ECON 101 Introduction to Economics1

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1 ECON 101 Introduction to Economics1 Session 10 Cost Concept Lecturer: Mrs. Hellen A. Seshie-Nasser, Department of Economics Contact Information: College of Education School of Continuing and Distance Education 2014/ /2017

2 Session Overview There is a difference between economist s measure of profit and accountant s measure of profit. Profit is the difference between total revenue and total cost. For economists, total cost includes the opportunity cost of owner s capital. This session seeks to explain the concept of cost in economics. Dr. RicMrs. Hellen Seshie-Nasser, Dept.of Economics, Slide 2

3 Session Objectives At the end of the session, the student should be able to: Differentiate between implicit cost and explicit cost. Determine economic cost. Understand accounting profit and economic profit. Understand costs in the short run with mathematical calculations. Calculate Total, Fixed and Variable costs as well as Per unit Fixed and Variable costs (Average Variable Cost, Average Fixed cost and Average Total Cost) Represent the various measures of costs with curves. Demonstrate the relationship between the cost curves. Understand costs in the long run. Slide 3

4 Session Outline The key topics to be covered in the session are as follows: Cost Concept Economic Costs Costs in the Short run Short and Long run cost curves Economies and Diseconomies of Scale Slide 4

5 Reading List Lipsey R. G. and K. A. Chrystal. (2007). Economics. 11 th Edition. Oxford University Press. Bade R. and M. Parkin. (2009). Foundations of Microeconomics. 4 th Edition. Boston: Pearson Education Inc., Begg. D. Fischer S. and R. Dornbusch. (2003). Economics. 7 th Edition. McGraw-Hill Slide 5

6 The Cost Concept Accounting cost refers to the monetary outlay on inputs. Thus, the explicit cost of inputs. Economic cost refers to the opportunity cost of use of resources. This involves both the explicit and implicit costs of resources Slide 6

7 The Cost Concept Economic cost Explicit Costs Plant and equipment Raw materials Wages and salaries (cost of resources acquired from outside the firm and paid for) Implicit Costs forgone wages forgone rent (forgone benefits as a result of use of owner resources) Slide 7

8 Economic Costs Explicit costs arise from transactions in which the firm purchases inputs or the services of other parties. E.g. wages and salaries of workers, cost of raw materials, insurance, electricity Implicit costs are those associated with the use of the firm s own resources and reflect the fact that these resources could have been employed elsewhere. These costs are sometimes difficult to measure. Examples: A firm in the owner s own building, where he does not pay rent. This cost is implicit Being a manager of his own production firm, he does not pay himself a salary. Slide 8

9 Economic Costs Economists thus count the opportunity cost of the owner s capital as part of a firm s costs. It includes an estimate of what the capital, and any other advantages owned by the firm, could have earned in their best alternative uses. Thus economic cost is the opportunity cost of resources used explicit costs paid in money wages, rent, material, etc. implicit costs opportunity cost of resources used Slide 9

10 Accounting Profit and Economic profit Accounting profit = total revenue(tr) explicit costs TR = (price)(quantity) It ignores opportunity cost Economic profit includes opportunity costs. Economic profit = total revenue - total costs = (price)(quantity) - (explicit + implicit costs) Slide 10

11 Economic View vs.. Accounting View Slide 11

12 Normal Profit Amount of accounting profit = opportunity costs of resources It is the same as zero economic profit That is, TR opportunity costs = 0 Slide 12

13 Costs in the Short Run Costs are measured in 3 ways: total cost marginal cost average cost Total cost of production varies with the rate of output. In the short run, there are two types of costs; Fixed costs Variable costs Slide 13

14 Costs in the Short Run Assume the costs of producing chairs as: Labour = 6/ hour TFC = 10/ hour (the cost of the workshop) workers TP TFC TVC TC Slide 14

15 TC, TVC and TFC TC TC TVC 10 TFC Slide 15 Q = output

16 Short Run Total Cost Curves Cost TC Cost TC TVC TVC TFC TFC Output Output Dr. Richard Boateng, UGBS Slide 16

17 Per unit Costs Average Fixed Cost (AFC) is the total fixed cost divided by the quantity of output. It is the fixed cost per unit of output. It declines with output level. Since fixed cost is constant, the greater the output, the lower the AFC Average Variable Cost (AVC) is the variable cost per unit of output. Slide 17

18 Per unit Costs Average total cost (ATC) is the total cost per unit of output. Total cost divided by quantity of output. It can also be expressed as the sum of AFC and AVC. Slide 18

19 Per unit Costs TP TFC TVC TC AFC AVC AC Slide 19

20 Marginal Cost Marginal cost (MC) is the change in total cost resulting from changing the rate of production by one unit. Change in TC due to one-unit increase in output (Q) MC = change in TC change in Q Slide 20

21 TP, TFC, TVC, TC and MC TP TFC TVC TC MC Slide 21

22 MC, ATC, AVC & AFC AC, MC MC ATC AVC AFC Slide 22 Q = output

23 Relationship between Short Run per unit Cost Curves Cost MC ATC AVC Output Slide 23 AFC

24 MC and AC MC intersects AC at the minimum of AC When MC < AC, AC is falling When MC > AC, AC is rising Slide 24

25 What shifts cost curves? Technology make more with same inputs shifts TP, MP, AP up changes ATC curve Changes in factor prices (e.g. increase in input prices) increase fixed costs -- TFC, AFC shift up -- TC shifts up increase wages (variable) -- TVC, AVC, MC shift up -- TC shift up Slide 25

26 Long Run Costs: Average Cost (LRAC) In the LR, all inputs (and costs) are variable. TC = TVC AC = AVC Short Run AC curves are from different plant sizes The long run AC gives the lowest average cost when all inputs are variable. It is the envelop of all short run ACs Slide 26

27 Long Run Costs: Average Cost (LRAC) AC AC1 AC2 AC3 AC4 LRAC Slide 27 Q = output

28 Economies of Scale What happens if in the Long run the firm increases plant AND labour by 10%? Will; AC fall? AC rise? AC stay same? ECONOMIES OF SCALE If inputs are increased by 10% and this leads to an increase in output by more than 10%, then AC falls. Why? gains from specialization both from -- Labour -- Capital The firm is said to exhibit Increasing Returns to Scale Slide 28

29 Diseconomies of Scale On the other hand, if inputs are increased by 10%, and output increases by less than 10%, then AC rises. Why? The firm has grown large such that, it has become too hard to control. The firm is said to be exhibiting Decreasing Returns to Scale CONSTANT RETURNS TO SCALE It occurs if for example, the firm increases inputs by 10%, and output also increases by same 10%. AC remains same Dr. Richard Boateng, UGBSMrs. Hellen Seshie- Nasser, Dept.of Economics, Slide 29

30 Economies of Scale vs Diseconomies of Scale AC AC1 ATC2 ATC3 ATC4 economies of scale constant returns to scale diseconomies of scale Q = output Slide 30

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