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

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Economic Cost and Profit

Definition and Firm's Goal

In microeconomics, 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 the central objective guiding firm decisions.
Profit is the difference between total revenue and total cost.

Accounting Profit vs. Economic Profit

There are two main approaches to measuring a firm's profit: accounting profit and economic profit.

Accounting profit is calculated by accountants to ensure correct tax payments and inform investors. It is defined as:

Accounting rules are based on established standards (e.g., Revenue Canada).
Economic profit is calculated by economists to predict firm decisions. It considers opportunity costs:

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

Spending on market resources is an explicit cost and an opportunity cost, as the firm could have used these resources elsewhere.

Resources Owned by the Firm

Using owned capital incurs an implicit cost, as the firm could have sold the capital or rented it out. The implicit rental rate of capital consists of:

Economic depreciation: Change in 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

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.
Owner’s labor: Opportunity cost is the wage income forgone from the best alternative job.

Economic Accounting: A Summary

Economic profit is calculated as:

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 profit calculations, while accountants consider only explicit costs.

Explicit costs: Outlay of money required.
Implicit costs: No outlay of money required.

Decision Time Frames

Short Run vs. Long Run

Firm decisions are categorized by time frame, affecting flexibility and reversibility.

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 cannot be changed or recovered (e.g., non-resalable plant). Sunk costs are 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 quantity of labor employed.

Product Schedules and Curves

As labor increases:

Total product increases.
Marginal product increases initially, then decreases.
Average product decreases.

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	20	4	4.00

Total Product Curve

The total product curve shows how total output changes with the quantity of labor employed. It separates attainable output levels from unattainable ones in the short run.

Marginal Product Curve

The marginal product curve illustrates the change in output from hiring additional workers. Initially, marginal product increases due to specialization, then decreases due to limited capital and workspace.

Increasing marginal returns: Arise from specialization and division of labor.
Diminishing marginal returns: Occur as each additional worker has less access to capital.

Law of Diminishing Returns

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 average and marginal product:

When marginal product exceeds average product, average product increases.
When marginal product is below average product, average product decreases.
When marginal product equals average product, average product is at its maximum.

Short-Run Cost

Cost Concepts and Curves

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

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).

Marginal Cost

Marginal cost (MC) is the increase in total cost from a one-unit increase in output.

With increasing marginal returns, MC falls as output increases.
With diminishing marginal returns, MC rises as output increases.

Average Cost

Average cost measures are derived from total cost measures:

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

Shapes of Cost Curves

The AFC curve falls as output increases (spreading fixed cost).
The AVC and ATC curves are typically U-shaped due to initially falling costs (increasing returns) and eventually rising costs (diminishing returns).
MC curve intersects AVC and ATC at their minimum points.

Why the ATC Curve Is U-Shaped

ATC is the vertical sum of AFC and AVC.
U-shape arises from two forces:
- Spreading fixed cost over more output (AFC falls).
- Diminishing returns (AVC rises faster than AFC falls).

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 factor prices.
Technological improvements increase productivity, shifting product curves up and cost curves down.
Higher fixed costs shift TC and ATC up, but not MC. Higher variable costs shift TC, ATC, and MC up.

Additional info: These notes cover core microeconomic concepts from Chapter 10: The Costs of Production, including definitions, formulas, and graphical relationships essential for understanding firm behavior in the short run.