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

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Economic Cost and Profit

The Firm and Its Goal

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.

Profit maximization is central to firm survival and decision-making.

Accounting Profit

Accounting profit is measured by accountants to ensure correct tax payments and to inform investors about the use of their funds. It is calculated as:

Accounting Profit = Total Revenue - Total Cost
Accountants follow professional standards and tax regulations.

Economic Profit

Economists measure profit to predict firm decisions, focusing on economic profit, which considers opportunity costs. Economic profit is defined as:

Economic Profit = Total Revenue - Total Opportunity Cost of Production
Opportunity cost includes both explicit and implicit costs.

Opportunity Cost of Production

The opportunity cost of production is the value of the best alternative use of resources employed by the firm. It is the sum 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 requiring an outlay of money by the firm (e.g., wages, materials).
Implicit costs: Input costs not requiring a monetary outlay (e.g., foregone interest, owner’s time).

Resources Bought in the Market

These are explicit costs. The money spent could have been used to buy other resources for alternative production.

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 consists of:

Economic depreciation: Change in market value of capital over time.
Interest forgone: Return on funds used to acquire the capital.

The Cost of Capital as an Opportunity Cost

Financial capital invested in the business has an opportunity cost.
Example: If $300,000 is invested in a factory instead of a savings account earning 5%, the forgone $15,000/year is an implicit 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.
If the owner supplies labor without a wage, the opportunity cost is the wage forgone from the best alternative job.

Economic Accounting: A Summary

Economic profit equals total revenue minus total opportunity cost of production. The following table summarizes 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 forgone wages	$100,000
Opportunity Cost of Production	$370,000
Economic Profit	$30,000

Economists versus Accountants

Economists and accountants differ in their treatment of costs:

Accountants consider only explicit costs for profit calculation.
Economists include both explicit and implicit costs (opportunity costs).

Decision Time Frames

Short Run vs. Long Run

Firms make decisions in two time frames:

Short run: At least one input (usually capital/plant) is fixed; other inputs (labor, materials) can be varied. Short-run decisions are easily reversed.
Long run: All inputs, 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 or recovered; irrelevant to current decisions.

Short-Run Technology Constraint

Production Concepts

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, then decreases.
Average product decreases.

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

Total Product Curve

The total product curve shows the relationship between labor employed and total output. It separates attainable output levels from unattainable ones in the short run.

Marginal Product Curve

The marginal product curve illustrates the additional output produced by each additional worker. Initially, MP increases due to specialization, then decreases due to limited capital and workspace.

Example: First worker produces 4 units, second produces 6 units (total 10), third produces 3 units (total 13).

Law of Diminishing Returns

Increasing marginal returns arise from specialization and division of labor. Diminishing marginal returns occur as each additional worker has less access to capital and workspace.

The law of diminishing returns states:

As a firm uses more of a variable input with a given quantity of fixed inputs, the marginal product of the variable input eventually diminishes.

Average Product Curve

The average product curve shows the relationship between AP and MP:

When MP > AP, AP increases.
When MP < AP, AP decreases.
When MP = AP, AP is at its maximum.

Short-Run Cost

Cost Concepts

To produce more output in the short run, a firm must employ more labor, increasing costs. Three main cost concepts:

Total cost (TC): Cost of all resources used.
Marginal cost (MC): Increase in total cost from a one-unit increase in output.
Average cost (AC): Cost per unit of output.

Total Cost

Total fixed cost (TFC): Cost of fixed inputs; does not change with output.
Total variable cost (TVC): Cost of variable inputs; changes with output.
Total cost equation:

Marginal Cost

Marginal cost (MC) is calculated as:

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

Average Cost

Average fixed cost (AFC):
Average variable cost (AVC):
Average total cost (ATC): or

Cost Curves

AFC curve falls as output increases.
AVC and ATC curves are typically U-shaped due to the law of diminishing returns and spreading fixed costs.
MC curve intersects AVC and ATC at their minimum points.

Why the ATC Curve Is U-Shaped

At low output, AFC falls rapidly, pulling ATC down.
At higher output, AVC rises due to diminishing returns, pushing ATC up.

Relationship Between Product and Cost Curves

MC is at its minimum when MP is at its maximum.
When MP rises, MC falls; when AP rises, AVC falls.
AVC is at its minimum when AP is at its maximum.

Shifts in Cost Curves

Technology: Increases in productivity shift product curves up and cost curves down.
Prices of factors of production: Increases in input prices shift cost curves upward.
Increase in fixed cost shifts TC and ATC up, but not MC.
Increase in variable cost shifts TC, ATC, and MC up.

Example Table: Total Product, Marginal Product, and Average Product

Labour (workers/day)	Total Product (sweaters/day)	Marginal Product (additional sweaters)	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	20	4	4.00

Example Table: Economic Accounting

Item	Amount
Total Revenue	$400,000
Opportunity Cost of Production	$370,000
Economic Profit	$30,000

Additional info: These notes expand on the original slides by providing definitions, formulas, and examples for key microeconomic concepts related to output and costs, suitable for exam preparation.