1. Chapter 7
Production Costs
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1

2. In this chapter, you will
learn to solve these
economic puzzles:
Whyare is the difference
Why would an accountant
What multi-screen movie
say a firm is makingand
between the short-run a
theatres replacing single-
profitthe long-run?
and an economist
screen theaters?
say it’s losing money?
2

3. What is a basic
assumption in economics?
The motivation for
business decisions is
profit maximization
3

4. To understand Profit,
what is necessary?
To distinguish between the
way economists measure
costs and the way
accountants measure costs
4

5. What are Explicit Costs?
Payments to nonowners of
a firm for their resources
5

6. What are Implicit Costs?
The opportunity costs
of using resources
owned by the firm
6

7. What is an example of
Implicit Costs?
When you invest your nest
egg in your own enterprise,
you give up earning
interest on that money
7

8. How is Accounting
Profit defined?
Total revenue minus
total explicit costs
8

9. What are Total
Opportunity Costs?
Explicit costs + Implicit costs
9

10. What is Economic Profit?
Total revenue minus
total opportunity costs
10

11. Computech’s Accounting Versus Economic
Profit
Item Accounting Profit Economic Profit
Total Revenue $500,000 $500,000
Less Explicit costs:
Wages & salaries $400,000 $400,000
Materials $50,000 $50,000
Interest paid $10,000 $10,000
Other payments $10,000 $10,000
Less implicit costs:
Foregone salary 0 50,000
Foregone rent 0 10,000
Foregone interest 0 5,000
Equals profit $30,000 -$30,000
11
Exhibit 1

12. What is Normal Profit?
The minimum profit
necessary to keep a
firm in operation
12

13. When economists use the
term “Profit”, which
profit do they mean?
Economic profit which,
unlike accounting profit,
includes implicit costs
13

14. What is a Fixed Input?
Any resource for which the
quantity cannot change
during the period of time
under consideration
14

15. What is the Short Run?
A period of time so
short that there is at
least one fixed input
15

16. What is the Long Run?
A period of time so long
that all inputs are variable
16

17. What is a Variable Input?
Any resource for which the
quantity can change
during the period of time
under consideration
17

18. What is the
Production Function?
The relationship between
the maximum amounts of
outputs a firm can
produce and various
quantities of inputs
18

19. What do Technological
Advances make possible?
More output is possible from
a given quantity of inputs
19

20. What is
Marginal Product?
The change in total output
produced by adding one
unit of a variable input,
with all other inputs used
held constant
20

21. What is the Law of
Diminishing Returns?
The principle that beyond
some point the marginal
product decreases as
additional units of a
variable resource are
added to a fixed factor
21

22. What does the Law
of Diminishing
Returns assume?
Fixed inputs; it is therefore
a short-run concept
22

23. 60 Production Function
50
Total Output
40
30
Total Output
20
10
Quantity of Labor
1 2 3 4 5 6
23

24. 12 Marginal Product Curve
10
Marginal Output
8
6
Law of
4 Diminishing
Returns
2
Quantity of Labor
1 2 3 4 5 6
24

25. What is
Total Fixed Cost?
Costs that do not vary
as output varies and
that must be paid even
if output is zero
25

26. What is
Total Variable Cost?
Costs that are zero when
output is zero and vary
as output varies
26

27. What is Total Cost?
The sum of total fixed cost
and total variable cost at
each level of output
27

28. TC = TFC + TVC
28

29. What is
Average Fixed Cost?
Total fixed cost divided
by the quantity of
output produced
29

30. AFC = TFC / Q
30

31. What is Average
Variable Cost?
Total variable cost
divided by the quantity
of output produced
31

32. AVC = TVC / Q
32

33. What is
Average Total Cost?
Total cost divided by the
quantity of output produced
33

34. ATC = AFC + AVC = TC/Q
34

35. What is Marginal Cost?
The change in total cost
when one unit of
output is produced
35

36. MC = ∆TC/∆ Q = ∆TVC/∆Q
36

37. Short-Run Cost Curves
$800
$700
$600 Cost per unit TFC TC
$500
TVC
$400
$300
$200 TFC
$100
1 2 3 4 5 6 7 8 9 Q
37

38. Short-Run Cost Curves
$80
$70 Cost per unit MC
$60 ATC
$50
$40 AFC AVC
$30
$20
$10 AFC
1 2 3 4 5 6 7 8 9 Q
38

39. What is the Marginal-
Average Rule?
When MC < AC, AC falls
When MC > AC, AC rises
If MC = AC, AC at minimum
39

40. What is the relationship
between slopes of the
MC and MP curves?
The rising portion of the
MP curve corresponds to
the declining portion of the
MC curve, and vice versa
40

41. What is the relationship
between the minimum
and maximum points of
the MR and MP curves?
The maximum point of the
MP curve corresponds to
the minimum point of the
MC curve
41

42. 12 Marginal Product Curve
10
8
Total Output
6
Maximum
4
2
Quantity of Labor
1 2 3 4 5 6
42

43. Short-Run Cost Curves
$80
$70 Minimum MC
$60 Cost per unit
$50
ATC
$40 AVC
$30
$20
$10
1 2 3 4 5 6 7 8 9 Q
43

44. What is the Long-run
Average Cost Curve?
The curve that traces the
lowest cost per unit at
which a firm can produce
any level of output when
the firm can build any
desired plant size
44

45. Short and Long-run Average Cost Curves
$80
$70 Short-run average
$60 total cost curves
$50
$40
$30
$20
$10 Long-run average cost curve
2 4 6 8 10 12 14 16 18 Q
45

46. What are
Economies of Scale?
A situation in which the
long-run average cost
curve declines as the
firm increases output
46

47. What are Constant
Returns to Scale?
A situation in which the
long-run average cost
curve does not change as
the firm increases output
47

48. What are
Diseconomies of Scale?
A situation in which the
long-run average cost
curve rises as the firm
increases output
48

49. Long-run Average Cost Curve
$80
$70 Constant returns to scale
$60 Economies of scale
$50
$40 Diseconomies of scale
$30
$20
$10
2 4 6 8 10 12 14 16 18 Q
49

50. Key Concepts
50

51. Key Concepts
• What is a basic assumption in economics?
• What are Explicit Costs?
• What are Implicit Costs?
• How is Accounting Profit defined?
• What are Total Opportunity Costs?
• What is Economic Profit?
• What is Normal Profit?
51

52. Key Concepts cont.
• When economists use the term “Profit”, which
• When economists study the economy, what tim
• What is a Fixed Input?
• What is the Short Run?
• What is the Long Run?
• What is a Variable Input?
• What is Marginal Product?
52

53. Key Concepts cont.
• What is the Law of Diminishing Returns?
• What is Total Fixed Cost?
• What is Total Variable Cost?
• What is Total Cost?
• What is Average Fixed Cost?
• What is Average Variable Cost?
• What is Average Total Cost?
• What is Marginal Cost?
• What are Economies of Scale?
• What are Diseconomies of Scale?
53

54. Summary
54

55. Economic profit is equal total
revenue minus both explicit and
implicit costs. Implicit costs are the
opportunity costs of foregone
returns to resources owned by the
firm. Economic profit is important
for decision-making purposes
because it includes implicit costs
and accounting profit does not.
Accounting profit equals total
revenue minus explicit costs.
55

56. The short run is a time period
during which a firm has at least one
fixed input, such as its factory size.
The long run for a firm is defined as
as a period during which all inputs
are variable.
56

57. A production function is the
relationship between output and
inputs. Holding all other factors
of production constant, the
production function shows the
total output as the amount of one
input, such as labor, varies.
57

58. Marginal product is the change
in total output caused by a one-unit
change in a variable input, such as
the number of workers hired, the law
of diminishing returns states that
after some level of output in the
short run, each unit of the variable
input yields smaller and smaller
marginal product. This range of
declining marginal product is the
region of diminishing returns.
58

59. Total fixed costs consists of costs
that cannot vary with the level of
output, such as rent for office space.
Total fixed costs is the cost of inputs
that do not change as the firm changes
output in the short run. Total variable
cost consists of costs that vary with the
level of output, such as wages. Total
variable cost is the cost of variable
inputs used in production. Total cost is
the sum of total fixed cost and total
variable cost.
59

60. Short-Run Cost Curves
$800
$700
$600 Cost per unit TFC TC
$500
TVC
$400
$300
$200 TFC
$100
1 2 3 4 5 6 7 8 9 Q
60

61. Marginal cost is the change is
total cost associated with one
additional unit of output. Average
fixed cost is the total fixed cost
divided by total output. Average
variable cost is the total variable cost
divided by total output. Average total
cost is the total cost, or the sum of
average fixed cost and average
variable cost, divided by output.
61

62. Short-Run Cost Curves
$80
$70 Cost per unit MC
$60 ATC
$50
$40 AFC AVC
$30
$20
$10 AFC
1 2 3 4 5 6 7 8 9 Q
62

63. The marginal-average rule
explains the relationship between
marginal cost and average cost.
When the marginal cost is less than
the average cost, the average cost
falls. When the marginal cost is
greater than the average cost, the
average cost rises. Following this
rule, the marginal cost curve
intersects the average total cost
curve at their minimum points.
63

64. Marginal cost and marginal
product are mirror images of each
other. Assuming a constant wage rate,
marginal cost equals the wage rate
divided by the marginal product.
Increasing returns cause marginal cost
to fall, and diminishing returns cause
marginal cost to rise. This explains the
U-shaped marginal cost curve.
64

65. 12 Marginal Product Curve
10
8
Total Output
6
Maximum
4
2
Quantity of Labor
1 2 3 4 5 6
65

66. $80
$70 Minimum MC
$60 Marginal cost
$50
$40
$30
$20
$10
1 2 3 4 5 6 7 8 9 Q
66

67. The long-run average cost curve is a
curve drawn tangent to all possible
short-run average total curves. When the
long-run average cost curve decreases as
output increases, the firm experiences
economies of scale. If the long-run
average cost curve remains unchanged
as output increases, the firm experiences
constant returns to scale. If the long-run
average cost curve increases, the firm
experiences diseconomies of scale.
67

68. Long-run Average Cost Curve
$80
$70 Constant returns to scale
$60 Economies of scale
$50
$40 Diseconomies of scale
$30
$20
$10
2 4 6 8 10 12 14 16 18 Q
68

69. Chapter 7 Quiz
©2000 South-Western College Publishing
69

70. 1. Explicit costs are payments
to
a. hourly employees.
b. insurance companies.
c. utility companies.
d. all of the above.
D. Explicit costs are payments to non
owners of a firm.
70

71. 2. Implicit costs are the opportunity costs of
using the resources of
a. outsiders.
b. owners.
c. banks.
d. retained earnings.
B. Implicit costs are opportunity costs that a
business owner incurs when using resources
owned by the firm.
71

72. 3. Which of the following equalities is true?
a. Economic profit = total revenue - accounting
profit.
b. Economic profit = total revenue - explicit
costs - accounting profit.
c. Economic profit = total revenue - implicit
costs - explicit costs.
d. Economic profit = opportunity costs +
accounting costs.
C. The difference between accounting profit
and economic profit is that economic profit is
total revenue minus both explicit and implicit
costs. Accounting profit is total revenue
minus explicit costs only.
72

73. 4. Fixed inputs are factors of production that
a. are determined by a firm’s size.
b. can be increased or decreased quickly as
output changes.
c. cannot be increased or decreased quickly as
output changes.
d. none of the above.
C. In the short run, there are two types of
inputs, fixed and variable. Because a firm
cannot change its plant capacity, some of its
inputs are fixed. In the long run, all costs are
variable.
73

74. 5. An example of a variable input is
a. raw materials.
b. energy.
c. hourly labor.
d. all of the above
D. As a firm produces more, it will use
more raw materials, energy, and labor.
Therefore, all are variable costs.
74

75. 6. Suppose a car wash has 2 washing stations and
5 workers and is able to wash 100 cars per day.
When it adds a third station, but no more
workers, it is able to wash 150 cars per day.
The marginal product of the third washing
station is
a. 100 cars per day.
b. 150 cars per day.
c. 5 cars per day.
d. 50 cars per day.
D. 50 cars is how many extra cars can be
washed by adding a new machine, ceteris
paribus.
75

76. 7. If the units of variable input in a
production process are 1, 2, 3, 4, and 5 and
the corresponding total outputs are 10, 22,
33, 42, and 48, respectively, the marginal
product of the fourth unit is
a. 2.
b. 6.
c. 9.
d. 42.
C. The difference between 42 and 33 is 9, the
extra output when producing 4 units
instead of 3.
76

77. 8. The total fixed cost curve is
a. upward sloping.
b. downward sloping.
c. upward, and then downward sloping.
d. unchanged with the level of output.
D. Fixed costs never change regardless of the
units of output; therefore its curve has to be
horizontal at a fixed cost dollar value.
77

78. 9. Assuming that the marginal cost curve is a
smooth U-shaped curve, the corresponding
total cost curve has a (an)
a. linear shape.
b. S-shape.
c. U-shape.
d. reverse S-shape.
D. Marginal cost decreases as output increases
from zero, and then increases beyond a certain
output level. A reverse-S-Shape total cost curve
corresponds to the changes in its slope (MC) as
output expands.
78

79. $1,500 Total Cost Curve
Total Cost
Exhibit 10
$1,250
$1,000
TC
$750
$500
$250
Quantity of Output
50 100 150 200 250 300
79

80. 10. If both the marginal cost and the average
variable cost curves are U-shaped, at the
point of minimum average variable cost, the
marginal cost must be
a. greater than the average variable cost.
b. less than the average variable cost.
c. equal to the average variable cost.
d. at its minimum.
C. If the margin is above the average, the
average will increase. If the margin is less
than the average, the average will decrease.
If the margin equals the average, average
does not change, that is, it is a horizontal
curve. 80

81. 11. Which of the following is true at the point
where diminishing returns set in?
a. Both marginal product and marginal
cost are at a maximum.
b. Both marginal product and marginal
cost are at a minimum.
c. Marginal product is at a maximum and
marginal cost at a minimum.
d. Marginal product is at a minimum and
marginal cost at a maximum.
C. The rising portion of the MP curve
corresponds to the declining portion of the
MC curve, and vice versa
81

82. 12. As shown in Exhibit 10, total fixed cost for
the firm is
a. Zero.
b. $250
c. $500.
d. $750
e. $1,000
B. $250 is the answer because total cost is 0
when output is zero. These are costs that
have to be paid even when output is zero.
82

83. 13. As shown in Exhibit 10, the total cost of
producing 100 units of output per day is
a. Zero.
b. $250.
c. $500.
d. $750.
e. $1,000.
C. A vertical line drawn at 100 units
crosses the total cost curve at $500.
83

84. 14. In Exhibit 10, if the total cost of producing
99 units of output per day is $475, the
marginal cost of producing the 100th unit of
output per day is approximately
a. Zero.
b. $25.
c. $475.
d. $500
B. When total cost at 99 units is $475 and
total cost at 100 units is $500, the cost of
producing the 100th unit is $25.
84

85. 15. Each potential short-run average total
cost curve is tangent to the long-run
average cost curve at
a. the level of output that minimizes
short-run average total cost.
b. the minimum point of the average
total cost curve.
c. the minimum point of the long-run
average cost curve.
d. a single point on the short-run
average total cost curve.
D. The long-run LRAC is derived from all possible
SRAC. Geometrically, the only way to draw this
is to connect all the curves by a smooth curve;
thus, the LRAC curve touches each SRAC curve
at only one place.
85

86. Short and Long-run Average Cost Curves
$80
$70 Short-run average
$60 total cost curves
$50
$40
$30
$20
$10 Long-run average cost curve
2 4 6 8 10 12 14 16 18 Q
86

87. 16. Suppose a typical firm is producing X units
of output per day. Using any other plant size,
the long-run average cost would increase. The
firm is operating at a point which its
a. long-run average cost curve is at a
minimum.
b. short-run average total cost curve is at a
minimum.
c. both (a) and (b) are true.
d. neither (a) nor (b) is true.
C. When a firm is producing at the minimum
points of the long-run average cost curve, it is
operating at the most efficient level possible.
87

88. 17. The downward-sloping segment of the long-
run average cost curve corresponds to
a. diseconomies of scale.
b. both economies and diseconomies of scale.
c. the decrease in average variable cost.
d. economies of scale.
D. Economies of scale takes place when a
firm increases its efficiency by producing
more units of output.
88

89. Long-run Average Cost Curve
$80
$70 Constant returns to scale
$60 Economies of scale
$50
$40 Diseconomies of scale
$30
$20
$10
2 4 6 8 10 12 14 16 18 Q
89

90. 18. Long-run diseconomies of scale exist
when the
a. short-run average total cost curve falls.
b. long-run marginal cost curve rises.
c. long-run average cost curve falls.
d. short-run average cost curve rises.
e. long-run average cost curve rises.
E. Diseconomies of scale are evident when
increasing output leads to inefficiencies.
90

91. 19. Long-run constant returns to scale
exist when the
a. short-run average total cost curve is
constant.
b. long-run average cost curve rises.
c. long-run average cost curve is flat.
d. long-run average cost curve falls.
C. Constant returns to scale are
evident when there is no change in
costs as output increases.
91

92. Internet Exercises
Click on the picture of the book,
choose updates by chapter for
the latest internet exercises
92

93. END
93