Output & Costs: Economic and Accounting Measures, Short-Run Product and Cost Curves

Economic Cost and Profit

Introduction to the Firm and Its Goals

A firm is an institution that hires factors of production and organizes them to produce and sell goods and services. The primary goal of a firm is to maximize profit. Firms that fail to maximize profit may be eliminated or taken over by other firms seeking profit maximization.

Accounting Profit vs. Economic Profit

• Accounting Profit: Calculated by accountants to ensure correct tax payments and inform investors. It is defined as total revenue minus total cost, using standard accounting rules.

• Economic Profit: Calculated by economists to predict firm decisions. It is defined as total revenue minus total cost, where total cost includes the opportunity cost of all resources used in production.

Formula for Economic Profit:

• $\text{Economic Profit} = \text{Total Revenue} - \text{Total Opportunity Cost of Production}$

Opportunity Cost of Production

The opportunity cost of production is the value of the best alternative use of resources employed by the firm. It consists of:

• Resources bought in the market (explicit costs)

• Resources owned by the firm (implicit costs)

• Resources supplied by the firm's owner (implicit costs)

Explicit and Implicit Costs

• Explicit costs: Input costs that require an outlay of money by the firm (e.g., wages, utilities).

• Implicit costs: Input costs that do not require an outlay of money by the firm (e.g., foregone interest, owner’s labor).

Resources Bought in the Market

These are explicit costs. The money spent on market resources is an opportunity cost because the firm could have used those resources differently.

Resources Owned by the Firm

These are implicit costs. If the firm uses its own capital, it incurs an opportunity cost because it could have sold or rented the capital. The implicit rental rate of capital includes:

• Economic depreciation: Change in the market value of capital over a period.

• Interest forgone: Return on funds used to acquire the capital.

The Cost of Capital as an Opportunity Cost

• Example: If $300,000 is invested in a factory instead of a savings account earning 5%, the forgone $15,000 per year is an implicit opportunity cost.

Resources Supplied by the Firm's Owner

• Owners may supply entrepreneurship and labor.

• Normal profit: The average profit an entrepreneur expects, considered an opportunity cost of entrepreneurship.

• Owner’s labor not taken as wage is an implicit cost equal to the wage income forgone from the best alternative job.

Summary Table: Economic Accounting

Item	Amount
Total Revenue	$400,000
Cost of Resources Bought in Market
Wood	$80,000
Utilities	$20,000
Wages	$120,000
Computer lease	$5,000
Bank interest	$5,000
Cost of Resources Owned by Firm
Economic depreciation	$25,000
Forgone interest	$15,000
Cost of Resources Supplied by Owner
Normal profit	$45,000
Owner's foregone wages	$100,000
Opportunity Cost of Production	$370,000
Economic Profit	$30,000

Economists versus Accountants

• Economists include both explicit and implicit costs in their calculation of profit.

• Accountants include only explicit costs.

Decision Time Frames

Short Run vs. Long Run

• Short run: Time frame in which at least one resource (usually capital/plant) is fixed. Other resources (labor, materials) can be varied. Short-run decisions are easily reversed.

• Long run: Time frame in which all resources, including plant size, can be varied. Long-run decisions are not easily reversed.

• Sunk cost: A cost that has already been incurred and cannot be changed. Sunk costs are irrelevant to current decisions.

Short-Run Technology Constraint

Relationship Between Output and Labor

To increase output in the short run, a firm must employ more labor. The relationship between output and labor is described by:

• 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 the quantity of labor employed.

Product Schedules and Curves

• As labor increases: Total product increases, marginal product increases initially but eventually decreases, and average product decreases.

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

Total Product Curve

• Shows how total product changes with the quantity of labor employed.

• Separates attainable output levels from unattainable levels in the short run.

Marginal Product Curve

• Shows the additional output produced by each additional worker.

• Initially, marginal product increases due to specialization (increasing marginal returns), then decreases as more workers share fixed resources (diminishing marginal returns).

Diminishing Marginal Returns

• Eventually, each additional worker adds less output than the previous one.

• Law of diminishing returns: As a firm uses more of a variable input with a fixed input, the marginal product of the variable input eventually diminishes.

Average Product Curve

• Shows the average output per worker.

• When MP exceeds AP, AP increases; when MP is below AP, AP decreases; when MP equals AP, AP is at its maximum.

Short-Run Cost

Types of Costs and Cost Curves

• 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.

• TC = TFC + TVC

Marginal Cost (MC)

• Increase in total cost from a one-unit increase in output.

• MC falls with increasing marginal returns, rises with diminishing marginal returns.

• $MC = \Delta TC / \Delta Q$

Average Cost Measures

• Average fixed cost (AFC): $AFC = FC / Q$

• Average variable cost (AVC): $AVC = VC / Q$

• Average total cost (ATC): $ATC = AFC + AVC$ or $ATC = TC / Q$

Shapes of Cost Curves

• AFC curve: Falls as output increases.

• AVC curve: U-shaped; falls to a minimum then rises.

• ATC curve: U-shaped; vertical sum of AFC and AVC curves.

• MC curve: Intersects AVC and ATC at their minimum points.

Why Cost Curves Are U-Shaped

• ATC curve is U-shaped due to two forces: spreading fixed costs over more output (AFC falls) and eventually diminishing returns (AVC rises).

Relationship Between Product and Cost Curves

• MC is at its minimum when MP is at its maximum.

• When MP is rising, MC is falling.

• AVC is at its minimum when AP is at its maximum.

• When AP is rising, AVC is falling.

Shifts in Cost Curves

• Cost curves shift due to changes in technology and prices of factors of production.

• Technological improvements increase productivity, shifting product curves up and cost curves down.

• Increases in fixed costs shift TC and ATC up, but not MC. Increases in variable costs shift TC, ATC, and MC up.

Summary Table: Total, Marginal, and Average Product

Labour (workers/day)	Total product (sweaters/day)	Marginal product (additional sweater)	Average product (sweaters/worker)
1	4	4	4.00
2	10	6	5.00
3	13	3	4.33
4	16	3	4.00
5	17	1	3.40

Example Application

• If a firm hires more workers, initially output rises rapidly due to specialization, but eventually each additional worker adds less output due to limited capital and workspace.

• Cost curves help managers decide optimal output levels and resource allocation.

Additional info: These notes expand on the provided slides with definitions, formulas, and context for microeconomics students, including the relationships between product and cost curves and the impact of technology and input prices on cost structures.