economists and accountants analyse a business. Economists are interested in studying how firms make production and pricing decisions. Because the decisions are based on both explicit and implicit costs, economists include both when measuring a firm's costs, economic costs. By contrast, accountants have the job of keeping track of the money that flows into and out of firms. As a result, they measure the explicit costs but often ignore the implicit costs. Learning Tip ‘An easy way of remembering the difference between explicit costs and implicit costs is as follows. Explicit costs are generally associated with factors that are not ‘owned by the firm. The opportunity cost of those factors, which are not owned by a firm, is simply the price that firm has to pay for them. Each cost requires direct payment of money by firms. Implicit costs, by contrast, are associated with factors that are owned by the firm. When a firm owns machinery, for example, it does not normally have to pay out money to use that machinery. Implicit costs are equal to what the factors could earn for the firm in some alternative use, either within the firm or rented out to some other firm. ‘The difference between economists and accountants is easy to see in the case of “Soft Diapers’ factory. When you give up the opportunity to earn money as a manager, your accountant will not ‘count this as a cost of your diapers business. Because no money flows out of the business to pay for this cost, it never shows up on the accountant's financial statements. An economist, however, Guill count the forgone income as a cost because it will affect the decisions that you make in your diaper business. For example, if your wage as a manager of a T-shirt producing company rises from $100 to $200 per day, you might decide that running your diaper business is too costly and choose to shut down the factory in order to become a full-time manager. Learning Tip When you hire workers to make the diapers, the wages you pay are part of your firm's costs. These are explicit costs. For example, assume that the cost of labour (wage) is $5.00 per hour. By contrast, some of a firm's costs are implicit costs. Imagine that you are a skilled manager and could earn $100 per day working as a manager in a neighbouring T-shirt manufacturing company. For every day that you work at your diaper factory, you give up $100 in income, and this forgone, income is also part of your costs. Similarly, the $100,000 savings that you have tied up to buy (or rent) a factory plant plus inventories of material for your operation could be placed in a bank account to earn interest, The interest forgone is the opportunity cost of your capital. 128Recall that economists define as opportunity cost the value of any sacrificed opportunity that results from some course of action, even if no outright monetary payment is made, Thus: the aad rehde pa CnCountered by a business are all the opportunity costs involved in production, and include both explicit and implicit costs. Therefore, for ‘Soft Diapers,” the explicit costs of Producing 1,000 diapers per day based on, say Technique A, are $210 "2 unite of labour (S5 per hour) and 10 units of capital (priced at $20 an hour of machine work). The implieit costs conser of two components: | the opportunity cost of the capital investment that you have tied up in this business 2. the opportunity cost of your own time as the owner manager of the firm that you have established, As for the first cost. you might estimate that, rather than making diapers, you could deposit your $100,000 in a bank account and earn $30 a day. Another implicit cost would be the wage that you as the owner of the firm sacrifice by working as the manager of your company, You might estimate the value of your work as $100, which is what you would earn by working for someone | ie. ese4.4eii_—s Diapers. Therefore, Economic costs = explicit costs + implicit costs $340 $210 $130 3 Distinguishing Between Relevant and Irrelevant Cost {mn analysing the cost of a particular activity, economists recommend that only those relevant to* the decision at hand should be considered. A cost is deemed to be relevant if it will be affected by the choice of alternatives being considered in a decision, Costs not affected by the outcome of a decision are considered to be irrelevant. Two commonly used ways to determine which costs are relevant are the criteria called respectively sunk versus incremental and the fixed versus variable, A sunk cost, sometimes referred to as historical cost, isa prior expenditure that is not affected by any decision concerning a future course of action. Based on the definition of relevant cost. sunk cost is clearly irrelevant, The opposite of sunk cost is incremental cost. This type of cost is considered to be relevant because it is defined as a cost that is associated with any decision about 8 future course of action. Fixed cost isthe cost that does not change withthe level of activity or Output. A variable cost is one that does change with the level of activity or output. Fixed cost is normally, but not always, considered irrelevant, while variable cost is considered relevant, Suppose. for example, that Mother's Day is on a the weekend and the owner of the local fruits and vegetable market buys 100 rose bouquets for $5 each. The owner figures that there is enough local demand to sell all 100 at $10 each to make a reasonable profit. However, the estimate turns out to be wrong. By mid-afternoon, 40 bouquets remain unsold. What should be done? At thisstage the 85 that was paid For the lowers is iretevant, {ts a historical or sunk cost it cannot Pe retrieved, A decision to sell the rest of the roses at a lower price should be independent of the price paid for the bouguets-- sunk. In tacl. if the owner must pay t0 have the unsold bouquets cked up for composting. it might be worth giving away any unsold flowers, ‘Learning Tip. Ir there is no alternative use for a factor of production, as in a machine that is designed to produce a specific product. and if it has no serap value. the opportunity cost is zero, In such a case, ifthe output from the machine is worth more than the cost of all the other inputs involved, the firm might as weil use the machine rather than let it stand idle, Likewise. the replacement cost is irrelevant. It should be taken into account only when the firm is considering replacing the machine. 3.1. Economic Profit When economic costs are subtracted from total revenue. the excess is known as economic profit If this gives a negative figure, the business faces a negative economic profit ora loss, The daily economic profit of Soft Diapers’ remains when you have calculated total revenue and subtracted sconemig costs from it, 11,000 diapers sold ata price of $1 each, then the total revenue gained by producing is $1,000 (S1 x 1,000 shirts), When the evonomic costs of $340 are deducted, we get an economic profit of $660 ($1,000 - $340) Economic profit, = _—_—_total revenue - economic costs $660 - $i.000 - $340 3.2 Practice My brother hes a plot of land that has three alternative uses: R, 8. and T. The revenue from each use is $5, $6. and $8. respectively. The accounting cost of each use is Zero, 1. The opportunity cost of using the land for Use $ is A. AS: B. BS8, the value in Use T. C. CSI, the difference in value between Use R and Use 8. . the value in Use R. D. DS2, the difference in value between Use T and Use S. “Answer: B, Opportunity cost is the value of the highest (next-best) alternative: Use T. 2. The economic profit of using the land for Use S is A. -$8, the value in the Use T B. $8, the value in the Use T 130C. -$2, the difference in value between Use T and Use S. D. $2. the difference in value between Use T and Use S. Answer: C. Economic profit is total revenue (which for Lise S is $6) minus total costs. Accounting costs ate zero, but economic opportunity’ costs are $8 (the revenue from Use T) 3. The local vegetable and fruits vendor can sell as many cantaloupes as he wishes at the market price of $2.00 each. Total cost to him of carrying each cantaloupe is $0.50. He chooses to sell 10 cantaloupes. He is making— A. a total economic profit of $15.00. B. a total economic profit of $20.00. C. anormal profit of $15.00 D. anormal profit of $20.00 Answer: A. Total profit is total revenue less total cost. For the vendor, total revenue is $20.00 and total cost is $5.00. Therefore, the difference is an economic profit of $15.00. 4 Time as a Factor in the Determination of Relevant Cost The time period in which a firm's cost structure is being considered is very important in determining which costs are relevant to a particular business decision. In the economic analysis of cost, the time factor is handled by dividing time periods into two basic types: the short run and the lang run, Recail that this distinetion was also used in the analysis of supply and demand and price elasticity. In the short run, we assume that there are certain resources such as land. factory space, and machinery that cannot be changed within the time period allowed. The cost of Using these resources is either sunk or fixed. Thus, there will always be certain costs that are irrelevant to a short-run decision, Long-run analysis assumes that there is enough time for managers to vary the costs of utilizing all their resources. Consequently. all long-run costs are either incremental or variable and therefore relevant to a particular business decision, 5 Production in the Short Run Recall from the previous section that the short run is the period during which quantities of one or more of a business's inputs cannot be varied. In manufacturing, companies usually cannot adjust the quantity of machinery they «se or the size of their factories on short notice. In agriculture. there is typically an additional quantity that cannot be varied —the land available for farming Inputs that cannot be ac’ usted in the short run are known as fixed inputs. Inputs that can be adjusted are know: « _isble inputs. Typically, variable inputs in the short run include the labour and materi: Is -.siness uses in production. For example. as owner of ‘Soft Diapers.” y are considering «:"" ng your current production of 1,000 packs (10 diapers per pack) of di aday. Youhave — sxcly bought three sewing machines and cannot acquire more without a 131considerable delay. Hence, the three machines represent a fixed input for your business in the Short run, However, you can change the number of workers you employ, so labour represents & variable input in the short run 6 Total, Average, and Marginal Product To increase production of a certain good or service, a business must employ more of all variable inputs, including workers. The result is a rise in total product, which is the overall quantity (Q) of utput associated with a given workforce. The employment of labour is a convenient measite of a company's scale of production, since labour is a variable input in making virtually all products. However, businesses also use other variable inputs, such as natural resources or semi-processed goods. Once again, let's look at “Soft Diapers.” Say you conduct a few experiments to see wha! happens to total produet for your business when the umber of workers employed is changed but the number of sewing machines—three—remains constant. Columns 1 and 2 of Figure 5-2 show that. as the number of workers increases, total product increases until the fifth worker is hired. In addition to total product, two other concepts are important when you are analysing production in the short run. Average product is the quantity of ‘output produced per worker and is found by dividing total product (Q) by the quantity of labour (L) employed. Marginal product, in contrast is the extra output produced when an additional worker is hired, Marginal product is calculated by dividing the change in total product (AQ) by the change in the amount of labour employed (AL). (The symbo! A is the Greek capital leter “delta,” which signifies a change in some variable.) Table 5-2: Production in the Short Run a @) (3) (4) LabourTotal Product Marginal Product Average Product wy) @ (AQ/AL) (Qi) Workers (Packs of (Packs of (Packs of per day diapers per day) diapers per day) diapers per day) 0 0 0 480 1 480 480 520 2 1000 500 350 3 1350 450 250 4 1600 400 100 5 1700 340 -50 6 1650, 270 Columns 3 and 4 of Figure 5-2 list the marginal and average produets for “Soft Diapers.” When you employ three workers, the workforce's average product is 450 packs of diapers pet day (1350 drapers. 3 workers). Ifa fourth worker is added, the marginal product of this worker is 250 +132packs, which comes from subtracting the old total product (1350 packs) from the new ‘otal product (1600 packs). and dividing the difference by the change in the workforce fivin three to four total product (Q) 1350 Average product = = = 430 number of workers (L.) 3 change in total product (AQ) (1600 ~1350) Marginal product = |... 250 change in workforce (AL) (43) Note that marginal product peaks when the second worker is hired and becomes negative at the same point that total product begins to drop. Meanwhile, average product peaks at 2 workers 7 Diminishing Marginal Returns ‘The marginal product values in Figure 5-2 reflect a law that applies to production in the short tun. According to the law of diminishing marginal returns, at some point —as more units of a variable input are added to a fixed input —the marginal product will start to decrease. since the new units of the variable input (for example, workers) are being added to an increasingly scarce fixed input (for example, land). For the law of diminishing marginal returns, consider what would happen if you used a flowerpot to grow food. If the law of diminishing marginal returns were false, then, as you used more labour, the total product of food grown in the flowerpot would rise at a faster and faster rate until the world's entire food supply could be provided from this single pot. The absurdity of this conclusion suggests that the law of diminishing marginal returns must be correct 8 Three Stages of Production The total product for “Soft Diapers’ is shown in the top graph of Figure 5-1, and its marginal product and average product are shown in the bottom graph. Both graphs can be divided into three ranges. In the bottom graph's first range, marginal product rises as more workers are added. In the top graph’s first range, total product rises at a higher and higher rate, giving the curve a positive slope that gets steeper. During the second range, marginal product begins to fall but is still positive. Total product in this second range continues to rise but at a lower rate, so that the curve becomes flatter. In the final range, marginal product falls below zero and total product decreases. Points in this last range will never be chosen by the business. 133Figure 5-1 Quantity F output Number of workers Quantity of output AP MP Li 12 Number of workers Learning Tip These rules are borne out by the bottom graph in Figure 5-1. At first, margina product is above average product, so that average product must be rising. At two age product crosses the marginal product curve, so that values for both must be equal. Here average product is constant, meaning it has a zero slope Beyond this point. marginal product is below average product, caus product to fall workers, aver werage Notice that, as the number of workers increases within stage I, the marginal product increases. The first worker has a marginal product of 480, whereas the second worker has a marginal product of $20 packs of diapers, This property is called inereasing returns the number of workers increases beyond stage I (stages Il and III), the mi ‘oduct decreases (law of diminishing or decreasing returns), The second worker has a mari! product of 520 diapers, the third worker has a marginal product of 350 packs, and the . arth worker has a marginal product of 250 packs of diapers. This property is called diminisiting marginal product. As the number of workers increases. additional workers have to share equipment and work in more crowded conditions. Hence. as more and more workers are hired, each additional worker contributes Jess 134to the production of diapers. Increasing and diminishing marginal product are apparent in both figures, the top and the bottom of Figure 5-1 ‘Learning Tip The total product curve tor “Soft Diapers’ is hill-shaped. with its peak at 5 workers and its slope dependent on the behaviour of marginal product. The first range. where marginal product rises, applies during the hiring of the first 2 workers. In the second range. during the hiring of the third, fourth, and fifth workers, marginal product falls yet remains positive. In the last range. from the sixth worker onward, marginal product falls and is negative. The shape of the average product curve can be linked to marginal product, since average product reaches a maximum where it crosses the marginal product curve at 2 workers ‘Learning Tip Note that the marginal product curve crosses the averaye curve from above, This means that as long as marginal product is greater than average product, the average curve must be rising, When marginal product is less than average Product, the averaye product curve must be declining, When the average and marginal products are equal, the average product curve must be at its peak. 8.1 Practice Use the following table to answer the next three questions. Labour Total Marginal Average (workers) Product Product __ Product _ 0 0 i 15 : 2 32 3 48 4 60 5 10 1. Total product. if 6 workers are employed. is— A. 70 units of output B. 73 units of output C. 78 units of output. D. 86 units of output, Answer: C. Total product is average product times the number of workers (13 x 6), 2. Average product, if 5 workers are employed, is A 10 units of output. 135B. 12 units of output. C. 14 units of output. D. 1S units of output. “Answer: C. With 4 workers, total product is 60 units. The fifth worker adds 10 more units 10 make a total of 70, Average product is total product divided by the number of workers (7005). 3. Diminishing returns set in with the _ worker. A. first B, second. C. third, D. fourth. ‘Angwer: C. The marginal products of the first, second, and third workers respectively are 15, 17. and 16. The decline begins with the third worker. 9 From the Production Function to the Total-Cost Curve Firms incur costs when they buy inputs to produce the goods and services that they plan to sell Iavthis section we examine the link between a firm's production process and its total cost, In the short run, just as businesses use fixed and variable inputs, they face corresponding fixed and aamnable costs, Fixed costs, or total fixed costs, (TFC), do not change when a business changes its {quantity of output, since these costs relate to fixed inputs such as machinery and land. Variable spate, or total variable costs, (TVC). in contrast relate to variable inputs, which change when & esiness adjusts the quantity produced. The most important variable costs are wages and payments for materials used in production, whereas the typical fixed cost isthe cost of prachinery. Total cost (TC) is the sum ofall inputs, both fixed and variable, and is found by adding fixed and variable costs at each quantity of output. Costs and production are two sides of the same coin, A firm’s total cst reflects its production function, whereas the firm's supply curve. discussed in the last chapter, is a reflection ofits ants relationships. To see how these related measures are derived, consider the example in Table 5:3. This table presents cost data on your neighbour — the T-shirt producer. From data on @ Fong toal cost we can derive several related measures of cost which will tun out to be useful when we analyse production and pricing decisions in future chapters. Your neighbour's total cost can be divided into two types. The fixed costs. which do not vaty vsith the quantity of output produced, are incurred even ifthe firm produces nothing &t all, Your neighbour's fixed costs include the rent she pays because this cost is the same regardless of how many T-shiets she produces. Similarly. if she needs to hire a full-time bookkeeper 0 Pay bills, 136regar second column in tity of T-shirts proc able 5-3 shows your neig! > bookkveper's salary is a fixed cost. The lixed cost, which in this example is $100 Her vatiab!« «asts, which change as the firm alters the quantity of output produced. include the cost of materials. fabric. thread, ink, and labour. The more T-shirt she makes, the more material she needs to buy. The third column of the table shows the variable cost. The variable cost is zero if she produces nothing, $56 if she produces one bundle (cach bundle consists of 20 units) of T- shirts and $106 if she produces two (20 bundles) T-shirts, and so on. A firm's total cost is the sum of fixed and variable costs, In Table 5-3, total cost in the fourth column equals fixed cost plus total variable cost. While marginal cost is based on changes in a business's total product, per-unit costs are expressed in terms of a single level of output. These vosts are related to a business's fixed costs, variable costs. and total costs. Hence. there are three separate types of pet-unit costs: average fixed cost, average variable cost. and average cost. Table 5-3: Measures of total and average cost (1) (2) G) (4) (3) (6) (7) (8) Quantity Total Total Average Average Average of Output Fixed able Total Fixed” Variable“ Total Marginal {Q] lens ost Cost Cost. Cost Cost Cost ofunits) {TFC mvc) TC) AFC] [AVC [ATC] Cl 0 100 0 100 1 100 56 156 100.00 56.00 156.00 36 2 100 106 206 50.00 53.00 103.00 50 3 10 154284 3333 51.33 84.67 48 4 100 205 305 28.00 51.25 76.25 51 5 190 263 363 20.00 52.60 72.60 38 6 100 332432 55.33 72.00 69 7 109 416516 5942 73.71 84 8 100 519 619 64.87 77.37 103 9 100 646-746 777 82.88 127 lo 100 801901 80.10 90.10 155 © Average fixed cost (AFC) is the fixed cost per unit of output, which you derive by dividing the business's fixed costs (TFC) by its total product (Q). * Similarly, average variable cost (AVC) is the variable cost per unit of output, which you derive by dividing the business's variable costs (TVC) by total product (Q). © The average fixed, average variable, and average total costs are found in columns 5, 6, and 7. When three bundles are produced, the business's fixed costs of $100.00 are divided by the total product. giving an average fixed cost of $33.33 per bundle, Similarly, the $254 variable costs at 137this level of production are divided by 3 bundles of T-shirt 1.33. Sce next page for the calculations, resulting in an average variable cost fixed costs (TFC) total product Q $154 $33.33 per batch (of 10 shitts) = — Average fixed cost (AFC) = 3 shirts, variable costs (TVC) total product Average variable cost (AVC) = Q $254 $51.33 per hateh (of 10shirts) = shirts Average total cost (ATC) (or simply ‘average cost’) is the business's total cost per unit of output Average cost is the sum of average fixed cost and average variable cost at each quantity of output. Therefore. for example, in column 7, when the T-shirt maker produces 3 bundles (units) of T-shirts. average fixed cost is $33.33 and average variable cost is $51.33, giving an average total cost of $84.66 Average total cost (AC) = average fixed cost (AFC) + average variable cost (AVC 84.66 = 3333 51.33 Although average total cost tells us the cost of the typical unit, it does not tell us how much total cost will change as the fitm alters its level of production. The last column in Table 5-3 shows the amount that total cost rises when the firm inereases production by one unit of output. This number is the marginal cost, For example, if your neighbour increases production from two to three (units) of T-shirts, total cost rises from $206 to $254, so the marginal cost of the third (unit) of T-shirts is $48. j MC = (Change in total cost)/(Change in quantity) = ATC/AQ =_305-254 = 51 4-3) As will be even clearer in the next chapter. your neighbour will find the concepts of average total cost and marginal cost extremely usefit! when deciding how many T-shirts to produce. Keep in mind, however. that these concepts clo not actually give your neighbour new information about her costs of production. Instead, average total cost and marginal cost express, in a new way. information that is already contained in her firm's total cost. Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Marginal cost tells us the increase in total cost that arises from producing an additional unit of output Learning Tip ‘The key to understanding why the average variable and average total costs change the way they do lies in understanding the changes that occur in marginal cost. Marginal cost is defined as the change in total variable cost divided by the change 138in output because fixed costs do not change. It can also be detined in total cost divided by the change in output the change Learning Tip “Marginal” has a different interpretation when referring to cost rather than to product. While marginal product is defined in terms of each unit of labour, with cost the focus shifis to new units of output 10 Cost Curves and Their Shapes Graphs of the cost data in Table 5-3 are presented in Figure 5-2 and enable us to see the pattem of change of the different measures of cost as output increases. They also help us to visualize the impact that marginal cost has on the average variable and average total costs. Using either the data in Table 5-3 or the graphs in Figure 5-2, we ean observe the following about marginal cost impact on average variable cost Figure 5-2 Costs (§), {n previous study blocks. graphs of supply and demand proved useful when you were analysing the behaviour of markets. Similarly. graphs of average and marginal cost heip you analyse the behaviour of firms, Figure 5-2 graphs your neighbour's costs using the data from Table §-3, The horizontal axis measures the quantity the firm produces. and the vertical axis measures marginal and average costs. The graph shows four curves: average total cost (ATC). averaye fixed cost (AFC), average variable cost (AVC), and marginal cost (MC). The cost curves shown here for your neighbour's T-shirt company have some features that are common to the cost curves of many firms in the economy. Let's examine three features in particular 139© the shape of marginal cost. © the shape of average total cost © the relationship between marginal and average total cost When no shirts are produced, the denominator of the average fixed cost formula is zero. that average fixed cost is an infinitely high number. Average fixed cost then falls as the tusiness's total product increases, since the denominator in the formula rises. Therefore, the average fixed cost curve has a negative (downward) slope which becomes Mater as ov"pus rises Your neighbour's average total cost curve is U-shaped (saucer-shaped). To understand why this, set remember that average total cost is the sum of average fixed cost and average variable cost “Average fixed cost always declines as output rises because the fixed cost is spreading owe" a larger number of units. Average variable cost typically rises as output increases because of diminishing marginal product. Average total cost reflects the shapes of both average fixed cost fand average variable cost, At very low levels of output, such as one or two bundles pet hour. average total cost is high because the fixed cost is spread over only a few units, Avsracie total ect then declines as output increases until the firm's output reaches six bundles of T-shirts per our. when average total cost falls to $72.00 per bundle. When the firm produces more thar 6 bundles, average total cost starts rising again because average variable cost rises substantially. “The bottom of the U-shape occurs at the quantity that minimizes average total cost. This quantity is sometimes called the minimum efficient scale ofthe firm. For your neighbour's comparly- the xs ecient eeale is six bundles. If she produces more or less than this amount, her average total cost rises above the minimum of $72. Now that you have scrutinized the impact that marginal cost has on average variable and aver total cost. you may wonder about the behaviour of marginal cost itself. Why does econonte analysis assume that marginal cost decreases and then. at some point. starts to increase a TNS Gf a good or service is produced? To answer this question, we need to review a concept referred to in economic theory as “the returns to a variable input.” Inthe short run. a fitm must work with a certain fixed quantity of resources or inputs such as road. factory or office space, machinery. and equipment. As additional amounts of variable inputs such as labour hours and raw materials are combined with the fixed inputs: more output is produced. AL frst, additional units of the variable inputs are assumed to result it intact revounts of additional output (also called marginal product). However. eventually. the additional inputs are expected to result in decreasing or diminishing marginal product. We can see this with a simple numerical example. Suppose one person, working with a fixed amount of factory space and machinery, produces 100 tints of output. Now suppose further that this person is joined by another worker. The two of them working together as a team produce 250 units of output, From the standpoint of the tuditional output contributed by each worker, the marginal product of the First worker is 100 and the marginal product ofthe second worker is 150. This is an 2xample of increasing returns © the variable input. labour. As the two workers are joined by still more people, sustained efforts to vrark ag eam may cause the marginal product of the additional workers to continue increasing, ‘At some point, however, the marginal product resulting from the additional workers will start to diminish because of the limits imposed by the fixed inputs. 140Learning Tip If you look at Figure 5-2 (or back at ‘Table 5-3), you will see something that may be surprising at first: Whenever marginal cost is less than average variable cost, AVC is falling. Whenever marginal cost is greater than average variable cost, AVC is rising. When marginal cost is equal to average variable cost, average variable cost neither decreases nor increases. (In the context of the numerical example provided here, this corresponds to the point of its minimum value.) The same statements can be made about the impact of marginal cost on average total cost. The reason marginal cost has this particular effect on both average variable and average total cost is the mathematical relationship between any marginal and average values, To see why, consider an analogy. Average total cost is like your cumulative grade point average, Marginal cost is like the grade in the next course you will take. If your grade in your next course is less than your grade point average, your grade point average will fall. If your grade in your next course is, higher than your grade point average, your grade point average will rise. The mathematics of average and marginal costs is exactly the same as the mathematics of average and marginal grades. To explain the relationship between returns to variable input and marginal cost, we have extended the example in the previous paragraph into the schedule of numbers shown in Table 5- 3. In this example, we assume that labour is the only variable input in this example, and the firm pays W (Wage rate) per hour to employ each worker. Thus, the wage rate is, in fact. the change in total variable cost if one work hour is hired. However, when the firm hires AL workers, total variable cost is (Wage rate x AL). Recall that the change in output resulting from the additional worker is each person's marginal product. Therefore, we can say thi ATVC — Wage rate X AL Wage rate Wage rate MC —— AQ AQ AQAL MP, Therefore the relationship between marginal cost and return to the variable input can be presented as follows: a. When a firm experiences increasing returns to its variable input (when its marginal product increases), its marginal cost will decrease. b. When a firm experiences decreasing (diminishing) returns to its variable input (when a firm's marginal product decreases), its marginal cost will increase. c. When a firm experiences @nstant returns to a variable input (when its marginal product neither increases nor decreases), its marginal cost will be constant over the range of output produced. 14141 Production in the Long Run you remember. the long run is the period in which quantities of all resources used in an industry can be adjusted. So, even those inputs that had been fixed in the short run—such as machinery. buildings. and cultivated land—can be adjusted in the long run, Because all inputs n vary in the long run, the law of diminishing marginal returns no longer has the same in which a firm can importance as in the short run, In this section. we review the various wai take advantage of this flexibility to reduce its costs over the fong run. 41, Economies and Diseconomies of Scale The term economies of scale is defined as the decrease in the unit cost of production as a firm increases all its inputs of production, This phenomenon is illustrated in Figure 5-3. Jn this figure, we sce that the average total cost curve, labelled ‘Plant 1.” represents a certain amount of capacity. AL its most efficient point, a firm with this plant capacity is able to produce Q) units of output at a unit cost of AtC). “Plant 2° represents a greater production capacity hecause it is positioned to the right of Plant 1. In addition, it is located on a lower level than Plant 1. signifying that over a certain range of output, the larger plant is able to produce greater amounts of output at a lower average cost than the smaller one, ic., the unit cost of ATC: igure 5-3 cnet ATC (Plant 1) | NU ATC (plant 2) AICI = ATC? | — r TY aa Qa & Quantiiy (Q) Sometimes ‘economies of scale” is used interchangeably with the term increasing returns 10 scale. Increasing returns to scale is a long-term phenomenon indicating that the firm's output {grows at a rate that is faster than the growth rates of its inputs. For example. a 100 percent tnerease in inputs results in more than 100 percent increase in output, say 200 percent, In this case, as the firm expands, the per-unit cost drops. The following are the main causes of economies of scale (Not to be confused with returns to variable input, which is a short-term phenomenon.) 14211.2 Division of Labour and Specialization strated over two centuries ago, increases jn the scale of production and wworket specialization ean go hand in hand. Performing iewer tasks allows vevken ty become tent at theit jobs. As a result, Smith concluded, quantities of output tend 10 cise mex guickly than the number of workers producing them. The impact of the division of lakes is just as prevalent today in labour-intensive production, For example, if'a very small resaurenn where workers do everything expands. then workers can begin to specialize in either nat preparation Or service, thus making both sets of workers more efficient in the tasks they do 11.2.1 Specialized Capital {n miost manufacturing industries, a greater sale of production is associated with the use of Spccialized machinery, Ifa car manufacturer raises the quantity of al its inputs, for example, creat Satipment can have more specialized functions, so that it performs fewer taske mere efficiently than before. Not every firm benefits from all the: example * Firms that have a high level of debt will usually not be able to borrow atthe lowest possible interest rate. * Size may not always offer the firm a cost advantage, Firms that are very large may become bureaucratic and inflexible, with management coordination and conta problems. factors when it increases scale of production. For * Oversized firms experience a disproportionate increase in staffand indirect labour The resulting increase in these types of cost may cause the averawe total cost te rice These are reasons for diseconomies of seale, or decreasing returns Decreasing retums occur when a business expands inputs to a product's production by a certain Percentage but sees output Hise by a smaller percentage, For example, a 100 percent expansion in al inputs may lead to its patbut rising by only 75 percent. In terms of Figure 5-3, this can expect the ATC associated with bigger plants to shift up and to the right, Figure 5-4 shows how short-run and long run costs are related, The long-run av raye-total-cost qurve is a much flatier saucer shape than the short-run average-total-cost curve. In addition: a a i sf. greater Mexibility firms have in the long run, In essence, in the long run, a firm gets to choose \which short-run curve it wants to use. However, in the short run, ithas to use whatever short-run curve it chose in the past. Figure 5-4 also shows a long-run average cost curve reflecting both economies and diseconomies of scale as well as constant returns to scale. When long-run average total vost declines xg output increases. there are said to be economies of scale. When long-run average total cost rises ae Guu Increases, there are said 10 be diseconomies of scale, When long-run average total cost does not vary with the level of output, there are said to be constant returns to scale 143Figure 5-4 Tes TCI Price LAC Te ATI congiant rentins 8 J Q Economies 1m Diseconomizs | Quantity Expressing this differently, assume that our firm (say. an auto making company) expands its assembly plant three times. Each time, it faces different short-run average 68 Te for each plant size. With each expansion of the plant, the curve shifts 10 the right, demonstrating the Peete of the increased output. When the plant is first expanded, the short-run avert cost curve fails from ATC, to ATC, This shift results from economies of scale or increasing retarss to rena Rccall that average cost is found by dividing total cost by the quantity of owtpat With cconomies of scale, output rises more rapidly than the total cost of inputs, s0 that average cost falls as the scale of production expands. With the second plant expansion, the shift of the short-run average cost curve (from ATC2 to [ATCs) reflects constant returns to scale. Output and the total costs of inputs rise at the same rate ‘when the plant is expanded this second time, so the average cost curve moves horizontally as the utput of automobiles rises. With the final plant expansion, the company's short-run average cost cane not only shifts to the right but also rises (from ATC; to ATCs), This shift reflects Steeconemies of scale. Since the plant's output is rising less rapidly than the total cost of input caaee the average cost curve rises as the production of automobiles continues (0 increase, Constant retums to scale are what you might expect ~ the middle of the teeter foWtet having at its high end, economies of scale (increasing returns to scale) and at its low end, diseconomies of seale (decreasing returns to scale). Constant returns to scale usually result when making more of an item requires repeating exactly the same tasks used to produce previous units of output. In sbjective terms, constant retums to scale occur jn a business that expands inputs a given percentage and sees output rise by the same percentage, The flowing table, Table 5-4 Pemarizes the causes of economies of scale and diseconomies of scale. 144Table 54 Reasons for Economies of Scale Reasons for Diseconomies of Scale Specialization in the use of labour and Disproportionate rise in transportation capital costs Indivisible nature of many types of capital Input market imperfections (e.g. wage equipment rates driven up) Productive capacity of capital equipment — Management coordination and control rises faster than purchase price problems Economies in maintaining inventory of Disproportionate rise in staff and replacement parts and maintenance indirect labour Discounts from bulk purchases Lower cost of raising capital funds Spreading of promotional and research-and-development costs Man: ment efficiencies (line and staff) Learning Tip While virtually all businesses face a saucer-shaped long-run average cost curve, these curves are not necessarily symmetrical for all industries. Often in an industry, one range (or portion of the curve) will dominate the long-run average cost, Here are some examples: Manufacturing industries tend to exhibit an extended range of increasing returns to scale due to the degree to which specialization is possible in the use of both labour and capital. This is particularly true of companies in which assembly-line techniques are used. It is not until output is very large that the conditions leading to constant returns to scale and decreasing returns to scale become relevant. In contrast. craft industries are dominated by constant returns to scale. Because raising output levels of crafts tends to depend on repeating exactly the method of production, an increase in input usually results in an equal increase in output. Hence, except at very low or very high levels of output. the long-run average cost curves for producers of items such as handmade pottery are horizontal. Decreasing returns to scale, are most prevalent for businesses in primary industries, as in some types of fishing, where the limits of resource supplies are particularly acute. In this case, the slope of the long-run average cost curve becomes positive at a relatively low level of output 14544.3 Economies of Scope In the Jong run. it is also possible for » ways to take advantage of economies of scope. This cost-saving phenomenon occurs when itis possible to produce two or more products together ata lower per-unit cost than for each product separately, A Key Factor in this ran of cost savings is the sharing of a company’s fixed cost by multiple products. For example cartain electronic stores that normally sell TVs, VCRs. DVD players, and computers, are now selfing CDs. videos. DVDs. ete, These latter products are displayed on racks that occupy oihenwise unused floor space in the stores. The use of this retail establishment's excess capaci ip this manner reduces the average total cost of selling each of the products. managers to identi Another way that a company can utilize economies of scope is to produce goods or services that require similar skills and experience. For example, when Pepsico expanded into the snack and face food business. it was able to utilize its background in one type of fast-moving consumer em (soft drinks) to another (chips. tacos and fried chicken), The product development. channels of distribution, and marketing know-how are very similar in these two product groups 441.4 The Learning Curve As pictured in Figure 5-5. the learning curve shows that a firm's unit east decreases as its t armufative output increases. Its rationale is that you improve with practice, Over the Jong run. 3s a firm produces more of a good or service. its workers are expected to get better at what they are “Joins. This inerease in labour productivity will then decrease the unit cost of production. But ther people besides the direct labour involved in the produetion process are also expected to improve with practice. For example. researchers may find less costly substitutes for ray eenvals currently used: engineers may develop more efficient production processes or product designs Figure 5-8 Unit cost Cumulative Q “The learning curve has played an important part in the strategic approach called fea ning-curve pricing. This approach advocates that a firm should set its price ata relatively ow fevel to Primulate demand, even though there is the possibility that it will earn minimal profit or even 146incur a loss at the outset. The greater demand will accelerate the learning effects that accompany the higher accumulated volume of production, As the company's costs are brought down the learning curve, the company will start to become profitable, 12 Break-Even Analysis What is to be done about those costs that are not relevant toa decision? Afier all. even if they are ignored, they must still be paid for. However, this, in fact, is the logic of designating a cost as irrelevant. By definition, an irrelevant cost is one that must be incurred, regardless of the alternative selected by the decision maker. The question of how this cost is recovered is a separate issue altogether. To understand this aspect of the problem. we can turn to a commonly used technique called break-even analysis. Break-even analysis is perhaps the most widely used application of the concept of relevant cost. You will find information on this subject in books on finance, accounting, and marketing as well as economics. This analytical technique addresses the basic question: “How many units of a particular product does a company have to sell to cover all its costs of production: that is, to ‘break even’? Another name for break-even analysis is cost-volume-profit analysis. This label describes the break-even problem more explicitly. That is. given the company’s fixed and variable cost, how much volume does it have to sell to break even? Moreover. once it passes the break-even point and becomes profitable, how much profit will it earn as its volume increases? Suppose your professor decides to open a seafood store. How many kilograms of seafood per month must he sell to break even? To answer this, we first divide his monthly costs into their fixed and variable components. Fixed cost is presented as a total figure. while the variable cost is shown on a per-unit basis. Variable cost per unit is also referred to as average variable cost (Ave) Table 5-5 Monthly Cost of Operating a Seafood Market Total Fixed Cost Variable Cost per Unit (Average Variable Cost or AVC) Rent $1,200 Average wholesale price per Utilities 400 kilogram of seafood $3.00 Wages 2,350 Interest payment on loan ‘1.500 Insurance 400 Miscellaneous 150 Total $6,000 To find the break-even point, we use the following equation: Que = Where QBE = the break-even quantity of product sold 147total fixed cost selling price of the product average variable cost of the product scontribution margin’ per unit of product sold that must be incurred. regardless of the alternative selected by the decision maker. The question dt how this cost is recovered is a separate issue altogether. To understand this aspect of the problem, we turn to break-even analysis. Figure 5-6 TR TC FC EB Qa The logic of break-even analysis is very straightforward. The amount by which the selling price exceeds the average variable cost is called the ‘contribution margin’ per unit of product sold When the amount of product sold reaches the point where the total contribution margin covers all the fixed costs of a product the firm breaks even. The break-even concept can also be shown graphically. In Figure 5-6, the break-even point occurs when the firms gota cost line crosses the total revenue line. Although our example is quite simple, we do not want to imply that break-even analys applies only to small and uncomplicated business operations. To be sure, larger and more complex pusinesses might have a mote difficult time dividing their costs into fixed and variable components, particularly when fixed and variable costs have to be determined for many different products, But no matter how complicated the situation, there still remains the basic concept of trenerating enough sales so that the contribution margin covers fixed cost 12.1 Practice For the total revenue TR = 32.5Q and total costs TC = 120 +12.5Q where Q represents thousands of units, determine the break-even level of output as well as the contribution margin. Answer: Setting TR =TC, Q= 6. Contribution margin = P- AVC = 32.5 ~ 12.5 = 20 Hint: TC = TFC (= 120) + TVC (= 12.5Q). 14812.2 Limitations of Break-Even Analysis This review of break-even analysis should give you a good idea of how the knowledge of a firms fixed and variable costs can help in the making of certain business decisions or in the analysis of particular manufacturing or marketing strategies, However. as useful as this technique can be. it is stil subject to several shortcomings. First, break-even analysis selects only one price for a par- ticular product and then proceeds to determine how much a firm has to sell at this price to break even. In order to consider the possibility of different amounts demanded by consumers at different prices (i.e, the price elasticity of demand), a whole schedule of prices and break-even points would have to be constructed. In other words, break-even analysis determines how much a firm with a given price and cost structure needs to sell in order to break even. However, it does not provide any indication of how many units it will actually sell. Second, and more important, this analysis assumes that a firm's average variable cost is constant. In certain circumstances, it is Quite possible for a firm's average costs to either decrease or increase as more of a good or service is produced. To explain why, the next study block guides you through the economic analysis of short-run cost, Supplementary Material The Production Possibility Frontier Consider the case of an island economy that produces only two goods: wine and grain. In a given period of time, the islanders may choose to produce only wine, only grain, or a combination of the two according to the following table: Production Possibility Table ‘Wine Grain {(thousands of bottles)|(thousands of bushels) 0. 15 5 14 9 12 { 12 9 14 5 15. 0 ‘The production possibility frontier (PPF) is the curve resulting when the above data is graphed, as shown below: 149Production Possibility Frontier ‘The PPF shows all efficient combinations of output for this island economy when the factors of production are used to their full potential. The economy could choose to operate at Jess than capacity somewhere inside the curve, for example at point a, but such a combination of goods would be less tlian what the economy is capable of producing. A combination outside the curve such as point b is not possible since the output leve! would exceed the capacity of the economy. ‘The shape of this production possibility frontier illustrates the principle of increasing cost. As more of one product is produced, increasingly larger amounts of the other product must be given up. In this example, some factors of production are suited to producing both wine and grain, but 1 the production of one of these commodities increases, resources better suited to production of the other must be diverted. Experienced wine producers are not necessarily efficient grain producers, and grain producers are not necessarily efficient wine producers, so the opportunity cost increases as one moves toward either extreme on the curve of production possibilities. ‘Suppose a new technique was discovered that allowed the wine producers to double their output, for a given level of resources. Further suppose that this technique could not be applied to grain production. The impact on the production possibilities is shown in the following diagram: Shifted Production Possibility FrontierIn the above diagram, the new technique results in wine production that is double its previous level for any level of grain production. Finally, if the two products are very similar to one another, the production possibility frontier may be shaped more like a straight line. Consider the situation in which only wine is produced, Let's assume that two brands of wine are produced, Brand A and Brand B, and that these two brands use the same grapes and production process, differing only in the name on the label. The same factors of production can produce either product (brand) equally efficiently. The production possibility frontier then would appear as follows: PPF for Very Similar Products Note that to increase production of Brand A from 0 to 3000 bottles, the production of Brand B must be decreased by 3000 bottles. This opportunity cost remains the same even at the other extreme, where increasing the production of Brand A from 12,000 to 15,000 bottles still requires that of Brand B to be decreased by 3000 bottles. Because the two products are almost identical inthis case and can be produced equally efficiently using the same resources, the opportunity cost of producing one over the other remains constant between the two extremes of production possibilities. Opportunity Cost Scarcity of resources is one of the more basic concepts of economics. Scarcity necessitates trade- offs, and trade-offs result in an opportunity cost. While the cost of a good or service often is thought of in monetary terms, the opportunity cost of a decision is based on what must be given up (the next best alternative) as a result of the decision. Any decision that involves a choice between two or more options has an opportunity cost. Opportunity cost contrasts to accounting cost in that accounting costs do not consider forgone opportunities. Consider the case of an MBA student who pays $30,000 per year in tuition and fees at a private university. For a two-year MBA program, the cost of tuition and fees would be $60,000. This is the monetary cost of the education. However, when making the decision to go back to school, one should consider the opportunity cost, which includes the income that the student would have earned if the alternative decision of remaining in his or her job had been made. If the student had been earning $50,000 per year and was expecting a 10% salary increase in one year, $105,000 in salary would be foregone as a result of the decision to return to schoo! Adding this amount to the educational expenses results in a cost of $165,000 for the degree 151Opportunity cost is useful when evaluating the cost and benefit of choices. It often is expressed in non-monetary terms. For example, if one has time for only one elective course, taking a course in microeconomics might have the opportunity cost of a course in management. By expressing the cost of one option in terms of the foregone benefits of another, the marginal costs and marginal benefits of the options can be compared. ‘As another example, if a shipwrecked sailor on a desert island is capable of catching 10 fish or harvesting 5 coconuts in one day, then the opportunity cost of producing one coconut is two fish (10 fish / 5 coconuts). Note that this simple example assumes that the production possibility frontier between fish and coconuts is linear. Relative Price Opportunity cost is expressed in relative price, that is, the price of one choice relative to the price of another. For example, if milk costs $4 per gallon and bread costs $2 per loaf, then the relative price of milk is 2 loaves of bread, If a consumer goes to the grocery store with only $4 and buys a gallon of milk with it, then one can say that the opportunity cost of that gallon of milk was 2 loaves of bread (assuming that bread was the next best alternative). In many cases, the relative price provides better insight into the real cost of a good than does the monetary price. Applications of Opportunity Cost ‘The concept of opportunity cost has a wide range of applications including: Consumer choice Production possibilities Cost of capital Time management Career choice Analysis of comparative advantage Adapted from : hutp://www.netmba.convecon! 15213 Summary and Review 1. A production function is a mathematical or numerical representation of the relationship between inputs and outputs. Increasing the quantity of a variable input should cause total production to increase: i.e., marginal product is positive 2. In the short run, production is governed by the law of diminishing marginal returns: as more units of a variable input are added to a fixed input, the marginal product will start to decrease at some point. Because all inputs can vary in the long run, the law of diminishing marginal returns no longer has the same importance as in the short run. 4. Because of the law of diminishing marginal returns, the marginal product curve is hill- shaped. The total and average product curves are also hill-shaped, because of their connections with changes in marginal product. versely related to Marginal cost. or the extra cost of producing another unit of output, is marginal product. The marginal cost curve is shaped like the letter "J 6. Average fixed cost represents fixed costs per unit of output. Its curve has a negative slope and is flatter at higher output levels, Average variable cost, or variable costs per unit of output, has a saucer-shaped curve that reaches its minimum where it crosses the marginal cost curve. 7. Average cost, or total cost per unit of output, is the sum of average fixed and average variable costs at given output levels. The curve for average cost is saucer-shaped and reaches a minimum where it intersects the marginal cost curve. 8. Economic cost includes the opportunity cost of all the factors of production and a normal rate of return for the owners of the firm, 9°. The long run is a time period sufficiently long for the firm to alter any and all of its factors of production. The short run is any time period less than that—the period in which each firm has a fixed scale of production with atleast one resource fixed in quantity. In the long run, new firms can enter or leave the market. In the short run, they can't 10. When. in the long run. all inputs can be varied, there ore three possible results for a busine increasing, constant, and decreasing returns to scale. 11. Increasing returns to scale exist when a given percentage change in inputs causes an even a greater percentage change in output. 2. Constant retums to scale exist wheh a given percentage change in inputs causes an equal per- centage change in output. When production of any additional product depends on repeating exactly the tasks used to produce the previous product, constant returns prevail : 15313. Decreasing returns to scale exist when a given percentage change in inputs causes a lower percentage change in output. Management difficulties and limited natural resources are the major causes, he long-run average cost curve is saucer-shaped, reflecting ranges first of increasing, then constant. and finally decreasing returns to scale. 4 15. In general, increasing returns to scale dominate in manufacturing industries, constant returns to scale dominate in craft industries, and decreasing returns to scale dominate in primary ndustries. (Overleat for Self-Test Questions) 15414 Self-Test Questions |. What is the relationship among a firm’ total revenue, profit, and total cost? How are they related? Give an example of an opportunity cost that an accountant might not count as a cost. Why would the accountant ignore this cost? : How and why does a firm's average-total-cost curve differ in the short run and in the long run? 4. Define economies and diseconomies of scale and explain why they might arise 5. Production processes may be labour-intensive or capital-intensive. To achieve productive efficiency. what criterion must a firm apply in choosing the produetion process to produce a certain quantity of output? 6. Which costs—economic costs or accounting costs—include both explicit costs (payments to those outside the business) and implicit costs (opportunity costs owners sustain by running the business)? 7. How do economists measure profitability? (Overleat for Review Problems) 15515 Review Problems Use the following information for the next two questions. You are making plans to establish ‘a cat wash business, Your research has isolated four distinct methods of production, each of which will produce the same number of clean cats. Technique Units of Capital Units of Labour Ay 2 20 B 4 15 Cc 6 u D 8 8 1. If'the hourly price of a unit of capital is $60 and the hourly wage is $6, which production technique should you choose in order to minimize costs: A. B, C, or D? 2. Which is the most labour-intensive method of production: A. B. C, or D?? 3. Use the following table for this question, Review Problem Table 4 Number of Marginal Total — Average Workers Product Product Product 1 12 2 16 a 14 4 13 i 10. a. Complete the total product and average product columns. b. With which worker do diminishing returns occur? cc. Graph the marginal and average product curves. 4, “When marginal product is decreasing, average product is constant.” True or false? Why? 5, Your friend operates a variety store that provides an annual revenue of $480,000. Each year he pays $25.000 in rent for the store, $15,000 in business taxes, and $350,000 on products to sell, He estimates he could put the $80,000 he has invested in the store into his friend's restaurant business instead and earn an annual 20 percent profit on his funds. He also etimates that he and his family could earn a total annual wage of $90,000 if they worked somewhere other than the store. a, Caleulate the total explicit costs and total implicit costs of running the variety store. b. What is the accounting profit of the variety store? c. What is the economic profit? 1564d. In what way is economic profit superior to accounting profit as an indicator of the overall performance of this business? Given the advantages of economic profit as performance indicator. explain why the concept of economic profit is not often used in account) & Should your friend consider closing down this business? Why’? 6. Identify each of the following short-run costs as either variable or fixed a. depreciation charges for a construction firm b. employee health benefits for an automobile-parts manufacturer ¢. lumber costs for a pulp-and-paper producer d._ property insurance for a restaurant. 7. How does the law of variable proportions (decreasing returns to scale) differ from the law of diminishing returns to labour? 8 Dist iguish between economies of scale and scope. 9. Daily production for Pot-Works, a flowerpot maker, varies with the number of workers employed, as shown in the table below Review Problem Table 2 Short-Run Production for Pot-Works {! ) 2) Q) 4) abour ‘otal Marginal Average Product Product Product {pots per day) (pots per day) (pots per day) 0 100 280 510 560 540 a. On one graph, draw the total product curve. On another graph, draw the marginal product and average product curves. Explain the relationships between these curves. b. On your graphs, identify the ranges where marginal product rises. where marginal product falls and is positive, and where marginal product is negative. 10. Suppose Honda's total cost of producing four cars is $225,000 and its total cost of producing five cars is $250,000. What is the average total cost of producing five cars? What is the marginal cost of the fifth car? 11. (advanced question) How do returns to scale influence the size of businesses in certain industries? 15714 Answer Key to Review Problems 5 Technique Total Cost A 2 x $60 + 20x St B 4x $60 + 15x $ Cc 6x $60 + 11x $ D 8x S60+ 8x $6= $528 Therefore, A is the least expensive technique and hence it is to be chosen. A is the least costly because labour is much cheaper than capital. Clearly A is the answer. This is compatible with the answer to the previous question, a, # of Workers Marginal (MP,) Total Average (APL) Produce Product Product i 12 12 12 a 16 28 14 3 14 42 14 4 13 55 13.75 5. 10 65 3 b. With the third worker MP,, begins to diminish. c. Diagram: tAagd 9 False. When MP is decreasing, AP could be rising or falling. $25,000 + $15,000 + $350,000 = $390,000 80,000 x 0.2) + $90,000 = $106,000 a. Explicit costs Implicit costs b. Accounting Profit = TR - Explicit costs = $480,000 - $390,000 = $90,000 ¢. Economic Profit = TR - Total costs (explicits + impli $480,000 ~ ($390,000 + $106,000) = -$16,000 ts) = 1584. Economie profit js superior in tha it is obtained afterall costs, including opportunity costs of time and capital, are accounted for. Any business decision should be based on this notion. Economic profit is hard to measure because the forgone alternatives (opportunity costs) are normally difficult to pinpoint with accuracy, as they are market driven and tend to fluctuate. It is true that sometimes an effort to determine opportunity costs could be subjective. © Yes. My friend will be better off working for someone else and depositing the capital investment in a financial institution instead, 6. a. fixed, b, fixed. c. variable, d, fixed 7. ‘The law of decreasing returns is a long-term phenomenon; the law of diminishing returns to labour is short-term. The former occurs when all inputs are flexible and changed at the same time, whereas the latter is caused by keeping capital fixed while changing labour. 8. Economies of scale arise when average cost of production decreases as the level of production increases. Economies of scope arise when the cost of producing two products Jointly is less than the cost of producing them separately, % a a) 2) @) (4) 0 0 0 0 1 100 100 100 2 280 180 140 3 510 230 170 4 560 50 140 g 540 -20 108 (continued overleaf) 159Diagrams: Q Total Product Q Labour Labour b. MP rises between 0 and the third unit of labour. It falls with unit 4 and becomes negative with unit 5 Total cost _ $250,000 5 5 10, Average total cost = = $50,000 Marginal cost of 5" unit = 250,000 ~225,000 = $25,000, 11. When firms face increasing or constant returns to scale they cin expand while taking advantage of falling or constant costs. In the former. decreasing average costs enable the firm to drive competitors out of the market and capture a bigger share of the market, This vway the firm grows in size to become one of the small namber of remaining firms(f not the only one). Industries such as auto, chemical, and pharmaceutical fall into this category 160