chapter 8. the meaning of costs opportunity costsopportunity costs measuring a firm’s opportunity...

Chapter 8Chapter 8Chapter 8Chapter 8

The Meaning of CostsThe Meaning of CostsThe Meaning of CostsThe Meaning of Costs

• Opportunity costsOpportunity costs

• Measuring a firm’s opportunity costsMeasuring a firm’s opportunity costs

– factors not owned by the firm: explicit costsfactors not owned by the firm: explicit costs

– factors already owned by the firm: implicit factors already owned by the firm: implicit costscosts

– irrelevance of historic costs and replacement irrelevance of historic costs and replacement costscosts

Production in the Short runProduction in the Short runProduction in the Short runProduction in the Short run

• Production functionsProduction functions

• Long-run and short-run production: Long-run and short-run production: – fixed and variable factorsfixed and variable factors

• The law of diminishing returnsThe law of diminishing returns

• The short-run production function:The short-run production function:– total physical product (total physical product (TPPTPP))

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar

Number of workers

012345678

TPP 0 310243640424240

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar TPP

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar TPP

a

b

Diminishing returnsset in here

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Number of farm workers

To

nne

s o

f wh

eat

pro

du

ced

pe

r ye

ar TPP

a

b

d

Maximum output

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

Production in the Short runProduction in the Short runProduction in the Short runProduction in the Short run

• Production functionsProduction functions

• Long-run and short-run production: Long-run and short-run production: – fixed and variable factorsfixed and variable factors

• The law of diminishing returnsThe law of diminishing returns

• The short-run production function:The short-run production function:– total physical product (total physical product (TPPTPP))

– average physical product (average physical product (APPAPP))

Production in the Short runProduction in the Short runProduction in the Short runProduction in the Short run

• Production functionsProduction functions

• Long-run and short-run production: Long-run and short-run production: – fixed and variable factorsfixed and variable factors

• The law of diminishing returnsThe law of diminishing returns

• The short-run production function:The short-run production function:– total physical product (total physical product (TPPTPP))

– average physical product (average physical product (APPAPP))

– marginal physical product (marginal physical product (MPPMPP))

Production in the Short runProduction in the Short runProduction in the Short runProduction in the Short run

• Production functionsProduction functions

• Long-run and short-run production: Long-run and short-run production: – fixed and variable factorsfixed and variable factors

• The law of diminishing returnsThe law of diminishing returns

• The short-run production function:The short-run production function:– total physical product (total physical product (TPPTPP))

– average physical product (average physical product (APPAPP))

– marginal physical product (marginal physical product (MPPMPP))

– the graphical relationship between the graphical relationship between TPPTPP, , APPAPP and and MPPMPP

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

Number offarm workers (L)

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

Number offarm workers (L)

TPP = 7

L = 1

MPP = TPP / L = 7

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

MPP

Number offarm workers (L)

Number offarm workers (L)

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

APP = TPP / L

Number offarm workers (L)

Number offarm workers (L)

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

Diminishing returnsset in here

Number offarm workers (L)

Number offarm workers (L)

b

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Maximumoutputb

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

0

10

20

30

40

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

TPP

-2

0

2

4

6

8

10

12

14

0 1 2 3 4 5 6 7 8

Ton

nes

of w

heat

per

yea

r

APP

MPP

b

b

d

d

Number offarm workers (L)

Number offarm workers (L)

Slope = TPP / L= APP

c

c

Wheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farmWheat production per year from a particular farm

Costs in the Short runCosts in the Short runCosts in the Short runCosts in the Short run

• Costs and inputsCosts and inputs

– costs and the productivity of factorscosts and the productivity of factors

– costs and the price of factorscosts and the price of factors

• Fixed costs and variable costsFixed costs and variable costs

• Total costsTotal costs

– total fixed cost (total fixed cost (TFCTFC))

– total variable cost (total variable cost (TVCTVC))

– total cost (total cost (TC = TFC + TVCTC = TFC + TVC))

Total costs for firm XTotal costs for firm XTotal costs for firm XTotal costs for firm X

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TFC

Output(Q)

01234567

TFC(£)

1212121212121212

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVC

TFC

Output(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

Total costs for firm XTotal costs for firm XTotal costs for firm XTotal costs for firm X

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TC

TVC

TFC

Output(Q)

01234567

TFC(£)

1212121212121212

TVC(£)

010162128406091

TC(£)

12222833405272

103

Total costs for firm XTotal costs for firm XTotal costs for firm XTotal costs for firm X

0

20

40

60

80

100

0 1 2 3 4 5 6 7 8

TVC

TFC

Diminishing marginal returnsset in here

TC

Total costs for firm XTotal costs for firm XTotal costs for firm XTotal costs for firm X

Costs in the Short runCosts in the Short runCosts in the Short runCosts in the Short run

• Marginal costMarginal cost– marginal cost (marginal cost (MCMC) and the law of diminishing ) and the law of diminishing

returnsreturns– the relationship between the marginal and the relationship between the marginal and

total cost curvestotal cost curves

Marginal costMarginal costMarginal costMarginal cost

Output (Q)

Co

sts

(£)

MC

x

Costs in the Short runCosts in the Short runCosts in the Short runCosts in the Short run

• Marginal costMarginal cost– marginal cost (marginal cost (MCMC) and the law of diminishing ) and the law of diminishing

returnsreturns– the relationship between the marginal and the relationship between the marginal and

total cost curvestotal cost curves

• Average costAverage cost– average fixed cost (average fixed cost (AFCAFC))– average variable cost (average variable cost (AVCAVC))– average (total) cost (average (total) cost (ACAC))

Costs in the Short runCosts in the Short runCosts in the Short runCosts in the Short run

• Marginal costMarginal cost– marginal cost (marginal cost (MCMC) and the law of diminishing ) and the law of diminishing

returnsreturns– the relationship between the marginal and the relationship between the marginal and

total cost curvestotal cost curves

• Average costAverage cost– average fixed cost (average fixed cost (AFCAFC))– average variable cost (average variable cost (AVCAVC))– average (total) cost (average (total) cost (ACAC))

• Relationship between average and Relationship between average and marginal costmarginal cost

Average and marginal costsAverage and marginal costsAverage and marginal costsAverage and marginal costs

Output (Q)

Co

sts

(£)

MC

x

Output (Q)

Co

sts

(£)

MC

x

AVC

y

Average and marginal costsAverage and marginal costsAverage and marginal costsAverage and marginal costs

Output (Q)

Co

sts

(£)

MC

x

y

AFC

AVC

Average and marginal costsAverage and marginal costsAverage and marginal costsAverage and marginal costs

Output (Q)

Co

sts

(£)

AFC

AVC

MC

x

AC

y

z

Average and marginal costsAverage and marginal costsAverage and marginal costsAverage and marginal costs