EXPLICIT COSTS A firms actual cash payments for

EXPLICIT COSTS A firm’s actual cash payments for its inputs IMPLICIT COSTS • Opportunity costs of non-purchased inputs such as the entrepreneur’s time and money. – opportunity cost of something is what you sacrifice to get it. • Opportunity cost of the entrepreneur’s time: Time given up to operate a firm; • Opportunity cost of funds: Money given up to set up and run a business.

Economic Cost • The sum of explicit and implicit costs. • The economic cost is higher because the economist includes implicit costs but the accountant does not.

Accounting versus Economic Cost Explicit Cost (Purchased Inputs) Accounting Approach $60, 000 Implicit Cost (Opportunity cost of entrepreneur) (Opportunity cost of funds) Total Cost Economic Approach $60, 000 $30, 000 $10, 000 ------$60, 000 ------$100, 000

TIME PERIODS • SHORT RUN A period of time over which at least one input to production is fixed. For most firms, the fixed input is capital: firm cannot modify production facility or build a new facility. • LONG RUN A period of time over which a firm is perfectly flexible in its choice of inputs. In the long run, a firm can build a new production facility (factory, store, office or restaurant) or modify an existing facility, hire a workforce, and buy raw materials.

Time Period Decisions • Short Run How much output to produce; • Long Run What type of production facility to build;

Principle of Diminishing Returns • Suppose an output is produced with two or more inputs, and we increase one input while holding the other inputs fixed. Beyond some point -called the point of diminishing returns -- output will increase at a decreasing rate.

Computer Chip Manufacturing • As firm packs more and more workers into factory, total output increases, but at a decreasing rate. ------flipping this around------ • As the firm steadily increases its output, the firm requires more and more workers to increase its output by a single chip.

Diminishing Returns and Increasing Marginal Cost For One More Chip Quantity of Additional Marginal Chips Labor Time Labor Cost Material Cost Small: 100 Medium: 300 Large: 400 2 hours 6 hours 10 hours $16 $48 $80 $10 $10 $26 $58 $90

Short-Run Marginal Cost The change in total cost resulting from a one-unit increase in the output of an existing production facility.

Short-Run Marginal and Average Cost Curves Marginal or Average 90 Cost $$$ short-run average short-run marginal total cost curve (SATC) cost curve (SMC) t f 68 58 26 e QUANTITY SMC SATC m 100 300 400 s 100 300 400 Quantity of Chips produced per hour 26 58 90 90 58 68

Short-Run Average Total Cost (SATC) • Equals the total cost divided by the quantity of output, or the cost per unit output. • Total cost is the sum of the fixed cost per chip, the labor cost per chip, and the material cost per chip. • U-shaped.

Short-Run Average Total Cost QUANTITY OF CHIPS SMALL Number of Chips Fixed Cost / Chip($) Labor Hours Labor Cost ($) Labor Cost / Chip ($) Material Cost / Chip ($) Total Cost / Chip ($) 100 72 100 8 10 90 MEDIUM LARGE 300 24 900 7, 200 24 10 58 400 18 2, 000 16, 000 40 10 68

Short-Run Average Total Cost Number of Chips Fixed Cost ($) Fixed Cost / Chip($) Labor Hours Labor Cost ($) Labor Cost / Chip ($) Material Cost / Chip ($) Total Cost / Chip ($) QUANTITY OF CHIPS SMALL MEDIUM LARGE 100 300 400 7, 200 72 24 18 100 900 2, 000 800 7, 200 16, 000 8 24 40 1, 000 3, 000 4, 000 10 10 10 9, 000 17, 400 27, 200 90 58 68

Average Costs • As production increases: Fixed cost per chip decreases from $72 to $24 to $18; Labor cost per chip increases from $8 to $24 to $40; Material cost per chip doesn’t change $10. • Cost is lowest ($58) at the medium level of production.

Marginal & Average-Total Cost Relationship • Short-run average total cost is at its minimum value where average total cost and marginal cost are equal. Average total cost slope = 0. • If marginal cost is less than average total cost, average total cost is decreasing -- has a negative slope. • If marginal cost is greater than average total cost, average total cost is increasing -- has a positive slope.

SHORT-RUN AVERAGE COST CURVES Average cost per chip ($) 90 72 68 58 50 34 24 18 Short-run average variable cost (SAVC) Short-run average total cost (SATC) t f u m g n v 100 p h Quantity SATC SAVC AFC 100 90 18 72 300 58 34 24 400 68 50 18 Average Fixed Cost 300 400 Quantity of Chips per Hour SATC = SAVC + AFC

LONG-RUN AVERAGE COST • Total cost divided by the quantity of output when the firm can choose a production facility of any size • The long-run average cost curve is L-shaped, initially the result of economies of scale.

Economies of Scale Cost saving associated with scaling up -adding more capital, labor and materials to produce more output may be caused by either of two effects: • Indivisible inputs; • Specialization

LONG-RUN AVERAGE COST CURVE FOR ALUMINUM PRODUCTION Average cost $ per pound 2. 80 Long-run average cost curve f e 2. 10 d c b 1. 60 1. 00 0. 50 1. 00 1. 50 2. 00 2. 50 Millions of Pounds of Aluminum per year

Indivisible Inputs • • Inputs which cannot be scaled down to produce a small quantity of output. Examples: Railroad track between two cities cannot be scaled from two to one track. An industrial mold must be complete to produce many copies or a single copy.

Specialization • In a small operation with just a few workers, each performs a wide variety of tasks. • In a large operation with many workers, each worker specializes in one or two tasks, and is more productive because: • Repetition increases productivity; • Workers spend less time switching from task to task.

Minimum Efficient Scale The output at which the longrun average cost curve becomes horizontal.

INDUSTRIES EXPERIENCING MINIMUM EFFICIENT SCALE INDUSTRY MINIMUM EFFICIENT SCALE British Sulfuric Acid 1 million tons British Steel 9 million tons U. S. Automobiles Large U. S. Breweries 200, 000 to 400, 000 per year 4. 5 million barrels

DISECONOMIES OF SCALE • Increase in output leads to increases in the average cost of production: higher costs accompany scaling up. • Diseconomies may occur for two reasons: • Coordination problems; • Increasing input costs.

Coordination Problems • Large organizations require several layers of management (a bureaucracy) to coordinate the activities of the different parts of the organization. This leads to a positively sloped average-cost curve.

Increasing Input Costs • As a firm increases its output, it will demand more of each of its inputs, which may lead to higher prices for some inputs. • Higher prices increases the average cost of production, resulting in a positively sloped average-cost curve.

FOUR TYPES OF MARKETS • Perfect Competition --A market with a very large number of firms, each of which produces the same standardized product and takes the market price as given. A price-taking firm.

FOUR TYPES OF MARKETS • Perfect Competition EXAMPLES • The wheat farmer, • The average stock investor

FOUR TYPES OF MARKETS • Monopolistic Competition --There are many firms, each sells a differentiated product. Because products sold by different firms are not perfect substitutes, each firm has some control over price. There are no barriers to entering the market.

FOUR TYPES OF MARKETS • Monopolistic competition --EXAMPLES • restaurants, • retail stores, • gas stations, • clothing

FOUR TYPES OF MARKETS • Oligopoly --- There are just a few firms in the market, a result of two sorts of barriers to entry: • economies of scale, • government may limit number of firms in the market

FOUR TYPES OF MARKETS • Oligopoly EXAMPLES • automobiles, • airline travel, • breakfast cereals

FOUR TYPES OF MARKETS • Monopoly --A single firm serves the entire market. A monopoly occurs when the barriers to entry are very strong, which could result from very large economies of scale or a government limit on the number of firms.

FOUR TYPES OF MARKETS • Monopoly --- EXAMPLES large scale economies: • local phone service, • electric power generation, established by government policy: • drugs covered by patents, • concessions in National Parks

Characteristics of Different Types of Markets Number Perfect Monopolistic Oligopoly Monopoly very large many few of firms Type of standardized differentiated product Control none slight over price Entry no barriers conditions Examples wheat soybeans no barriers restaurants retail stores clothing Competition one std or diff. unique considerable if not regulated large barriers automobiles local phone air travel and electric breakfast patented cereal drugs

TOTAL REVENUE • The money the firm gets from selling its product and is equal to price times quantity sold: Total Revenue = price quantity * *

ECONOMIC PROFIT Total revenue - total economic cost Total economic cost = explicit costs ( firm’s actual cash payments for inputs ) + implicit costs ( opportunity costs of non-purchased inputs, entrepreneur’s time or money ) such as