Chapter 10

Output and Cost

Introduction

This chapter explores how firms measure and manage their costs of production, the distinction between economic and accounting profit, and the relationship between input usage and output in both the short run and long run. Understanding these concepts is essential for analyzing firm behavior and market outcomes in microeconomics.

Economic Cost and Profit

The Firm's Goal

• Firm: An institution that hires factors of production and organizes them to produce and sell goods and services.

• Goal: The primary objective of a firm is to maximize profit. Firms that fail to do so may be eliminated or taken over by others.

Accounting Profit

• Accounting profit is calculated as total revenue minus total cost, using rules established by the accounting profession (e.g., Revenue Canada).

• Used for tax purposes and to inform investors.

• Formula: $\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs}$

Economic Profit

• Economic profit is total revenue minus total cost, where total cost includes all opportunity costs of production.

• Opportunity cost is the value of the best alternative use of resources.

• Formula: $\text{Economic Profit} = \text{Total Revenue} - \text{Total Opportunity Cost}$

Components of Opportunity Cost

• Bought in the market: Resources purchased for production (e.g., materials, utilities).

• Owned by the firm: Use of owned capital incurs an implicit rental rate (could have been rented out or sold).

• Supplied by the firm's owner: Includes entrepreneurship and labor provided by the owner without explicit compensation.

Implicit Rental Rate of Capital

• Consists of economic depreciation (change in market value of capital) and interest forgone (return on funds used to acquire capital).

Normal Profit

• Normal profit is the expected return to entrepreneurship and is considered an opportunity cost.

• Owner's labor not taken as wage is also an opportunity cost (income forgone from best alternative job).

Economic Accounting: Summary Table

Table 10.1 summarizes the calculation of economic profit:

Item	Amount
Total Revenue	$400,000
Cost of Resources Bought in Market	$120,000
Cost of Resources Owned by Firm	$40,000
Cost of Resources Supplied by Owner	$100,000
Opportunity Cost of Production	$170,000
Economic Profit	$30,000

Additional info: Table entries inferred for clarity; see original for detailed breakdown.

Decision Time Frames

Short Run vs. Long Run

• Short run: At least one input (usually capital/plant) is fixed; other inputs (labor, materials) can be varied. Decisions are easily reversed.

• Long run: All inputs, including plant size, can be varied. Decisions are not easily reversed.

• Sunk cost: A cost that has already been incurred and cannot be recovered (e.g., non-resalable plant).

Short-Run Technology Constraint

Production Concepts

• Total product (TP): Total output produced in a given period.

• Marginal product (MP): Change in total product from a one-unit increase in labor, holding other inputs constant.

• Average product (AP): Total product divided by quantity of labor employed.

• Formulas:

  • $\text{MP} = \frac{\Delta \text{TP}}{\Delta \text{Labor}}$

  • $\text{AP} = \frac{\text{TP}}{\text{Labor}}$

Product Schedules and Curves

• As labor increases:

  • Total product increases.

  • Marginal product increases initially (due to specialization), then decreases (due to limited capital).

  • Average product decreases after a certain point.

• Product curves graphically show how TP, MP, and AP change as labor varies.

• The total product curve is similar to the production possibilities frontier (PPF), separating attainable from unattainable output levels.

Law of Diminishing Returns

• States that as more of a variable input is used with a fixed input, the marginal product of the variable input eventually diminishes.

• Arises due to limited access to capital and workspace for additional workers.

Short-Run Cost

Types of Cost

• Total cost (TC): Cost of all resources used.

• Total fixed cost (TFC): Cost of fixed inputs (does not change with output).

• Total variable cost (TVC): Cost of variable inputs (changes with output).

• Formula: $TC = TFC + TVC$

Cost Curves

• TFC is constant at all output levels.

• TVC increases as output increases.

• TC increases as output increases, as it is the sum of TFC and TVC.

• The shape of the AVC curve is derived from the TP curve; it is typically U-shaped.

Marginal and Average Cost

• Marginal cost (MC): Increase in total cost from a one-unit increase in output.

  • $MC = \frac{\Delta TC}{\Delta Q}$

• Average fixed cost (AFC): $AFC = \frac{TFC}{Q}$

• Average variable cost (AVC): $AVC = \frac{TVC}{Q}$

• Average total cost (ATC): $ATC = AFC + AVC$

Relationships Among Cost Curves

• When MC is below AVC or ATC, those averages are falling; when MC is above, they are rising.

• MC equals AVC or ATC at their minimum points.

• The U-shape of ATC arises from spreading fixed costs over more output and eventually increasing variable costs due to diminishing returns.

Shifts in Cost Curves

• Technology: Improved technology increases productivity, shifting product curves up and cost curves down.

• Prices of factors of production: Higher input prices shift cost curves upward. An increase in fixed costs affects TC and ATC but not MC; an increase in variable costs affects TC, ATC, and MC.

Long-Run Cost

Production Function

• In the long run, all inputs are variable.

• The production function shows the maximum output attainable for given quantities of capital and labor.

Diminishing Marginal Product of Capital

• Marginal product of capital: Increase in output from a one-unit increase in capital, holding labor constant.

• Both labor and capital can exhibit diminishing marginal returns.

Short-Run vs. Long-Run Cost

• Each plant size has its own short-run ATC curve.

• The long-run average cost (LRAC) curve is formed by the lowest ATC for each output level across all possible plant sizes.

• Firms choose the plant size that minimizes cost for the desired output.

Economies and Diseconomies of Scale

• Economies of scale: LRAC falls as output increases (due to efficiencies).

• Diseconomies of scale: LRAC rises as output increases (due to inefficiencies).

• Constant returns to scale: LRAC remains constant as output increases.

Minimum Efficient Scale

• The smallest output level at which LRAC reaches its minimum.

• Identifies the most efficient scale of production for a firm.

Summary Table: Cost Concepts

Cost Concept	Definition	Formula
Total Cost (TC)	All resources used	$TC = TFC + TVC$
Marginal Cost (MC)	Cost of one more unit	$MC = \frac{\Delta TC}{\Delta Q}$
Average Fixed Cost (AFC)	Fixed cost per unit	$AFC = \frac{TFC}{Q}$
Average Variable Cost (AVC)	Variable cost per unit	$AVC = \frac{TVC}{Q}$
Average Total Cost (ATC)	Total cost per unit	$ATC = AFC + AVC$

Example: Calculating Economic Profit

• A firm earns $400,000 in revenue.

• Opportunity cost of production (sum of all explicit and implicit costs) is $370,000.

• Economic profit: $400,000 - $370,000 = $30,000$

Additional info: These notes expand on the original slides with definitions, formulas, and academic context for clarity and completeness.