Chapter 22 - The Costs Of Production

Chapter 22 Outline McConnell and Brue 14th Edition

1.	Because resources are scarce and may be employed to produce many different products the economic cost of using resources to produce any one of these products is an opportunity cost: The amount of other products that cannot be produced. In money terms the costs of employing resources to produce a product are also an opportunity cost: the payments a firm must make to the owners of resources to attract these resources away from their best alternative opportunities for earning incomes. These costs may be either explicit or implicit. Normal profit is an implicit cost and is the minimum payment that entrepreneurs must receive for performing the entrepreneurial functions for the firm. Economic or pure profit is the revenue a firm receives in excess of all its explicit and implicit economic (opportunity) costs. (The firm’s accounting profit is its revenue less only its explicit costs.) The firm’s economic costs vary as the firm’s output varies and the way in which costs vary with output depends on whether the firm is able to make short-run or long-run changes in the amounts of resources it employs. The firm’s plant is a fixed resource in the short run and a variable resource in the long run.
2.	In the short run the firm cannot change the size of its plant and can vary its output only by changing the quantities of the variable resources it employs. The law of diminishing returns determines the manner in which the costs of the firm change as it changes its output in the short run. The total short-run costs of a firm are the sum of its fixed and variable costs. As output increases the fixed costs do not change; at first the variable costs increase at a decreasing rate and then increase at an increasing rate; and at first total costs increase at a decreasing rate and then increase at an increasing rate. Average fixed variable and total costs are equal respectively to the firm’s fixed variable and total costs divided by the output of the firm. As output increases average fixed cost decreases; at first average variable cost decreases and then increases; and at first average total cost also decreases and then increases. Marginal cost is the extra cost incurred in producing one additional unit of output. Because the marginal product of the variable resource increases and then decreases (as more of the variable resource is employed to increase output) marginal cost decreases and then increases as output increases. At the output at which average variable cost is a minimum average variable cost and marginal cost are equal and at the output at which average total cost is a minimum average total cost and marginal cost are equal. On a graph marginal cost will always intersect average variable cost at its minimum point and marginal cost will always intersect average total cost at its minimum point. These intersections will always have marginal cost approaching average variable cost and average total cost from below. Changes in either resource prices or technology will cause the cost curves to shift.
3.	In the long run all the resources employed by the firm are variable resources and therefore all its costs are variable costs. As the firm expands its output by increasing the size of its plant average total cost tends to fall at first because of the economies of large-scale production but as this expansion continues sooner or later average total cost begins to rise because of the diseconomies of large-scale production. The economies and diseconomies of scales encountered in the production of different goods are important factors influencing the structure and competitiveness of various industries. Minimum efficient scale (MES) is the smallest level of output at which a firm can minimize long-run average costs. This concept explains why relatively large and small firms could coexist in an industry and be viable when there is an extended range of constant returns to scale. In other industries the long-run average cost curve will decline over a range of output. Given consumer demand efficient production will be achieved only with a small number of large firms. When economies of scale extend beyond the market size the conditions for a natural monopoly are produced wherein unit costs are minimized by having a single firm produce a product.