UNIT 7

Understand the theory of production and costs.

 THE CONCEPT OF COSTS
Cost – to the economist, the cost of using something in a
particular way is the benefit forgone by not using it in the
best alternative way. This is called opportunity cost.

Contrary to the fact that accountants and business people

consider only actual expenses incurred to produce a
product, the economist measures the cost of production as
the best alternative forgone by choosing to produce a
particular product.

The economist uses the opportunity cost principle to

determine the value of all the resources used in production.
 IMPLICIT VERSUS EXPLICIT COSTS

Explicit costs are the monetary payments for the factors

of production and other inputs bought or hired by the firm.

These are also opportunity costs, since the payments for

the inputs reflect opportunities that are sacrificed.

Implicit costs are those opportunity costs which are not

reflected in monetary payments.
 IMPLICIT VERSUS EXPLICIT COSTS

They include the costs of self-owned or self-employed resources.

For example, the owner of a one person business must consider what
he/she would have earned if he/she had not been running the firm (i.e
the opportunity cost of the owner’s time must be included in the cost
of production.

The true economic cost of using the resources in a particular way is

the value of the best alternative uses (or opportunities) sacrificed.

Economic Costs of Production = opportunity costs

= explicit costs plus implicit costs.
 PROFITS

Profit is the difference between revenue and cost; The

economist’s definition of profit is, however, not the same
as the accountant’s definition of profit.

As Economists, we distinguish between total (or

accounting ) profit, normal profit and economic profit.

Total ( or accounting) profit is the difference between

total revenue from the sale of the firm’s products(s) and
total explicit cost.
 PROFITS

Normal profit is equal to the best return that the firm’s

self-owned , self-employed resources could earn
elsewhere.

Economic profit is the difference between total revenue

from the sale of the firm’s product(s) and total explicit and
implicit costs (i.e. the total economic, or opportunity, costs
of all resources).
 PROFITS CONTINUED
Accounting profit = total revenue – total explicit costs

Economic Profit =Total Revenue – total costs (explicit + implicit)

Economic profit is the additional return to the owners of

the firm, over and above the opportunity cost (normal
profit) of their own inputs. Economic profit is sometimes
called excess profit, abnormal profit, supernormal profit and
pure profit.

It is the amount by which revenue exceeds the

opportunity cost of all the resources used in production.
 SHORT – RUN VS LONG – RUN

The Short Run: Fixed Plant

The short run is a time frame in which the quantities of some resources are fixed.
In the short run, a firm can usually change the quantity of labor it uses but not the quantity of
capital

The Long Run: Variable Plant

The long run is a time frame in which the quantities of all resources can be changed.

In the short run, a firm can expand output only by increasing the quantity of its variable inputs.
 SHORT-RUN PRODUCTION

A fixed input is an input whose quantity cannot be altered in the short run. By
contrast, a variable input is one whose quantity can be changed in the short run
(as well as the long run).

Fixed Costs – as far as business is concerned fixed costs do not change as output
changes. e.g. buildings and capital equipment.

Variable Costs – include those which do change with output such as fuel, raw
materials and labour.
 SHORT-RUN PRODUCTION

To increase output with a fixed plant, a firm must increase the quantity of labor
(or other variable inputs) it uses.
We describe the relationship between output and the quantity of labor by using
three related concepts:
• Total product
• Marginal product
• Average product
 SHORT-RUN PRODUCTION

Total Product
Total product (TP) is the total quantity of a good produced in a given period.
Total product is an output rate—the number of units produced per unit of time.

Total product increases as the quantity of labor employed increases.

 SHORT-RUN PRODUCTION
Average Product

Average product is the total product per worker employed.

It is calculated as:
Average product = Total product  Quantity of labor
 SHORT-RUN PRODUCTION

Marginal Product
Marginal product is the change in total product that results from a one-unit
increase in the quantity of labor employed.
It tells us the contribution to total product of adding one more worker.
When the quantity of labor increases by more (or less) than one worker, calculate
marginal product as:

Marginal product MP = Change TP

Change in Quantity of Labour
LAW OF DIMINISHING RETURNS
 LAW OF DIMINISHING RETURNS

The law of diminishing returns states that as more of a variable input is

combined with one or more fixed inputs in a production process, points
will eventually be reached where first the marginal product, then the
average product and finally the total product start to decline.
LAW OF DIMINISHING RETURNS
PRODUCTION
SHORT RUN COSTS
Total Cost
A firm’s total cost (TC) is the cost of all the factors of
production the firm uses.
Total cost divides into two parts:
Total fixed cost (TFC) is the cost of a firm’s fixed factors of
production, used by the firm—the cost of land, capital,
and entrepreneurship.
Total fixed cost doesn’t change as output changes.
SHORT RUN COSTS

Total variable cost (TVC) is the cost of the variable

factor of production used by a firm—the cost of labor, raw
materials etc.
To change its output in the short run, a firm must (for
instance) change the quantity of labor it employs, so total
variable cost changes as output changes.
Total cost is the sum of total fixed cost and total variable
cost. That is,
TC = TFC + TVC
COSTS- FIXED, VARIABLE AND TOTAL
Cost of a unit of fixed input = R450
Cost of a unit of variable input = R2, 400
COSTS- FIXED, VARIABLE AND TOTAL
SHORT RUN COSTS
Total cost (TC) is simply the cost of producing a certain quantity of the firm’s
product.

Average Cost (AC) is the total cost (TC) divided by the number of units (or quantity)
of the product produced (Q).

Marginal Cost (MC) is the addition to total cost (change in TC) required to produce
an additional (extra) unit of the product (change in quantity).

Computationally;

Thus AC = Total Cost (TC)

Total Product(TP)

MC = Change in TC
Change in TP
SHORT RUN COSTS