Principles of EconomicsEC 201Dr. BresnockFall, 2002Production Costs in the Short-RunPrinciples of EconomicsEC 201California State Polytechnic University, PomonaDr. BresnockFall, 2002Lecture 10 Opportunity Costs -- value of the next best alternative. (Remember production possibilitiescurve description.)Explicit Costs -- monetary payments for resources that are external to the firm. i.e. paymentsfor any labor, capital, land and/or entrepreneurial ability which are not owned by the firm.Implicit Costs -- opportunity costs of self-owned, self-employed resources in their next bestalternative use. i.e. If I hire myself to run my own business then the implicit cost for my self-employed labor is the salary that I will forgo in the next best alternative job if I were hired byanother employer.Note: Economists count all explicit and implicit costs prior to reporting a residual or “pureeconomic profit.” In other words, economists account for wages paid to labor, interest paid tocapital, rent paid to land, and a “normal” profit paid to the entrepreneurial to cover risk, etc.Any residual revenue that remains after deducting these four categories of resource payments isthe “pure economic profit.” Technically the “normal” profits that are the payment to theentrepreneurial are an implicit cost. Thus, since accountants count only explicit costs prior todetermining their “profits,” accountants’ profit figures lump “normal” and “pure” economicprofit together.Diagram 1 Economic vs Accounting ProfitsEC 201 Lecture 10Fall, 2002 A. BresnockNote: Production costs are distinguished between short-run and long-run costs. The short-runis defined as a time period too short to allow a firm to alter its plant capacity but long enough toallow for more or less intensive use of existing plant capacity. i.e. In the short-run, the existingplant capacity may be utilized at 60%, 85%, 100%, etc. capacity. In the long-run, new plantscan be built. Thus, the long-run time period is long enough to allow for changes in the existingnumber of plants, and other changes that emerge from technological change.Ex. “Footloose firms” like software developers – can move easily, can replace equipmenteasily – thus the short run may be very short, i.e. days. The auto industry uses lots of capitalequipment in the form of factories, machinery, etc. Auto plants do not change location. Hencethe short run for the auto industry may be very long indeed, i.e. 15 – 20 years.Note: The concept of diminishing returns applies due to a fixed factor of production and isthus a short run concept. In the long run, there is no such thing as diminishing returns.Production Costs in the Short-RunIn the short-run variable resources can be added to increase production or decrease production.The law of diminishing returns underlies the relationship between short-run costs and thephysical production process.Fixed Costs -- costs that do not change as output changes. These costs must be paid even ifoutput is zero. i.e. rent, insurance, salaries to top management, interest.TFC = Total Fixed Cost. (Overhead Cost)Graph 1 Total Fixed CostVariable Costs -- costs which increase with levels of output or decrease when output isdecreased. i.e. materials, fuel, most labor. TVC = Total Variable Cost. 2EC 201 Lecture 10Fall, 2002 A. BresnockGraph 2 Total Variable CostNote: Initially as variable costs increase the rate of change of these variable costs isdecreasing. This growth pattern of variable costs can be tracked back to the productionfunction where one will see that MP is increasing when the variable costs are increasing at adecreasing rate. Once the point of diminishing returns is reached, however, variable costs growat an increasing rate and MP is declining at the same time. The connection between productioncosts and the production function is critical to understanding decision making by the firm.Total Costs -- the sum of all fixed and variable costs. Thus, TC = TFC + TVCGraph 3 Total Cost3EC 201 Lecture 10Fall, 2002 A. BresnockAverage, or Per Unit, Costs -- these costs are determined at a particular level of output. Theyare most useful in quick comparisons.Average Fixed Costs -- defined as AFC = TFC/Q where Q represents units of output Graph 4 Average Fixed CostNote: AFC declines as Q increases. In other words, the fixed cost is spread over more units ofoutput, sometimes referred to as “spreading the overhead.”Average Variable Costs -- defined as AVC = TVC/QGraph 5 Average Variable Cost4EC 201 Lecture 10Fall, 2002 A. BresnockAverage Total Costs – defined as ATC = TC/QGraph 6 Average Total CostMarginal Costs -- the extra, or additional, cost of producing one more unit of output. MC = Change in TC =  TC = TC2 – TC1 Change in Q  Q Q2 – Q1Marginal Cost may also be defined as:MC = Change in TVC =  TVC = TVC2 – TVC1 Change in Q  Q Q2 – Q1WHY? 5EC 201 Lecture 10Fall, 2002 A. BresnockNote: The relationship between: (a) TC, TVC and MC, (b) TP, MP and MC, and (c)relationship between AVC, ATC, and MC. The MC curve cuts the AVC and ATCcurves at their minimum points.Graph 7 Total Cost, Total Variable Cost, and Marginal Cost6EC 201 Lecture 10Fall, 2002 A. BresnockGraph 8 Marginal Product and Marginal Cost7EC 201 Lecture 10Fall, 2002 A. BresnockGraph 9 Marginal Cost, Average Total Cost and Average Variable CostNote: Practice calculating these costs by working out the first 8 columns of “Additional Problem 4” Costs. Do not continue with theremaining portions of Additional Problem 4.Also work through all parts of the other “Additional Cost” problemsto prepare for the exam. Production Costs in the Long RunIn the long run firm’s can adjust their plant size as the demand for theirproduct grows over time. This