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©
1989 John Petroff
LEARNING OBJECTIVE
The purpose of this chapter is to analyze how costs of
production change as output is changed. First the concept of
economic costs is investigated. Short run patterns of total,
average and marginal costs are derived on the basis of the law
of diminishing returns. Long run cost patterns are briefly
outlined.
OPPORTUNITY COST
All costs in economics are said to be opportunity costs because
anytime a resource is used for any purpose, it implies that some
other good cannot be produced with that quantity of the
resource, that some other resource is not used for the given
production instead, and that revenues from other production are
foregone. Thus, costs are either explicit cost for the resource
used or implicit costs from alternative use of the resource.
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When a student takes a course in economics, the cost of
taking the course is more than just the money spent on tuition, textbooks and study aids. For instance, the time devoted to studying could have been used to work in a supermarket and earn a nice salary. That salary is not an out-of-pocket cost, but an opportunity cost, which is a real cost nevertheless. |
NORMAL PROFIT
Among the implicit costs of a firm, normal profit is the most
important cost which must be met. Normal profit is that income
the business owner, or entrepreneur, would receive if he/she
were engaged in some other activity or employment. Thus,
if the business owner does not derive what he/she feels
he/she deserves, then he/she may well close the business.
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The owner of a small retail specialty store uptown should
expect the store to generate at least as much income as what he/she could earn working as a manager for the department store downtown. Otherwise, the reasonable decision would be to close the store. |
PURE PROFIT
Pure profit, also known as economic profit, is the excess of
revenues over all costs of the firm, explicit as well as
implicit (i.e. opportunity) costs (one of which is normal
profit). Pure or economic profit, thus, differs from accounting
profit since in accounting profit only out-of-pocket explicit
costs are taken into consideration.
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As opposed to normal profit, pure profit is a reward for
taking the risk in running a business, and sometimes it can be negative. Thus, the owner of a store will see ups and downs in total profit due to changes in pure profit, which occasionally eats up some of the normal profit. |
SHORT RUN
The short run time framework for a firm is that time period
during which some of its resources, and thus costs, are fixed.
A typical example of a fixed cost for most firms is rent or the
salary of key personnel (such as the president of the company).
The number of days, months or years which consitutes the
short run differs greatly from firm to firm.
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Most commercial rentals require a lease (a contract to
rent for several months or years). Setting up a business also often requires installation of fixtures, furniture or equipment. Over the duration of the lease, the business would lose a lot of money if it had to change location. Thus, space is pretty much fixed over that period of time. |
LONG RUN
The time framework is considered to be long run when all the
costs of a firm can be changed to some extent. For instance,
the factory size can be modified. In the long run, there are no
truly fixed costs: all costs are variable.
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At the expiration of the rental lease, a business can move
to a more desirable location, which can be larger or smaller. Thus, in the long run, not even the working space of the business has to remain the same: everything can change. |
DIMINISHING RETURNS
The law of diminishing returns shows the observable occurrence
that if variable inputs are increased beyond a certain point the
incremental (or marginal) quantity produced (or returns) starts
to decrease. Starting from a very low level of production, firms
usually will benefit from increasing efficiency at first, but
the gains dissipate and production becomes less efficient when
the size capacity of the firms is overutilized.
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In a restaurant, the first employees that need to be hired
are probably the manager, the cook and the waiter or waitress. Without them the restaurant would be very inefficient. Other help can be hired later: maitre d', somellier, cashier, kitchen attendants, etc. If there are too many waiters in the restaurant or too many cooks in the kitchen, they may spill or spoil the broth. |
LAW OF DIMINISHING RETURNS
The law of diminishing return takes place only in the short run.
It is entirely due to the presence of some fixed resource, and
the need to overutilize that fixed resource.
FIXED COSTS
Fixed costs are those costs over which a firm has no control.
They are usually tied to fixed inputs or resources. The fixed
costs must be paid, otherwise the firm may have to close down.
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Rent is a typical fixed cost. It does not change from month
to month (or from year to year) over the period of the lease, no matter what the volume of output may be. |
VARIABLE COST
Variable costs are those costs which a firm can change at will.
They pertain to inputs or resources which are not fixed.
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Salaries, especially those of extra help and part-time
employees are typical variable costs. Many other expenses are also variable: freight and postage, telephone in excess of the basic rate, maintenance and cleaning, and energy consumption. All these change with the volume of production. |
TOTAL COST
Total cost is the sum of all costs: fixed and variable. The total
cost curve is represented graphically as an upsloping curve:
costs increase as output volume increases. The curve is
generally S shaped, reflecting the increasing efficiency
starting from a low level of production, and then a decreasing
efficiency as the volume of production goes beyond the point of
diminishing returns.
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The total cost of the restaurant increases as the number
of meals increases (which is the volume of output here). When the restaurant becomes overcrowded and the law of diminishing returns sets in, the total cost increases very fast because employees become less efficient. |
AVERAGE FIXED COST
Average fixed cost is calculated by dividing total fixed cost
by
the quantity produced. AFC=TFC/Q. The average fixed cost curve
is represented graphically as an ever decreasing curve
asymptotic to the horizontal axis.
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The rent paid by the restaurant is divided (or allocated), among more and more meals as the volume of production increases. The average cost per meals attributable to the fixed rent decreases as the number of meals increases. |
AVERAGE VARIABLE COST
Average variable cost is calculated by dividing total variable
cost by quantity produced. AVC=TVC/Q. The average variable cost
curve is graphically represented by a U shaped curve reflecting
the increasing then decreasing efficiency in production as
volume changes.
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Starting from a few meals and customers, a restaurant can
improve its efficiency and decrease its average variable cost per meal as it increases it volume. After having expanded too much, the average variable cost start to rise as employees start to get in each others way when the restaurant is too crowded. |
AVERAGE TOTAL COST
Average total cost is calculated by dividing total cost by the
quantity produced. ATC=TC/Q. It can also be obtained by adding
up average fixed cost and average variable cost at each level
of
production. The average total cost curve is represented
graphically as a U shaped curve with a steep decreasing portion
and a mildly increasing portion. These are attributable to the
fixed and variable cost patterns.
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The pattern of the average total cost of the restaurant
is a combination of the pattern of average fixed costs and average variable costs. As output increases, average total cost decreases then increases with diminishing returns. |
MARGINAL COST
Marginal cost is calculated by dividing the change in total cost
by the change in quantity. MC=(change in TC)/(change in Q). The
marginal cost curve is represented graphically by a U shaped
curve reflecting the increasing then decreasing efficiency as
volume increases.
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The marginal, or additional, cost per meal changes more
than the average total cost for each meal. The cost of one additional meal start to increase before average total cost does. |
MARGINAL COST GRAPH
The shape of the marginal cost curve can be explained by the
pattern of total cost: it is due to the law of diminishing
returns. The trough (or minimum) of the marginal cost curve
corresponds to the point of diminishing returns. Marginal cost
itself is also the slope of the tangent to the total cost curve.
MINIMUM AVERAGE TOTAL COST
Marginal cost curve intersects the average total cost curve
at its minimum (or trough). One may verify that this must
necessarily be true by observing that
- if marginal cost is below average cost, average cost decreases,
- if marginal cost is above average cost, average cost increases,
Average cost remains the same only if marginal cost is neither
above nor below.
ECONOMIES OF SCALE
Economies of scale, or economies of large scale, result from
gains in efficiency as the size of production is increased along
with appropriate changes in fixed resources to utilize the
available resources more fully. Economies of scale can only
occur in the long run.
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Economies of scale are observable in most manufacturing. Automobile production is especially sensitive to volume. A single car (for instance, those constructed for car racing) can cost millions of dollars. But, when the same features are incorporated in millions of parts, the cost becomes affordable. Recent studies indicate the minimum production of a line of cars is 100,000 units. |
ECONOMIES OF SCALE CAUSES
The major causes for the presence of economies of scale are
- division of tasks and labor specialization minimizing labor
cost,
- more intensive use of highly skilled personnel,
- more intensive use of capital (for instance, with shifts),
- ability to utilize by-products rather than discard them.
ECONOMIES OF SCALE GRAPH
Economies of scale are observed graphically by a pattern of
lowering of the marginal and average total cost curves. The
envelope of the short run average total cost curves can be
looked upon as a long run cost curve.
DISECONOMIES OF SCALE
Diseconomies of scale take place when the size of a firm is
excessive. A firm may indeed increase its size to take advantage
of economies of scale, but the gains disappear when the firm
reaches a certain size. Diseconomies of scale belong to the long
run and must be clearly distinguished from diminishing returns
which occur in the short run. It is often argued that
diseconomies of scale are rarely - if ever - observed in
industry because firms would cut back on their size.
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General Motors is still made of several divisions which
have never been integrated into a single production. There may be many reasons for this. An apparent one is that keeping the divisions separate stimulates some amount of competition among them, and thus avoids diseconomies of large scale. |
DISECONOMIES OF SCALE CAUSES
Some of the possible causes of diseconomies of scale are
- difficulties in control and supervision,
- slow decision making due to excessive size of administration,
- lack of employee motivation.
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