What are Costs?
* Goal of a firm is to maximize profit
* Total Revenue = Q x P
* Total Cost = market value of inputs firm uses in production * Profit = TR – TC
* Costs of production = opportunity costs of output of goods and services * Explicit costs = input costs that require outlay of money by firm * i.e. $1000 spent on flour = opportunity cost of $1000 because can’t be spent elsewhere * Implicit costs = input costs that do not require outlay of money by firm * i.e. working as baker at $10/hour, but could be making $20/hour as a computer analyst * Economists include both costs, while accountants often ignore implicit costs * Important implicit cost = opportunity cost of capital
* i.e. use $300,000 savings to buy factory, but could have invested it at interest rate of 5%/year * ∴ forgone $15,000/year in interest income = implicit opportunity cost of business * i.e. use $100,000 savings and borrow $200,000 from bank * Explicit cost will now include $10,000 paid to bank in interest * Opportunity cost is still $15,000 (OC of $10,000 paid to bank is $10,000 and there is a forgone interest savings of $5000) * Economic profit = TR – TC (including both explicit and implicit costs) * Accounting profit = TR – TEC (total explicit costs)
* Consequently, accounting profit is often > economic profit * For economist, business is only profitable if it can cover all explicit and implicit costs Production & Costs
* In short run = size of factory is fixed because it cannot be built overnight, but output can be varied by varying the number of workers * In long run = size of factory and number of workers can be varied * Production function: relationship b/w quantity of inputs used to make a good and the quantity of output of that good (short-run) * Marginal product = increase in output that arises from additional unit of input * MP = ∆TP/∆Q
* Law of diminishing marginal product = property whereby the marginal product of an input declines as the quantity of the input increases * Slope of production function (quantity of input vs. quantity of output) = marginal product * Graph become “flatter” as marginal product decreases (see graph) * Total cost curve = graph w/ quantity produced on x-axis and total cost on y-axis * Graph becomes “steeper” as quantity of output increases (see graph) * Fixed costs = costs that do not vary with quantity of output produced * i.e. rent of factory, bookkeeper’s salary etc.
* Variable costs = costs that do vary with the quantity of output produced * i.e. cost of raw materials, wages of workers (increases as more output produced) etc. * Average Total Cost = TC/Q
* Also equal to average fixed cost + average variable cost * Average fixed cost = FC/Q
* Average variable cost = VC/Q
* Marginal cost = increase in total cost arising from an extra unit of production * MC = ∆TC/∆Q
* Marginal cost rises as the quantity of output produced rises (see graph) Typical Cost Curves
* In many firms, MP does not start to diminish immediately after hiring 1st worker * 2nd or 3rd worker may actually have higher MP than first, b/c a team of workers can divide tasks and work more productively than a single worker * AFC, AVC, MC, and ATC will look different for this scenario Costs in the Short Run and in the Long Run
* Division of total cost between fixed and variable costs depends on time horizon * In a few months, GM cannot adjust number/size of factories, only workers * Cost of factories, is therefore, fixed cost in short run * Over several years, however, GM can expand size and number of factories * Cost of factories, is therefore, variable cost in long run * Because fixed costs become variable in the long run, the ATC curve in short run differs from the ATC curve in the long-run * Long-run ATC is much flatter than short-run ATC
* Short-run curves also lie...
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