2015 by McGraw-Hill Ryerson Ltd.

Chapter 4
Costs of Production

2015 by McGraw-Hill Ryerson Ltd.

Learning Objectives
After this chapter you will be able to:
identify economic costs (explicit and
implicit) of production and economic
profit
describe short-run (total, average, and
marginal) products, and the law of
diminishing marginal returns
derive short-run (total, average, and
marginal) costs
explain the long-run results of production

2015 by McGraw-Hill Ryerson Ltd.

Types of Production
There are three main sectors in the
economy:
the primary sector, which consists of
industries that extract or cultivate natural
resources
the secondary sector, which consists of
industries that fabricate or process goods
the service sector, which consists of trade
and information industries

2015 by McGraw-Hill Ryerson Ltd.

Productive Efficiency
Businesses can choose from
different production processes.
A labour-intensive process
employs more labour and less
capital.
A capital-intensive process
employs more capital and less
labour.

The lowest-cost process provides

2015 by McGraw-Hill Ryerson Ltd.

Economic Costs
Economic costs include:
explicit costs, which are payments
to resource supplies outside a
business
implicit costs, which are what
owners give up by being involved
in a business

Economic profit is found by

subtracting economic costs (both
2015 by McGraw-Hill Ryerson Ltd.

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

2015 by McGraw-Hill Ryerson Ltd.

Production in the Short

Run
In the short run:
some inputs (such as capital) are fixed
other inputs (such as labour) are variable

Other product measures besides total

product include:
average product, which is total product
divided by the number of workers
marginal product, which is the extra total
product associated with an additional worker

2015 by McGraw-Hill Ryerson Ltd.

The Law of Diminishing

Returns
Short-run production is
determined by the law of
diminishing marginal returns.
According to this law:
the addition of more variable input
causes marginal product to fall
after some point
average product also falls after
some point

2015 by McGraw-Hill Ryerson Ltd.

Average and Marginal Values

Average and marginal values are related
using three rules:
If an average value is rising, then the
marginal value must be above the average
value.
If an average value is falling, then the
marginal value must be below the average
value.
If an average value stays constant, then the
marginal value must equal the average value.

2015 by McGraw-Hill Ryerson Ltd.

10

Total
Product
(q)
(workers (T-shirts
per day) per day)
0

80

200

250

270

280

270

Marginal
Product
(q/L)
(T-shirts
per day)

80
120
50
20
10
-10

Average
Product
(q/L)
(T-shirts
per day)
-80
100
83.3
67.5
56
45

300

TP

250
200
150
100
50
0

Number of Workers Employed per Day

T-Shirts Produced per Day

Labour
(L)

T-Shirts Produced per Day

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

Diminishing
returns set in

120
100
80
60

AP

40
20
0
-20

MP

Number of Workers Employed per Day

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11

Costs in the Short Run

Short-run costs include:
fixed costs (costs of all fixed
inputs)
variable costs (costs of all variable
inputs)
total cost (fixed costs + variable
costs)

2015 by McGraw-Hill Ryerson Ltd.

12

Marginal Cost
Marginal cost is the extra cost of
producing another unit of output.

It equals the change in total cost

divided by the change in total
product.

The marginal cost curve is

shaped like a J because of the
law of diminishing marginal
returns.
2015 by McGraw-Hill Ryerson Ltd.

13

Marginal Cost
FIGURE 4.6

12

MC
10

$ per T-Shirt

8
6
Diminishing
returns set in

4
2

50

100

150

200

250

300

Quantity of T-Shirts Produced Per Day

2015 by McGraw-Hill Ryerson Ltd.

14

Per-Unit Costs
Per-unit costs include:
average fixed cost (fixed costs
divided by total product)
average variable cost (variable
costs divided by total product)
average cost
either total cost divided by total
product
or average fixed cost + average

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15

Short-Run Costs
FIGURE 4.5
Labour
(L)

Total Marginal Fixed Variable

Product Product Costs Costs
(MP)
(q)
(FC)
(VC)

80

200

250

270

280

80
120
50
20
10

Average
Marginal Average
Average
Cost
Cost
Fixed Costs Variable
(AC)
(MC)
(AFV)
Costs
(AFC + AVC)
(TC/q)
(FC/q)
(AVC)
(VC/q)

Total
Cost
(TC)
(FC + VC)

$825

$0

$825

825

140

965

825

300

1125

825

425

1250

825

535

1360

825

640

1465

2015 by McGraw-Hill Ryerson Ltd.

140 $1.75
160

1.33

125

2.50

110

5.50

105 10.50

$10.31

$1.75

$12.06

4.13

1.50

5.63

3.30

1.70

5.00

3.06

1.98

5.04

2.95

2.29

5.24

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The Family of Short-Run Cost

Curves FIGURE 4.7
12
MC

$ per T-Shirt

10
8

AC
b

AFC
AVC

2
a
0

50

100

150

200

250

300

Quantity of T-Shirts Produced Per Day

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17

Returns to Scale (a)

All inputs can be changed by the
same proportion in the long run.
Increasing returns to scale means
the % change in output > the %
change in inputs.
Constant returns to scale means
the % change in output = the %
change in inputs.
Decreasing returns to scale means

2015 by McGraw-Hill Ryerson Ltd.

18

Returns to Scale (b)

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

2015 by McGraw-Hill Ryerson Ltd.

19

Costs in the Long Run

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

an initial range of increasing returns to scale

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

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20

Costs in the Long Run

FIGURE 4.8
Long-Run Average Costs

AC4

$ per Magazine

AC1

AC2

Range A

Long-Run AC

AC3

Range B

Range C

Quantity of Magazines per Week

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Costs in the Long Run

FIGURE 4.9
Possible Long-Run Average Costs
Extended Range of
Decrease Returns
to Scale

Extended Range of
Constant Returns
to Scale

Extended Range of
Increasing Returns
to Scale

Quantity of Output

Long-Run AC

Quantity of Output

2015 by McGraw-Hill Ryerson Ltd.

$ per Unit

Long-Run AC

$ per Unit

$ per Unit

Long-Run AC

Quantity of Output

22

Critic of the Modern

Corporation
John Kenneth Galbraith:
suggested that ownership and control
are separated in large corporations
argued that shareholders (the
owners) give up control to managers
held out the possibility that managers
are more interested in maximizing
sales than in maximizing profit

2015 by McGraw-Hill Ryerson Ltd.

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