,Principles of Economics,Session 5,Topics To Be Covered,Categories of Costs Costs in the Short Run Costs in the Long Run Economies of Scope,The Firms Objective,Maximum Profits,The economic goal of the firm is to maximize profits.,A Firms Profit,Profit is the firms total revenue minus its total cost. Profit = Total revenue - Total cost,Costs as Opportunity Costs,A firms cost of production includes all the opportunity costs of making its output of goods and services.,Opportunity Cost,The value of the next best use for an economic good, or the value of the sacrificed alternative.,Explicit and Implicit Costs,A firms cost of production include explicit costs and implicit costs. Explicit costs involve a direct money outlay for factors of production. Implicit costs, also called normal profit, refer to the opportunity cost of using the owners own resources.,Economic Profit versus Accounting Profit,Economists measure a firms economic profit as total revenue minus all the opportunity costs (explicit and implicit). Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs. In other words, they ignore the implicit costs.,Economic Profit versus Accounting Profit,When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit.,Economic Profit versus Accounting Profit,Total Cost of Production,Total cost of production may be divided into fixed costs and variable costs.,Fixed and Variable Costs,Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do change as the firm alters the quantity of output produced.,Family of Total Costs,TC = Total Costs TFC=Total Fixed Costs TVC=Total Variable Costs,Fixed Cost Cost paid by a firm that is in business regardless of the level of output Sunk Cost Cost that have been incurred and cannot be recovered e.g. advertising expenditure,Fixed Cost vs. Sunk Cost,Personal Computers: most costs are variable e.g. components, labor Software: most costs are sunk e.g. cost of developing the software,Variable Cost and Sunk Cost,Total Cost,Total Cost Curves,Average Costs,The average cost is the cost of each typical unit of product. Average costs can be determined by dividing the firms costs by the quantity of output produced.,Family of Average Costs,ATC=Average Total Costs AFC=Average Fixed Costs AVC=Average Variable Costs,Family of Average Costs,Average Costs,Average Cost Curves,Output (units/yr.),Cost ($ per unit),25,50,75,100,0,1,2,3,4,5,6,7,8,9,10,11,U-Shaped ATC and AVC Curves,The ATC curve is U-shaped. At very low levels of output average total cost is high because fixed cost is spread over only a few units. Average total cost declines as output increases. Average total cost starts rising because average variable cost rises substantially. The AVC curve is also U-shaped for its relationship with the ATC curve.,Marginal Cost,Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:,Marginal Cost,Marginal Cost Curve,Output (units/yr.),Cost ($ per unit),25,50,75,100,0,1,2,3,4,5,6,7,8,9,10,11,Cost Curves for a Firm,Output (units/yr.),Cost ($ per unit),25,50,75,100,0,1,2,3,4,5,6,7,8,9,10,11,MC,ATC,AVC,AFC,From TC to AC and MC,P,Q,100,200,300,400,0,1,2,3,4,5,6,7,8,9,10,11,12,13,TFC,TVC,A,TC,25,50,75,100,0,1,2,3,4,5,6,7,8,9,10,11,MC,ATC,AVC,AFC,B,A,B,AFC= slope of line from origin to a point on TFC AVC = slope of line from origin to a point on TVC ATC = slope of line from origin to a point on TC MC = slope of tangent to a point on TC or TVC,P,Q,Properties of Cost Curves,AFC falls continuously When MC AVC or MC ATC, AVC and ATC increase,Properties of Cost Curves,MC crosses AVC and ATC at the minimums of AVC and ATC, respectively. Minimum AVC occurs at a lower output than minimum ATC,Costs in the Long Run,For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run some costs are fixed. In the long run fixed costs become variable costs.,Costs in the Long Run,Because many costs are fixed in the short run but variable in the long run, a firms long-run cost curves differ from its short-run cost curves.,If LMC LAC, LAC will rise LMC = LAC at the minimum of LAC,Long-Run Average and Marginal Cost,Long-Run Average and Marginal Cost,Output,Cost ($ per unit of output,Average Total Cost in the Short and Long Runs,Quantity of,Cars per Day,0,Average,Total,Cost,The optimal plant size will depend on the anticipated output. Firms can change scale to change output in the long-run. The long-run average cost curve is the envelope of the firms short-run average cost curves.,Long-Run Costs and Returns to Scale,Long-Run Cost with Economies and Diseconomies of Scale