Chapter 13 Costs and the Supply of Goods

1) Explicit, Implicit and Total Costs

• Demand reflects the preferences of consumers and how those preferences
influence the allocation of final goods.
• Costs of production influence the use of resources to produce those goods and
reflect the many possible uses of those resources.
• Three types of cost are relevant to the allocation of resources to the production
of
final goods.
o Explicit costs are measurable operating expenses.
o Implicit costs are the returns the employed resource would have earned in its
next best use. They include the opportunity cost of a firm’s equity and owner-
provided service.
o Total costs are the sum of both the explicit and implicit costs for all the
resources used by the firm.
ü Economic profit considers both explicit and implicit costs.
ü Accounting profit ignores implicit costs, such as the opportunity cost of
equity capital.
ü For this reason, accounting profits are generally higher than economic profits.
ü When the firm’s revenues are just equal to its total costs (explicit and implicit,
including the normal rate of return), economic profits are zero.
• In the short run, it is difficult to alter production methods. The short run is
defined as that time period over which the size of plant and equipment cannot be
changed. The length of the short run varies from industry to industry.
• The long run is the period of time necessary for the firm to change its production
methods and resource uses. In the long run, all resources (inputs) are variabl
Chapter 13 Costs and the Supply of Goods
1) Explicit, Implicit and Total Costs
• Demand reflects the preferences of consumers and how those preferences
influence the allocation of final goods.
• Costs of production influence the use of resources to produce those goods and
reflect the many possible uses of those resources.
• Three types of cost are relevant to the allocation of resources to the production
of
final goods.
o Explicit costs are measurable operating expenses.
o Implicit costs are the returns the employed resource would have earned in its
next best use. They include the opportunity cost of a firm’s equity and owner-
provided service.
o Total costs are the sum of both the explicit and implicit costs for all the
resources used by the firm.
ü Economic profit considers both explicit and implicit costs.
ü Accounting profit ignores implicit costs, such as the opportunity cost of
equity capital.
ü For this reason, accounting profits are generally higher than economic profits.
ü When the firm’s revenues are just equal to its total costs (explicit and implicit,
including the normal rate of return), economic profits are zero.
• In the short run, it is difficult to alter production methods. The short run is
defined as that time period over which the size of plant and equipment cannot be
changed. The length of the short run varies from industry to industry.
• The long run is the period of time necessary for the firm to change its production
methods and resource uses. In the long run, all resources (inputs) are variabl
Chapter 6 Summary
1. Explicit, Implicit, and Total Costs
- Demand reflects the preferences of consumers and how those preferences
influence the allocation of final goods.
- Costs of production influence the use of resources to produce those goods and
reflect the many possible uses of those resources.
- Three types of costs are relevant to the allocation of resources to the production of
final goods.
+ Explicit costs are measurable operating expenses.
+ Implicit costs are the returns the employed resource would have earned in its next best
use. They include the opportunity cost of a firm’s equity and owner-provided service.
+ Total costs are the sum of both the explicit and implicit costs for all the resources used
by the firm.
- Economic profit considers both explicit and implicit costs.
- Accounting profit ignores implicit costs, such as the opportunity cost of equity
capital.
For this reason, accounting profits are generally higher than economic profits.
- When the firm’s revenues are just equal to its total costs (explicit and implicit,
including the normal rate of return), economic profits are zero.
- In the short run, it is difficult to alter production methods. The short run is defined
as that time period over which the size of plant and equipment cannot be changed. The
length of the short run varies from industry to industry.
- The long run is the period of time necessary for the firm to change its production
methods and resource uses. In the long run, all resources (inputs) are variable.
- 2) Types of Costs
- • Opportunity cost is the cost of forgoing the next best alternative
investment with
- the resources being used.
- o The opportunity cost of equity capital is the implied rate of return
that
- investors require in order to encourage them to continue to supply the firm
- with capital. It is the rate of return that could be earned if the capital were put
- to the next best use.
- • Sunk costs are those costs already incurred and are not considered
in current
- decisions.
- • Fixed costs remain unchanged in the short run. They are related to
the passage of
- time, not the level of production. The expense on a current building lease is a
- fixed cost.
- • Average fixed costs are fixed costs divided by output. Average
fixed costs
- declines as output increases.
- 2) Types of Costs
- • Opportunity cost is the cost of forgoing the next best alternative
investment with
- the resources being used.
- o The opportunity cost of equity capital is the implied rate of return
that
- investors require in order to encourage them to continue to supply the firm
- with capital. It is the rate of return that could be earned if the capital were put
- to the next best use.
- • Sunk costs are those costs already incurred and are not considered
in current
- decisions.
- • Fixed costs remain unchanged in the short run. They are related to
the passage of
- time, not the level of production. The expense on a current building lease is a
- fixed cost.
- • Average fixed costs are fixed costs divided by output. Average
fixed costs
- declines as output increases.
- 2) Types of Costs
- • Opportunity cost is the cost of forgoing the next best alternative
investment with
- the resources being used.
- o The opportunity cost of equity capital is the implied rate of return
that
- investors require in order to encourage them to continue to supply the firm
- with capital. It is the rate of return that could be earned if the capital were put
- to the next best use.
- • Sunk costs are those costs already incurred and are not considered
in current
- decisions.
- • Fixed costs remain unchanged in the short run. They are related to
the passage of
- time, not the level of production. The expense on a current building lease is a
- fixed cost.
- • Average fixed costs are fixed costs divided by output. Average
fixed costs
- declines as output increase
- 2) Types of Costs
- • Opportunity cost is the cost of forgoing the next best alternative
investment with
- the resources being used.
- o The opportunity cost of equity capital is the implied rate of return
that
- investors require in order to encourage them to continue to supply the firm
- with capital. It is the rate of return that could be earned if the capital were put
- to the next best use.
- • Sunk costs are those costs already incurred and are not considered
in current
- decisions.
- • Fixed costs remain unchanged in the short run. They are related to
the passage of
- time, not the level of production. The expense on a current building lease is a
- fixed cost.
- • Average fixed costs are fixed costs divided by output. Average
fixed costs
- declines as output increase
- 2) Types of Costs
- • Opportunity cost is the cost of forgoing the next best alternative
investment with
- the resources being used.
- o The opportunity cost of equity capital is the implied rate of return
that
 - investors require in order to encourage them to continue to supply the firm
- with capital. It is the rate of return that could be earned if the capital were put
- to the next best use.
- • Sunk costs are those costs already incurred and are not considered
in current
- decisions.
- • Fixed costs remain unchanged in the short run. They are related to
the passage of
- time, not the level of production. The expense on a current building lease is a
- fixed cost.
- • Average fixed costs are fixed costs divided by output. Average
fixed costs
- declines as output increase
2. Types of Costs
- Opportunity cost is the cost of forgoing the next best alternative investment with
the resources being used.
- The opportunity cost of equity capital is the implied rate of return that investors
require in order to encourage them to continue to supply the firm with capital. It is the
rate of return that could be earned if the capital were put to the next best use.
- Sunk costs are those costs already incurred and are not considered in current
decisions.
- Fixed costs remain unchanged in the short run. They are related to the passage of
time, not the level of production. The expense on a current building lease is a fixed cost.
- Average fixed costs are fixed costs divided by output. Average fixed costs decline
as output increases.
- Variable costs (e.g., wages and raw materials) are incurred when the firm
- produces output. They are related to the level of production, not the passage of
- time.
- Average variable cost equals the total variable cost divided by output.
- Average total cost equals the total costs (fixed and variable) divided by the number
of units produced.
- Marginal cost is the cost of producing one additional unit of output.
3. Law of diminishing returns and its impact on a company’s cost
- The law of diminishing returns states that as more and more resources (e.g., labor)
are devoted to a production process holding the quantity of other inputs constant, the
output increases, but at a decreasing rate.
- For example, if an acre of corn needs to be picked, the addition of a second and
third worker is highly productive. But if you already have 300 workers in the field, the
productive capacity of the 301st worker is not near that of the second worker.
- Concepts related to the law of diminishing returns are as follows:
+ Total product is the total output of goods associated with a specific rate of resource
input. As resource input increases, total product increases.
+ Marginal product is the increase in total output associated with an additional unit of
input.
+ Average product equals the total output (product) divided by the units of the variable
input required to produce that level of output.
4. Shapes of the short-run marginal cost, average variable cost, average fixed
cost, and average total cost curves

Figure 1: Cost curves

- The concept of diminishing marginal returns and the short-run average/marginal
cost structures are illustrated in <Figure 1>.
- Panel (a) in <Figure 1> shows that total cost (TC) is equal to variable cost (VC)
plus fixed costs (FC).
+ Here it is illustrated that as production increases, VC and TC increase at a decreasing
rate, then flatten out, and then increase at an increasing rate (TC and VC curves arch
upward). This is where diminishing returns take effect.
- Panel (b) of <Figure 1> illustrates the unit cost structure.
+ Here is can be seen that when marginal costs (MC) are below both average variable
costs (AVC) and average total costs (ATC), the average falls.
+ When the MC, the cost of producing the next unit, moves above the average cost line
(AVC or ATC), the average will start to rise. Thus, MC=AVC when AVC is at its
minimum. The same holds for ATC.
 5. Economies and diseconomies of scale

Figure 2: Long-run Average Total Cost

- While short-run cost curves apply for a specific size of plant, the long-run cost
structure indicates the optimal quantity to produce at different plant sizes. In the long run
everything is variable, including plan and equipment. Long-run cost curves are known as
planning curves. As such, there is often a trade-off between the size of the firm and unit
costs in the long run.
- Three reasons unit cost may decline as output or plant size increases are:
+ Savings due to mass production.
+ Specialization of labor and machinery.
+ Experience.
- As shown in <Figure 2>, economies of scale are present when unit costs fall as
output increases and diseconomies of scale are present when costs rise as output
increases. The flat portion of the long-run average total costs (LRATC) curve in <Figure
2> represents constant returns to scale. As shown, the optimal firm size will produce Q*
units of output.
- 6) Factors that cause cost curves to shift
-
- Cost curves shift for the following reasons:
- • Changes in resource prices.
- • Changes in taxes paid.
- • Changes in regulations that increase costs (e.g., environmental regulations,
safety
- regulations, etc.).
- • Improvements in technology that lower production costs.
-
- Each of these factors can change the marginal cost of a unit of output. Lower
input
- prices, lower taxes, reduced regulatory costs, and better technology will all lower
the
- marginal cost for the firm. This will, in turn, lower the AVC and ATC
 6. Factors that cause cost curves to shift
Cost curves shift for the following reasons:
- Changes in resource prices.
- Changes in taxes paid.
- Changes in regulations that increase costs (e.g., environmental regulations, safety
regulations, etc.).
- Improvements in technology that lower production costs.
Each of these factors can change the marginal cost of a unit of output. Lower input prices,
lower taxes, reduced regulatory costs, and better technology will all lower the marginal
cost for the firm. This will, in turn, lower the AVC and ATC