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Microeconomics Chapter 9

by: Greg Marzo

Microeconomics Chapter 9 ECON 1010-01

Marketplace > Tulane University > Economcs > ECON 1010-01 > Microeconomics Chapter 9
Greg Marzo
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Microeconomics chapter 9--Topics included in this chapter: explicit/implicit costs, law of diminishing returns and short run production costs, fixed and variable cost’s relation to average, total, ...
Intro to Microeconomics
Armine Shahoyan
Class Notes




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This 5 page Class Notes was uploaded by Greg Marzo on Thursday March 3, 2016. The Class Notes belongs to ECON 1010-01 at Tulane University taught by Armine Shahoyan in Spring 2016. Since its upload, it has received 30 views. For similar materials see Intro to Microeconomics in Economcs at Tulane University.


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Date Created: 03/03/16
Chapter 9: Business and the Cost of Production Intro to Microeconomics 1010-01 Topics included in this chapter: explicit/implicit costs, law of diminishing returns and short run production costs, fixed and variable cost’s relation to average, total, and marginal cost, a company’s size in relation to long run costs Calculating Cost and Profit  Economic Costs: The cost for company to produce a good (ie: cost of land, labor, capital or entrep. Ability). This cost includes explicit and implicit costs.  Explicit Cost: A cost that can be reported (for example, in a bakery, the costs to make the cupcakes can include the cost for the ingredients, the cost for the baker, etc.)  Implicit Cost: The invisible costs (for example, the owner of a bakery’s opportunity cost to open the bakery is his old job as a lawyer which pays 100$/hr. The implicit cost is the 100$/hr. While he is not actually spending that explicitly, he is no longer working as a lawyer so does not earn the 100$/hr as a lawyer). For example: Aperson’sinitialsalaryis$15,000.Hegainsa $2,000rentfrom thepropertyheleases. He also has an interest of $1,000. Therefore, his total income is $17,000 (15,000+2,000). The person decides to open a small business. He takes the property he leased back so he can open his store there (so he loses the $2,000). He quits his old job to open business (-$15,000). He loses his interest (-$1,000) and has a cost of $4,000 for his entrep. abilities. Therefore, his implicit cost is $22,000 (2,000+15,000+4,000+1,000) because this is what he could have made if he did not open the business. The cost to open the business includes the cost of the resources needed to make the good at $50,000, the wage of a store clerk at $12,000 and the cost of utilities at $2,000. Therefore, his total explicit cost is $64,000 The business after a set period makes a revenue (total revenue) of $160,000. Was it worth it for the business person to open the business? To calculate whether it was worth it, we must find the person’s accounting and economic profit. Since his revenue was $160,000 and his total explicit costs were $64,000, his total accounting profit was $96,000. This is only the written accounting cost and does not include the opportunity costs of the business person. To find economic profit, subtract the $96,000 we calculate above by his implicit cost of $22,000. The economic profit is $74,000. Since this answer is positive, this person made more money from his business than staying at his old job. Therefore it was worth it. If this difference was negative, it would not be worth it since he lost money. Take Away: Accounting Profit= total revenue – explicit costs Economic Profit= Accounting Profit – implicit costs o Implicit can include the opportunity cost, the value of next best use, and normal profit o The original amount of income from the old job (the 100$/hr) is seen as a normal profit. This gets included in the cost of the business person. The remaining profit of the business person is the economic profit. For example, the baker’s normal profit is 100$/hr because that was his salary as a lawyer. But when he opened the bakery, he made 150$/hr. His total profit is 150$/hr but his economic/extra profit is 50$/hr.  Sunk Costs: When a company’s marginal costs are greater than the marginal benefits, you have to stop producing because it is not efficient. o Short and Long Run  Short run period: Period of time too short for a company to change resource amounts can’t be changed—usually fixed cost items. For example, it is the time period where it is impossible for a company to build a new building to produce.  Long run period: Period of time where company can build/change additional fixed assets Long run and short run periods are determined by the industry and company size. It is usually shorter for small businesses  The Law of Diminishing Returns: In a short run period of time, as additional units of a resource are added, the products produced will decline (ie: the point where adding another person to labor will cause a decline in production). To see this, let’s take a look only at 1 resource variable: labor. Recall the following equations; ????ℎ???????????????? ???????? ???????????????????? ???????????????????????????? ???????????????????? ???????????????????????????? ???????????????????????????????? ???????????????????????????? = ????ℎ???????????????? ???????? ???????????????????? ???????????????????? ???????????????????????????? ???????????????????????????? = ???????????????????? ???????? ???????????????????? Unit of variable Total produced Marginal Product Average product (# of people) (TP) (each person’s contribution) (product/labor) 0 1 15 15 Increasing 15/1= 15 marginal returns 2 35 20 35/2= 17.5 3 65 30 65/3= 21.6 4 85 20 Diminishing 85/4= 21.3 5 100 15 marginal returns 100/5= 20 6 108 8 108/6= 18 7 108 0 Negative 108/7= 15.4 8 100 -8 marginal returns 100/8= 12.5 Since the goal of the company is to maximize the total product and not marginal, the optimal amount for this company is 6 units of labor. When the total product increases sharply when the marginal product is increasing. Total product increases at a lower rate when the marginal product is diminishing. When the marginal product is negative, the product decreases. The marginal product can be negative but the average product is always positive. labor vs total product 120 108 108 100 100 100 85 80 65 60 35 total product 20 15 0 1 2 3 4 5 6 7 8 Labor 35 30 25 20 15 10 5 0 marginal/average product -5 1 2 3 4 5 6 7 8 -10 labor marginal product average product This is just a model. The law of diminishing returns assumes that workers are equal quality. In reality, the marginal product would decrease with each additional worker because the best were the first ones to be hired. Let’s take another example: Q TFC TVC TC AFC AVC ATC MC total total fixed total variable total cost averg. Fixed avg variable avg. total marginal product cost cost (TFC+TVC) cost cost cost cost AFC= TFC/Q AVC= TVC/Q ATC=TC/Q MC=ΔTC/ ΔQ 0 50 0 50 1 50 65 115 50 65 115 65 2 50 105 155 25 52.5 77.5 40 3 50 140 190 16.6 46.6 63.3 35 4 50 170 220 12.5 42.5 55 30 5 50 205 255 10 41 51 35 6 50 250 300 8.3 41.6 49.9 45 7 50 297 347 7.1 42.4 49.6 47 8 50 345 395 6.3 43.1 49.4 48 9 50 410 460 5.5 45.5 51 65 10 50 485 535 5 53.5 58.5 75 Notice that the average fixed cost (Total fixed cost/quantity) is decreasing. The average variable cost (total variable cost/quantity) is parabolic. It starts to decrease but increases again. The average total cost (total cost/quantity) is also parabolic where it decreases then 140 increases. (see graph) 120 In the graph, the average total cost can be found by adding 100 average variable cost and average fixed cost. 80 C60t AFC 40 AVC 20 0 1 2 3 4 5 6 7 8 9 10 Quantity AFC AVC ATC The average fixed costs remains in this manner for the short time period. For a long time period, the graph looks like this:  Economies/diseconomies of scale: In companies (large or small), when the average total costs are decreasing, this is called economies to scale. When the average total costs increase, this is called diseconomies to scale (because the more quantity, the greater the cost). When a company’s costs for the quantity are constant, this is called conditions returned to scale. The large the company, the longer the conditions returned to scale. Yet, a diseconomy to scale will eventually occur.  Minimum Efficient Scale: Smallest level of output where company can minimize the average costs in the long run


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