1. business and industrial

Options and Outcomes - Chapter 10
Chapter 10
How Are Costs Determined and What Do They
Mean?
In the previous chapter, we explored a little about production. We did that so
that we can understand the supply decisions of sellers, by better understanding cost.
Ultimately, supply decisions are based on cost. We've seen something of cost in the
past, but now we introduce new shapes, sizes, and flavors (mouth watering flavors, at
that).
How Do We Determine Cost?
Which costs are easy to count, and which are not?
One way to think about cost is to simply add up the money payments that using
resources (to make output) will entail. The costs of using resources that must be purchased, and thus require monetary payment are called explicit costs. However, as we
have already seen, the cost of doing or using something can also mean the alternatives
given up or the opportunity cost. The opportunity costs associated with using resources
that are owned by a firm (producer), and which don’t involve a money payment, are
called implicit costs. Obviously, finding out the implicit costs of producing a product
can be difficult, since there are no receipts or cancelled checks to record.
115
116
One implicit cost that can be estimated is the implicit (normal) rate of return
that must be earned by investors to continue to supply capital to a firm. This is called the
opportunity cost of capital, equal to the amount of interest income that could be
earned on alternative investments. This is roughly the interest that could be earned if the
capital assets owned by the firm were sold, and the funds invested in some other way.
Notice, it is not really the opportunity cost of the capital owned by the firm, as that
would require an estimate of the rental value in its next best use, or some similar estimate, but it is an approximation at least.
117
Which costs change when output increases, and which do not?
In the short run, some costs won't change when output is increased or decreased. We call the costs that cannot be (or don't need to be) changed in the short run
fixed costs. Fixed costs are the costs associated with capital and similarly fixed inputs
(in the short run). The costs that do change when output is increased or decreased in
118
115
116
117
118
explicit costs -money costs; expenditures for resources that must be purchased or rented, and thus require money payment
implicit costs - opportunity costs of using resources that do not require
money payment to obtain or use
opportunity cost of capital -and estimate of the implicit costs of the firm's
assets, based on the interest income that could have been earned if a
similar sum had been invested at the going interest rate
fixed costs -costs that do not change in the short run as output is changed;
the costs associated with fixed inputs in the short run
Copyright 2006 by Ray Bromley
How Are Costs Determined?
93
Options and Outcomes - Chapter 10
the short run are called variable costs. Variable costs are the costs associated with
labor and other variable inputs in the short run. Notice, fixed costs can be implicit or
explicit, as can variable costs.
119
Which costs help us make decisions in the short run?
Since only variable costs can change in the short run, all short run decisions are
made based solely on variable costs (we will talk about the long run later in the chapter). Even so, there are different kinds of variable costs, each of which is helpful in
making different kinds of short run decisions.
As was pointed out on page 87, there are different kinds of sellers who may
make different kinds of decisions. However, they all use the same measures of cost to
do so. Just to get some idea of how the costs are used, we will start out showing the
kinds of decisions that a seller would make if he or she were such a small part of the
market that the price is outside of his or her control. This kind of seller is called a price
taker, and we will examine the decisions of price takers in greater detail in the next
chapter.
120
How does a seller decide whether to produce anything?
Suppose a seller is trying to decide whether to make any product at all. If the
seller decides not to make anything on a particular day (or week or month) the seller
will still have her fixed costs, but can avoid the variable costs in the short run. She can
do this by having all of the workers stay home and by not ordering any materials.
This is still a short run decision, just a sort of big one. To make this decision the
seller will weigh the utility of producing today, for example, against the cost. We assume
that the utility would be today's revenue (you know, PxQ) and the cost would be the
variable cost of operating today.
When considering today’s variable cost against today’s revenue,
if Revenue Variable Cost, then the seller will open up (produce),
121
because the utility is at least as great at the cost of opening up. In other terms,
if PxQ Variable Cost, then the seller will open up. Dividing by the amount of output,
Q, we get
P Q Variable Cost
, then open up,
if
Q
Q
or if P Variable Cost
, then open up.
Q
We call the variable cost per unit of output average variable cost (AVC),
Variable Cost
in the above equation.
which is simply
Q
122
119
120
121
122
94
variable costs -those costs that do change in the short run as output is
changed; the costs of using variable inputs
price taker -a seller that takes the market price; a seller that is such a small
part of the market that it cannot control the price or set a price much different from that of other sellers
open up - to produce output in the short run; to operate
average variable cost (AVC) -variable cost per unit of output
How Are Costs Determined?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 10
So, the seller will find it worthwhile to open up if
P AVC (Average Variable Cost). Otherwise, if price is less than average variable cost,
the seller will chose not to open up, or will choose to shut down.
123
AVC will depend on the level of output that the seller produces, but as long as
the price is greater than AVC at even its lowest point (its minimum), it will pay to open.
How is average variable cost related to production?
Variable Cost
, and thus can always
Q
be determined if we know variable cost and the amount of output being produced, Q, it
is also related to the measures of production that we explored earlier in the chapter.
Specifically, it is related to average product.
This is because the variable cost is the cost of the variable input. If we focus on
labor as being the variable input, then the cost of using it is its price (or wage ) times the
amount of labor being used. So, variable cost = wage x variable input or VC= wage x
labor.
Variable Cost
wage labor
=
.
Average Variable Cost =
Q
Q
While average variable cost is defined as
124
But using some math...
Average Variable Cost =
wage labor
labor
variable input
= wage x
= wage x
.
Q
Q
output
output
, which is the
variable input
mathematical inverse of the last term in our average variable cost formula.
variable input
1
In other words,
is
.
output
average product
But, on page 91, we found that the average product is
Thus, Average Variable Cost = wage x
Average Variable Cost =
variable input
1
= wage x
or
output
average product
wage
.
average product
If you don't follow all of that, just remember the last line, and know that the average
variable cost in inversely related to the average product.
123
124
shut down - decision to cease producing output; to not open or operate in
the short run
wage -the price of a unit of labor
Copyright 2006 by Ray Bromley
How Are Costs Determined?
95
Options and Outcomes - Chapter 10
Application: finding average variable cost
Returning to our cake example (see page 91), if ten hours of labor are hired at $15 an hour, the
variable cost (of labor) is $15x10=$150. If the ten hours of labor produce 21 cakes, the average
variable cost of each cake is
$150
21
= $7.14 (approximately).
But to find the average variable cost of each cake, we could have instead used the average
product. We found that the average product of labor is 2.1 cakes if 10 hours of labor is used. The
wage
$15
is thus
average product
2.1
, which also gives us $7.14 as the average variable cost. Similar
calculations can be found below.
Labor input (hours)
0
Cakes (Q)
0
Average Product (AP)
Variable Cost, VC (wage=$15)
wage
AVC calculation
AP
=
1
1
1
$15
VC
15
Q
1
Average Variable Cost
or
2
3
1.5
$30
15
15
1
1.5
$15
or
4
9
2.25
$60
30
15
3
2.25
$10
or
6
14
2.33
$90
60
15
9
2.33
$6.67
or
8
18
2.25
$120
90
15
14
2.25
$6.43
or
10
21
2.1
$150
120
15
18
2.1
$6.67
or
150
21
$7.14
How much product is it worthwhile to produce and sell?
Suppose a seller is trying to decide whether she can afford to sell a unit of a
good at a particular price. If the price a buyer will pay is the only benefit she will receive
for selling the good, then she will compare the price to her cost of selling one unit of the
good to that buyer.
We call the cost of making and selling one unit of a good the marginal cost.
Yep, this is our old friend from chapter 2. Now, we are looking at marginal cost as the
money cost of using the variable resource or resources to make one additional unit of a
change in Variable Cost
product. That means that marginal cost is
. (Actually, it is also
change in Q
the change in cost divided by the change in output, but only variable cost can change in
the short run).
125
Marginal cost can tell a seller how much output to make or sell. If the price of
the good is at least as big as the marginal cost of making one more of the good, then it's
worth making and selling that one more unit. The seller will find it worthwhile to make
and sell every unit for which
P Marginal Cost
How is marginal cost related to production?
change in Variable Cost
change in Q
Marginal cost is defined as
, and thus can always be
determined if we know how much variable cost is changing for a particular change in
the amount of output being produced. However, just as the average variable cost is
related to average product, the marginal cost of making a product is determined by the
marginal product.
Remember, variable cost = wage x variable input or VC= wage x labor.
125
96
marginal cost - the cost of producing or selling an additional unit of output
How Are Costs Determined?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 10
So, Marginal Cost =
change in Variable Cost
change in (wage labor)
=
.
change in Q
change in output
But, if the wage doesn't change, it turns out that...
change in (wage labor)
change in variable input
Marginal Cost =
= wage x
.
change in output
change in output
change in output
But, remember that marginal product is
change in variable input
change in variable input
matical inverse of the last term. So,
marginal cost =wage x
marginal cost =
is
change in output
1
marginal product
, which is the mathe1
marginal product
, and
or
wage
.
marginal product
Application: finding marginal cost
Returning to our cake example (see page 91), we can find the marginal cost of producing a
particular cake, such as the 21st by noting that it takes 10 hours of labor (at a wage of $15) to produce
21 cakes, so the variable cost (of labor) is $15x10=$150. If three fewer cakes had been made, only 8
hours of labor would have been needed at a variable cost of $15x8=$120. So, the difference in
variable cost is ($150-$120=) $30 to produce (21-18=) 3 additional cakes. We can thus calculate the
cost of each individual (additional) unit of output as
change in variable cost
change in output
=
$30
3
=$10. .
But to find the marginal cost of the 21st cake, we could have instead used the marginal product.
We found that the marginal product of labor is 1.5 cakes if 10 hours of labor is used. The
wage
marginal product
is thus
$15
1.5
, which also gives us $10.00 as the marginal cost. Similar calculations can
be found below (MC stands for marginal cost).
Labor input (hours)
0
1
Cakes (Q)
0
1
Marginal Product (MP)
1
Variable Cost, VC (wage=$15) $15
calculation of MC as
calculation of MC as
Marginal Cost
Copyright 2006 by Ray Bromley
2
3
2
$30
4
9
3
$60
6
14
2.5
$90
8
18
2
$120
10
21
1.5
$150
change in VC
15 - 0
30 - 15
60 - 30
90 - 60
120 - 90
150 - 90
change in Q
1- 0
3 -1
9-3
14 - 9
18 - 14
21- 18
wage
15
15
15
15
15
15
MP
1
2
3
2.5
2
1.5
$15
$7.50
$5
$6
$7.50
$10
How Are Costs Determined?
97
Options and Outcomes - Chapter 10
How are average variable cost and average total cost related?
Figure 10-1
COST
PER
UNIT of
OUTPUT
minimums
MARGINAL
COST
AVERAGE
TOTAL
COST
AVERAGE
VARIABLE
COST
Q = OUTPUT
OUTPUT
PER
UNIT of
INPUT
diminishing returns
maximum
AVERAGE
PRODUCT
AVERAGE
PRODUCT
MARGINAL
PRODUCT
INPUT
The rules we discussed for the
relationship between marginal product and average product also work for marginal cost and
average variable cost. If the marginal cost (of a
particular unit of output) is greater than the
average variable cost, the average variable cost
will go up when that output is produced. You
can see this relationship on the graph of
marginal cost and average variable cost to the
left (Figure 10-1). At the amount of input for
which average variable cost is minimized,
marginal cost is equal to average variable cost.
At input levels where marginal cost is above
average variable cost, the average variable cost
is rising (the curve slopes up as more output is
produced). At input levels where marginal cost
is below average variable cost, average variable
cost is falling (the curve slopes down).
If the graph of marginal cost and
average variable cost looks like an upside down
version of the marginal product/average product
graph, remember that marginal cost is inversely
related to marginal product, and average
variable cost is inversely related to average
product. If marginal product is rising, marginal
cost is falling, and vice versa. If average product
is rising, average variable cost is falling, and vice
versa.
What have we learned about supply choices, so far?
So far, we have learned that a producer (price taker) can decide whether to operate (produce, open up) by comparing the price to average variable cost at its lowest
level.
So, the question...
"Should the seller produce ANY output?"
is answered by asking
"is PAVC at the minimum AVC?"
If so, operate; otherwise, shut down.
Also, a producer will find it adds to its profit by making and selling only those
units of output that will sell for a price at least as great as the marginal cost of making or
selling them.
The question...
"How much output should the seller make or sell?"
is answered by asking the question
"is P MC for this amount of output?"
The producer then produces every unit of output for which the price is at least
as great as the marginal cost.
98
How Are Costs Determined?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 10
Application: making short run decisions
Using our cake example, and the costs that we have found…
Labor input (hours)
0
1
2
4
6
8
10
Cakes (Q)
0
1
3
9
14
18
21
Average Variable Cost (of labor)
$15
$10
$6.67
$6.43
$6.67
$7.14
Marginal Cost (of labor)
$15
$7.50
$5
$6
$7.50
$10
Let’s add in the additional marginal cost of ingredients (materials). Suppose that, in addition to
the labor costs shown above, every cake involves a materials cost of $1. This would add $1 to each
calculation of average variable cost and marginal cost, making the cost table look like…
Cakes (Q)
0
1
3
9
14
18
21
AVC
$16
$11
$7.67
$7.43
$7.67
$8.14
MC
$16
$8.50
$6
$7
$8.50
$11
What is the lowest that the price of a cake can be, if this producer is to make any cake?
Remember, the price has to be at least as big as the minimum average variable cost, which is $7.43
(at least on the table). As long as the price is that high or higher, the producer will make output. This
occurs at an output of 14 cakes, so if the producer makes any cake, she will make at least that many.
Suppose that the market price of cakes is $9.00. The producer will make cakes, since the price is
greater than the minimum AVC. We also know that she will make at least 14 cakes. In addition, she
will make every cake for which the marginal cost is less than (or perhaps just) $9.00. The marginal
cost of the 18th cake is $8.50 and the marginal cost of the 21st cake is $11, so the producer would be
willing to make 18 cakes, but not 21.
In fact, if we knew more about the individual cakes’ marginal costs, we might discover a
different output for the producer, but given the jumps of output on the table, our best guess would be
that the producer will make 18 cakes.
How do we figure out profits?
So far, we have not discussed profit much. In the short run, if a seller makes the
decisions we outlined above, it will be making as much money as it can, given its costs.
Since we have discussed all the decisions that the firm can make in the short run,
calculating how big profit is will simply enable us to see, after the decisions are made,
how well the firm is doing. In this sense, it is like the score of a game; you play the best
you can, but if in the end you lose, there really isn't much else you could have done
differently.
Profit is calculated by finding the revenues of the firm minus its costs.
Actually, there are two ways of computing profit. If profit is calculated by taking
the firm’s total revenue and subtracting only the explicit costs, we find what is called
accounting profit. When all costs (including the implicit) are deducted from revenue,
the result is called economic profit, which is generally less than accounting profit. All
costs (fixed and variable) that we consider in economics will include the implicit as
well as explicit cost. So, when we talk of profit, we will mean economic profit, unless
we specify accounting profit.
126
127
To figure out profit, we need to figure out all of the costs. If all of the costs of the
firm are added together, we call the result total cost. Total cost is thus the sum of fixed
costs (FC) and variable costs (VC). So far, since fixed costs can’t be altered in the short
run, we have not done much with them here. However, they will play a role when we
126
127
accounting profit – profit calculated by subtracting explicit costs from revenue
economic profit – profit calculated by subtracting both implicit and explicit
costs from revenue
Copyright 2006 by Ray Bromley
How Are Costs Determined?
99
Options and Outcomes - Chapter 10
calculate profit.
Total Cost (TC) = VC + FC
Profit is Revenue minus Total Cost, or
Profit= Revenue - Total Cost, or
But, remember that revenues are the price (P) of the product times the amount of the
product that is made and sold (Q), so
Profit = PxQ - TC
On a per unit basis, dividing by output (Q), profit per unit of output would be
Profit P Q Total Cost
Total Cost
=
=PQ
Q
Q
Q
Total Cost
is average total cost (ATC), which is total cost divided by the amount of
Q
output. Thus, profit per unit of output is simply P - ATC.
128
If the price is bigger than the ATC, the profit will be positive.
So, the question
"is profit being made by the seller, at the output selected?"
is answered by asking
"is P> ATC for this amount of output?"
To find profit, we can find the revenue of the amount of output being produced
and subtract the total cost of making it. But another way would be to find profit per unit
and then multiply the profit per unit by the amount of output actually being produced
(designated as Q*). Profit per unit is calculated as the price minus the average total cost
of producing the selected quantity of output (ATC*), since the amount of output will
affect the size of average total cost.
Profit = Q* x (P-ATC*)
128
100
average total cost (ATC)– total cost per unit of output being produced
How Are Costs Determined?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 10
What is average total cost like?
ATC will vary depending on how much output we produce. How does ATC
change as output is increased? Remember that Total Cost (TC) = VC + FC, so
Total Cost
Total Cost Variable Cost Fixed Cost
VC+FC
=
=
=
+
ATC =
Q
Q
Q
Q
Q
But, we already know that
Variable Cost
is average variable cost (AVC).
Q
Fixed Cost
is also a kind of average cost, which
Q
$
we call average fixed cost (AFC).
What does average fixed cost look like? Well, the
fixed cost (the numerator) won't change, but at
bigger values of output (Q) we will be dividing by
a bigger number, so AFC will get smaller as Q gets
bigger, as can be seen at the right (Figure 10-2).
Figure 10-2
129
If we add AVC to AFC, we get average total
cost (ATC), which is also total cost divided by the
amount of output.
Knowing this will help us understand what
ATC is like, since it will look like AVC with AFC
added on. This means that ATC will be far above
the AVC for small amounts of output, and will get
closer to AVC as output is increased (as shown
below in Figure 10-3).
Notice
that
the
relationship between the
marginal cost and average total
cost is similar to the
relationship between marginal
cost and average variable cost.
If the marginal cost is above
ATC, ATC is rising. If the
marginal cost is below ATC,
ATC is falling. Marginal cost
crosses ATC at the minimum
average total cost.
COST
PER
UNIT of
OUTPUT
AFC= FC/Q
Q
Figure 10-3
minimums
MARGINAL
COST
AVERAGE
TOTAL
COST
AVERAGE
VARIABLE
COST
Q = OUTPUT
129
average fixed cost (AFC)- short run fixed cost divided by the amount of
output being produced
Copyright 2006 by Ray Bromley
How Are Costs Determined?
101
Options and Outcomes - Chapter 10
Summary of the uses of short run costs:
1. When deciding whether to produce anything in the short run:
"Should the seller produce ANY output?" is really asking
"is PAVC at the minimum AVC?"
2. When deciding how much to produce in the short run:
"How much output should the seller make or sell?" is really asking
"is P MC for this amount of output?"
The amount of output for which every unit has a marginal cost no greater than
the price will be the right amount to produce and sell. This amount can be
called Q*.
3. When trying to learn whether the seller is making any profit:
"is profit being made by the seller, at the output (Q*) selected?" is really asking
"is P ATC for this amount of output?"
If it is, then the amount of profit is Q* times P-ATC*, where the ATC* is the
average total cost of producing exactly Q* units.
Application: finding short run average total cost and profit
Returning to our cake example, suppose we want to determine what the profit will be if our
baker produces the profit-maximizing number of cakes. To find profit, we can find the income or
revenue from selling cake, and subtract the total cost of the amount of cake being produced. We
could also use the average total cost to help us.
To find average total cost, we need to know fixed cost. Suppose that fixed costs are $20 per
day. We can find average total cost by either taking the total cost of making each amount of output
and dividing by output, or by finding average fixed cost and adding it to average variable cost.
Labor input (hours)
0
1
2
4
6
8
10
Cakes (Q)
0
1
3
9
14
18
21
Variable Cost of Labor (VCL)
0
$15
$30
$60
$90
$120
$150
Variable Cost of Materials (VCM) 0
$1
$3
$9
$14
$18
$21
Fixed cost (FC)
$20
$20
$20
$20
$20
$20
$20
Total Cost (FC+VCL+VCM)
$20
$36
$53
$89
$124
$158
$191
calculation of ATC as
Average Total Cost
calculation of AFC as
TC
Q
36
1
53
3
89
9
124
14
158
18
191
21
$36
$17.67
$9.89
$8.86
$8.78
$9.10
FC
20
20
20
20
20
20
Q
1
3
9
14
18
21
Average Fixed Cost
$20
$6.67
$2.22
$1.43
$1.11
$0.95
AVC (including materials @ $1 each)
$16
$11
$7.67
$7.43
$7.67
$8.14
ATC as AVC+AFC
$36
$17.67
$9.89
$8.86
$8.78
$9.09
Notice that the value of the ATC of producing 21 cakes will be a different number depending on
how it is calculated, due to rounding error.
As we already found, if the market price of cakes is $9.00, the producer would be willing to
make 18 cakes (but not 21).
One way to find profit is to determine revenue and subtract all costs. The revenue from making
18 cakes and selling them for $9 each would be 18x$9=$162. The total cost of making 18 cakes (from
the table above) is $168. Thus, profit is $162-$158=$4.
To calculate the profit using average total cost, we could find the profit per unit (price minus
ATC) and multiply by the number of cakes being made (18). This gives us $9-$8.78=$0.22 profit per
cake. Multiplying by 18 cakes gives 18 x $0.22 = $3.96, which is off a little due to rounding in the ATC
calculation.
102
How Are Costs Determined?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 10
How do we show the long run?
In the long run, costs are all variable. This means that even capital can be altered. Output can be changed by changing both capital and labor.
We say that when a producer is changing the amount of capital and other inputs
that it is using, the producer is changing its "scale." You can think of scale as an acronym (although it isn't) – Scale is Capital And Labor and Everything.
130
How do we show changing everything? Well, we sort of cheat. Since the short
run cost curves show changing everything but capital, we think of changing scale in the
long run as allowing the producer to pick which short run average total cost curve it
wants to have. If a firm picks a different short run average total cost, it is doing so by
acquiring a different amount of capital in the long run, to which it will apply its variable
inputs in the short run. Any change in capital in the long run can be shown by picking a
different short run average total cost curve. Changing other inputs in the long run can be
shown (as they are in the short run) by picking a different point on a short run average
total cost curve, or moving along a particular short run average total cost curve.
If we draw all of the short run average total cost curves that a producer could
select between, and then draw another curve containing all of these, the new curve is
called the long run average total cost curve. It is also called long run average cost,
since there is no meaningful distinction between fixed, variable and total cost in the
long run. This is shown in Figure 10-4 below.
131
Figure 10-4
$
SRATC curves
Long Run
Average
Total
Cost
Diseconomies of
Scale
Economies of
Scale
Increasing
Returns to Scale
Constant Returns
to Scale
Decreasing Returns
to Scale
Output
SCALE
130
131
scale- the size of a firm or producing entity in the long run; increasing the
output of a firm in the long run by increasing all of inputs, including capital, is increasing scale.
long run average (total) cost- average total cost in the long run as output is
increased by changing scale; the curve showing long run average total
cost is the lower boundary of all of the possible short run average total
cost curves.
Copyright 2006 by Ray Bromley
How Are Costs Determined?
103
Options and Outcomes - Chapter 10
The long run average total cost curve slopes down (indicating lower average
costs) if the scale is increased from a very small scale to a little larger scale. These
declining average costs as scale is increased are called "economies of scale" or "increasing returns to scale."
132
As output and scale are increased, a point is reached at which greater scale no
longer decreases average costs. This begins the range of output for which we say there
are "constant returns to scale;" average costs neither rise nor fall as scale is increased.
133
Eventually, larger scale will lead to average costs getting larger. This is referred
to as "diseconomies of scale," or "decreasing returns to scale."
134
Remember, scale can only be changed in the long run, so any mention of scale
means we are talking about the long run.
$
SRATC curves
Long Run
Average
Total
Cost
Diseconomies of
Scale
Economies of
Scale
Increasing
Returns to Scale
Constant Returns
to Scale
Decreasing Returns
to Scale
Output
SCALE
132
133
134
104
economies of scale- the situation of decreasing average total cost as scale is
increased; average total costs fall as more output is produced. Also called
"increasing returns to scale."
constant returns to scale- the situation in which changing scale does not
alter average total cost
diseconomies of scale- the situation of increasing average total cost as scale
is increased; average total costs rise as more output is produced. Also
called "decreasing returns to scale."
How Are Costs Determined?
Copyright 2006 by Ray Bromley
Options and Outcomes - Chapter 10
Questions for Review and Practice
1
What is the difference between accounting profit and economic profit? Which
will generally be larger?
2
If a firm is making accounting profit, will it necessarily make economic profit? If a
firm is making economic profit, will it necessarily be making accounting profit?
3
If a firm is making zero economic profit, what does it mean? Will the firm go out
of business in the short run? What about the long run?
4
What is marginal cost? How is it related to the marginal product of an input in the
short run?
5
What is average variable cost? How is it related to average product of an input in
the short run?
6
What is average total cost? How is it related to productivity of variable inputs in
the short run?
7
What relationship does marginal cost have to average variable cost? What relationship does marginal cost have to average total cost?
8
Which kind of cost is relevant to a firm’s decision to increase output in the short
run?
9
Describe the differences between diminishing returns to a variable input and
diseconomies of scale. What do the two concepts have in common?
10
The following table shows production possibilities for a small business in the short
run. Fixed costs are $200 and the wage (price of the variable input) is $10. Fill in
the missing portions of the table, then answer the questions on the following
page.
labor price=$10
Fixed cost=
=$200
Variable
Input
(Labor)
Total
Product
(Q)
Marginal
Product
(MP)
Average
Product
(AP)
0
0
-
-
1
5
5
5
2
20
15
10
3
33
13
11
4
44
11
5
54
10
6
63
9
7
8
9
10
11
12
13
14
15
71
78
84
89
93
96
98
99
99
8
7
6
Copyright 2006 by Ray Bromley
10
200
Average
Variable
Cost
Total
Cost
(TC)
$0
-
$200
-
-
-
$10.00
$2.00
$210
$40.00
$42.00
$2.00
$20.00
$1.00
$220
$10.00
$11.00
$0.67
$30.00
$0.91
$230
$6.06
$6.97
$0.77
11
$40.00
$0.91
$240
$4.55
$5.45
$0.91
10.8
$50.00
$0.93
$250
$3.70
$4.63
$1.00
10.5
$60.00
$0.95
$260
$3.17
$4.13
$1.11
10.1429
$70.00
$0.99
$270
$2.82
$3.80
$1.25
9.75
$80.00
$1.03
$280
$2.56
$3.59
$1.43
9.33333
$90.00
$1.07
$290
$2.38
$3.45
$1.67
8.9
$100.00
$1.12
$300
$2.25
$3.37
$2.00
8.45455 $110.00
$1.18
$310
$2.15
$3.33
$2.50
$120.00
$1.25
$320
$2.08
$3.33
$3.33
2
7.53846 $130.00
$1.33
$330
$2.04
$3.37
$5.00
1
7.07143 $140.00
$1.41
$340
$2.02
$3.43
$10.00
$1.52
$350
$2.02
$3.54
-
5
4
3
0
8
6.6
Variable
Cost
(VC)
$150.00
Average
Fixed
Cost
Average
Total
Cost
Marginal
Cost
(MC)
How Are Costs Determined?
105
Options and Outcomes - Chapter 10
10a
10b
10c
10d
10e
10f
10g
10h
10i
10j
10k
106
What happens to total product when marginal product is zero?
What happens to average product when marginal product is greater than
average product?
What happens to average product when marginal product is less than average product?
At what amount of input does marginal product begin to decrease?
At what level of total product does marginal cost begin to increase? (In
other words, at what level of output will the marginal cost first be higher
than it was for smaller outputs on the table?)
What is the approximate minimum marginal cost? (In other words, what
is marginal cost before it begins to increase?)
From the values on the table, describe how marginal product and marginal cost are related?
What is happening to average variable cost when it equals marginal
costs?
Marginal cost equals average variable cost at what output level?
What is happening to average total cost when it equals marginal cost?
Marginal cost equals average total cost at what output level?
11
A finance professor recently criticized a local firm for including “normal return to
capital (normal profit)” as a cost in its annual report. “How can profit be a cost?”
he laughed. Using economics, how might you respond to the finance professor?
12
Which of the following statements are true and which are false?
A. Since implicit costs do not involve payment, they should not be considered as
costs when decisions are made.
B. If the use of resources owned by the firm does not involve a financial transaction, accounting statements will generally fail to account for the opportunity costs of their use.
C. The use of resources owned by the firm will have no opportunity cost, and thus
should not be considered as contributing to cost.
D. If use of a resource involves only a money payment, then it is not an implicit
cost.
E. Resources owned by a firm do not generally have alternative uses, and thus
there are no implicit costs in real life.
F. Use of factory space owned by a firm will usually involve an implicit cost.
G. The payment for use of electricity by a firm is generally an explicit cost.
H. The time put into a business by its owner has no cost.
I. The time put into a business by its owner is an explicit cost.
J. If a firm uses vehicles it owns, the gasoline and maintenance costs must be
paid for in money, so all of the costs of using the vehicles are explicit.
K. The effects of economies of scale can only be seen in the long run.
How Are Costs Determined?
Copyright 2006 by Ray Bromley