aost of production lovewell2_ppt04451512hh
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Understanding Economics2nd edition
by Mark Lovewell and Khoa Nguyen
Chapter 4Costs of Production
Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.
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Chapter Focus
In this chapter you will: consider the major organizational forms of
business—sole proprietorships, partnerships, and corporations
learn about economic costs (explicit and implicit) of production and economic profit
analyze short-run (total, average, and marginal) products, and the law of diminishing marginal returns
derive short-run (total, average, and marginal) costs
examine long-run results of production (increasing returns to scale, constant to scale, and decreasing to scale) and long-run costs
Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.
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Types of Production
There are three main sectors in the economy the primary sector consists of industries
that extract or cultivate natural resources the secondary sector consists of industries
that fabricate or process goods the service sector consists of trade and
information industries
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Productive Efficiency
Businesses 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
productive efficiency
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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 explicit and implicit) from total revenue
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Production in the Short Run (a)
In the short run some inputs (such as capital) are fixed other inputs (such as labour) are variable
Inputs are combined to make a business’s total product average product is total product divided by
the number of workers marginal product is the extra total product
with an additional worker
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The Law of Diminishing Marginal Returns
Short-run production is determined by the law of diminishing marginal returns the addition of more variable input causes
marginal product to fall after some point average product also falls after some point
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Relating Average and Marginal Values
Average and marginal values are related using three rules if an average value rises then the marginal
value must be above the average value if an average value falls 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
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0 1 2 3 4 5 6
Number of Workers Employed per Day
T-S
hir
ts P
rod
uced
per
Day
50
100
150
200
250
300
Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.
Total, Marginal, and Average ProductsFigure 4.4, Page 97
0
1 2 3 4 5 6
Number of Workers Employed per DayT-S
hir
ts P
rod
uced
per
Day
40
60
80
100
120
-20
20
Labour(L)
(workersper day)
Total Product
(q)(T-shirtsper day)
MarginalProduct(Δq/ΔL)(T-shirtsper day)
Average Product
(q/L)(T-shirts per day)
0
1
2
3
4
5
6
0
80
200
250
270
280
270
--
80
100
83.3
67.5
56
45
80
120
50
20
10
-10
TP
MP
AP
Diminishingreturns set in
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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)
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Marginal Cost (a)
Marginal cost is the extra cost of producing an extra 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
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Marginal Cost (b)Figure 4.7, Page 100
0 50 100 150 200 250 300
Quantity of T-Shirts Produced Per Day
$ p
er
T-S
hir
t
2
4
6
8
10
12
MC
Diminishingreturns set in
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Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.
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
variable cost
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Short-Run Costs for Pure ‘n’ Simple T-Shirts Figure 4.6, Page 99
Labour
(L)
TotalProduct
(q)
FixedCosts(FC)
VariableCosts(VC)
TotalCost(TC)
(FC + VC)
MarginalCost(MC)
(ΔTC/Δq)
AverageFixed Costs
(AFV)(FC/q)
AverageVariable
Costs(AVC)(VC/q)
AverageCost(AC)
(AFC + AVC)
0
1
2
3
4
5
0
80
200
250
270
280
825
825
825
825
825
825
0
140
300
425
535
640
825
965
1125
1250
1360
1465
1.75
1.33
2.50
5.50
1050
140
160
125
110
105
80
120
50
20
10
10.31
4.13
3.30
3.06
2.95
1.75
1.50
1.70
1.98
2.29
12.06
5.63
5.00
5.04
5.24
Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.
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The Family of Short-Run Cost CurvesFigure 4.8, page 102
0 50 100 150 200 250 300
Quantity of T-Shirts Produced Per Day
$ p
er
T-S
hir
t
2
4
6
8
10
12
AVC
AFC
MC
AC
b
a
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Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.
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 the %
change in output < the % change in inputs
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Returns to Scale (b)
Increasing returns to scale are caused by the division of labour or 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 or limited natural resources
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Costs in the Long Run (a)
Long-run average cost is the minimum short-run average cost at every output
The long-run average cost curve is saucer-shaped because of various ranges of returns to scale initial range of increasing returns to scale middle range of constant returns to scale final range of decreasing returns to scale
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Quantity of Magazines per Week
$ p
er
Mag
azi
ne
Range A Range B Range C
Long-Run Average Costs
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Costs in the Long Run (b)Figure 4.9, page 105
AC1
AC2 AC3
AC4 Long-Run AC
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Costs in the Long Run (b)Figure 4.9, page 97
Possible Long-Run Average Costs
Quantity of Output
$ p
er
Un
it
Extended Range ofIncrease Returnsto Scale
Quantity of Output
$ p
er
Un
it
Extended Range ofConstant Returnsto Scale
Quantity of Output
$ p
er
Un
it
Extended Range ofIncrease Returnsto Scale
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Critic of the Modern Corporation
John Kenneth Galbraith suggests that ownership and control are
separated in large corporations argues that shareholders (the owners) give
up control to managers holds out the possibility that managers are
more interested in maximizing sales than in maximizing profit
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Measuring Business Performance (a)
Economists and accountants differ in the way they measure business performance.
For accountants, there are two main business records: a balance sheet shows a business’s assets,
or items that it owns. It also lists a business’s liabilities, or items that it owes, as well as owner’s equity, which is the owner’s stake in the business
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Income Statement for Jumbo HotdogsFigure A, Page 113
Total Sales
ExpensesFoodFuelDepreciationInterest on loanTotal explicit costs
Total profit
$50 000
$ 15 0003 5001 000
500$20 000
$ 30 000
Income Statement(for the year 2001)
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Measuring Business Performance (b)
An income statement shows a business’s activities in a given time period, with total sales (or revenue) and total expenses, which are its explicit costs.
One important explicit cost is depreciation, or the reduction in the value of a business’s durable assets. For these assets (excluding land), an
annual depreciation charge is included in the income statement as an expense.
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Calculation of Economic Profitfor Jumbo Hotdogs Figure B, Page 114
Total Revenue
Explicit CostsFoodFuelDepreciationInterest on loanTotal explicit costs
Implicit CostsOwner’s wageNormal profitTotal implicit costs
Economic Profit
$50 000
$ 15 0003 5001 000
500$20 000
$28 000
$ 2 000
$ 25 0003 000
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Accounting versus Economic Profit
Accounting profit is total revenue minus explicit costs
Because accountants only consider explicit costs, accounting profit always exceeds economic profit by the amount of the business’s implicit costs.
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Understanding Economics2nd edition
by Mark Lovewell
Chapter 4The End
Copyright © 2002 by McGraw-Hill Ryerson Limited. All rights reserved.