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  1. Chapter 8 Costs of Production

  2. Economic Principles • The character of entrepreneurship • Total cost, total fixed cost, and total variable cost • The law of diminishing returns Gottheil - Principles of Economics, 4e

  3. Economic Principles • Average total cost, average variable cost, average fixed cost, and marginal cost • Economies of scale, constant returns to scale, and diseconomies of scale Gottheil - Principles of Economics, 4e

  4. Economic Principles • The relationship between short-run average total cost and long-run average total cost • Downsizing Gottheil - Principles of Economics, 4e

  5. Fixed Cost Fixed cost • Cost to the firm that does not vary with the quantity of goods produced. The cost is incurred even when the firm does not produce. Gottheil - Principles of Economics, 4e

  6. Variable Cost Variable cost • Cost that varies with the quantity of goods produced. Variable costs include such items as wages and raw materials. Gottheil - Principles of Economics, 4e

  7. EXHIBIT 1A TOTAL FIXED COST FOR THE MAXIBOAT Gottheil - Principles of Economics, 4e

  8. EXHIBIT 1B TOTAL FIXED COST FOR THE MAXIBOAT Gottheil - Principles of Economics, 4e

  9. Exhibit 1: Total Fixed Cost for the Maxiboat When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve? • An upward-sloping line • A horizontal line • A downward-sloping line Gottheil - Principles of Economics, 4e

  10. Exhibit 1: Total Fixed Cost for the Maxiboat When plotting total fixed cost on a diagram with dollars on the “y” axis and output on the “x” axis, which of the following correctly describes the shape of the total fixed cost curve? a. An upward-sloping line b. A horizontal line c. A downward-sloping line Gottheil - Principles of Economics, 4e

  11. Labor Productivity Labor productivity • The output per laborer per hour Gottheil - Principles of Economics, 4e

  12. EXHIBIT 2 TOTAL VARIABLE COSTS PER FISHING RUN Gottheil - Principles of Economics, 4e

  13. Exhibit 2: Total Variable Costs Per Fishing Run Complete the sentence: When output is zero, total variable cost is _____. Gottheil - Principles of Economics, 4e

  14. Exhibit 2: Total Variable Costs Per Fishing Run Complete the sentence: When output is zero, total variable cost iszero. Gottheil - Principles of Economics, 4e

  15. Marginal Product Marginal product • The change in total product caused by a one-unit increase in a factor of production (such as labor). Gottheil - Principles of Economics, 4e

  16. The Law of Diminishing Returns Under what circumstances does the law of diminishing returns hold? • In the short run, when at least one factor of production is fixed. Gottheil - Principles of Economics, 4e

  17. The Law of Diminishing Returns Under what circumstances does the law of diminishing returns hold? • As more of a variable factor of production (such as labor) is added to the fixed factor, each will eventually run out of physical space and equipment to work effectively. Gottheil - Principles of Economics, 4e

  18. The Law of Diminishing Returns Under what circumstances does the law of diminishing returns hold? • With crowding, eventually the marginal product of each successive laborer will be less than the one previously added. Gottheil - Principles of Economics, 4e

  19. EXHIBIT 3 TOTAL VARIABLE COST

  20. Exhibit 3: Total Variable Cost If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve: a. It is upward-sloping and becoming steeper. b. It is upward-sloping and becoming flatter. c. It cannot start at the origin. Gottheil - Principles of Economics, 4e

  21. Exhibit 3: Total Variable Cost If total variable cost (TVC) is increasing at an increasing rate, then which of the following is true about the TVC curve: a. It is upward-sloping and becoming steeper. b. It is upward-sloping and becoming flatter. c. It cannot start at the origin. Gottheil - Principles of Economics, 4e

  22. EXHIBIT 4A TOTAL COST CURVE Gottheil - Principles of Economics, 4e

  23. EXHIBIT 4B TOTAL COST CURVE

  24. Exhibit 4: Total Cost Curve 1. How is total cost calculated? • Total cost is the sum of the total fixed and total variable costs of production. Gottheil - Principles of Economics, 4e

  25. Exhibit 4: Total Cost Curve 2. How is the shape of the total cost curve determined? • The shape of the total cost curve is principally determined by the shape of the total variable cost curve. Gottheil - Principles of Economics, 4e

  26. Exhibit 4: Total Cost Curve 2. How is the shape of the total cost curve determined? • This is because the total fixed cost is always the same ($2,000), regardless of what quantity is produced. Gottheil - Principles of Economics, 4e

  27. Average Total Cost Average total cost (ATC) • Total cost divided by the quantity of goods produced. ATC declines, reaches a minimum, then increases as more of a good is produced. Gottheil - Principles of Economics, 4e

  28. Average Fixed Cost Average fixed cost (AFC) • Total fixed cost divided by the quantity of goods produced. AFC steadily declines as more of a good is produced. Gottheil - Principles of Economics, 4e

  29. Average Fixed Cost Average variable cost (AVC) • Total variable cost divided by the quantity of goods produced. AVC declines, reaches a minimum, then increases as more of a good is produced. Gottheil - Principles of Economics, 4e

  30. Average Cost If total fixed cost is $1 million, total variable cost is $2 million, and output is 100,000, what is AFC, AVC, and ATC? • AFC is ($1 million/100,000) = $10 • AVC is ($2 million/100,000) = $20 • ATC is ($3 million/100,000) = $30—or • ATC = AFC + AVC = $10 + $20 = $30 Gottheil - Principles of Economics, 4e

  31. EXHIBIT 5A AVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES Gottheil - Principles of Economics, 4e

  32. EXHIBIT 5B AVERAGE FIXED COST, AVERAGE VARIABLE COST, AND AVERAGE TOTAL COST CURVES

  33. Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves 1. What is the difference between the ATC and AVC curves? • The difference between the ATC and AVC curves is AFC. Gottheil - Principles of Economics, 4e

  34. Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves 1. What is the difference between the ATC and AVC curves? • The ATC curve is the vertical sum of the AFC and the AVC curves. Gottheil - Principles of Economics, 4e

  35. Exhibit 5: Average Fixed Cost, Average Variable Cost, and Average Total Cost Curves 2. Why do the AVC and ATC curves become closer together as output increases? • Because (ATC - AVC) = AFC, and as output increases, AFC becomes smaller Gottheil - Principles of Economics, 4e

  36. Marginal Cost Marginal cost • The change in total cost generated by a change in the quantity of a good produced. Gottheil - Principles of Economics, 4e

  37. EXHIBIT 6A MARGINAL COST AND AVERAGE TOTAL COST CURVES Gottheil - Principles of Economics, 4e

  38. EXHIBIT 6B MARGINAL COST AND AVERAGE TOTAL COST CURVES

  39. Exhibit 6: Marginal Cost and Average Total Cost Curves 1. What are the shapes of the MC and ATC curves? • The ATC curve is U-shaped, and the MC curve is upward-sloping and intersects the ATC curve. Gottheil - Principles of Economics, 4e

  40. Exhibit 6: Marginal Cost and Average Total Cost Curves 2. What is the relationship between the MC and the ATC curves in Exhibit 6? • Within the output range 0 to 8,000, MC is below ATC, causing ATC to decrease. Gottheil - Principles of Economics, 4e

  41. Exhibit 6: Marginal Cost and Average Total Cost Curves 2. What is the relationship between the MC and the ATC curves in Exhibit 6? • Beyond an output of 8,000, MC is above ATC, causing ATC to increase. Gottheil - Principles of Economics, 4e

  42. Exhibit 6: Marginal Cost and Average Total Cost Curves 2. What is the relationship between the MC and the ATC curves in Exhibit 6? • At 8,000, MC = ATC. At this point ATC is at its minimum. • The MC curve always cuts the ATC curve from below at the ATC curve’s minimum. Gottheil - Principles of Economics, 4e

  43. EXHIBIT 7 AVERAGE TOTAL COST CURVES FOR TWO FISHING FIRMS WITH DIFFERENT FIXED COSTS

  44. Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs 1. In Exhibit 7, what is the average total cost for Strang and Burnett at an output of 2,000 fish? • At an output of 2,000 fish, Strang’s average total cost is $0.70. • At the same output level, Burnett’s average total cost is $1.10. Gottheil - Principles of Economics, 4e

  45. Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs 2. What explains the difference in the average total cost for Strang and Burnett? • The difference is due to the fact that Strang and Burnett have different fixed costs associated with the different capacity boats that they use. Gottheil - Principles of Economics, 4e

  46. Exhibit 7: Average Total Cost Curves for Two Fishing Firms with Different Fixed Costs 3. How does efficiency change as output quantity increases? • At an output less than 4,000, Strang’s operation is more efficient. • When output increases above 4,000, Burnett’s operation becomes more efficient. Gottheil - Principles of Economics, 4e

  47. Economies of Scale Economies of scale • Decreases in the firm’s average total cost brought about by increased specialization and efficiencies in production realized through increases in the scale of the firm’s operations. Gottheil - Principles of Economics, 4e

  48. Constant Returns to Scale Constant returns to scale • Costs per unit of production are the same for any level of production. Changes in plant size do not affect the firm’s average total cost. Gottheil - Principles of Economics, 4e

  49. Diseconomies of Scale Diseconomies of scale • Increases in the firm’s average total cost brought about by the disadvantages associated with bureaucracy and the inefficiencies that eventually emerge with increases in the firm’s operations. Gottheil - Principles of Economics, 4e

  50. EXHIBIT 8 ECONOMIES OF SCALE, DISECONOMIES OF SCALE, AND CONSTANT RETURNS TO SCALE Gottheil - Principles of Economics, 4e