Costs •Accounting Costs •Economic Costs •Supply ACCOUNTING COSTS • Accounting costs are monetary (usually explicit). • Accounting profit = Revenue – Accounting costs. ECONOMIC COSTS • Economic costs = accounting costs + opportunity costs. • Economic profit = revenue – economic costs. • Economic profit = revenue – (accounting costs + opportunity costs). ECONOMIC COSTS • Economic costs = accounting costs + opportunity costs. • In economic analysis we use economic costs. • To make a wise decision we need to consider all costs and not only monetary costs. • Opportunity costs should be considered as they have an important bearing on our decision making. These include opportunity cost for resources owned by the firm itself. OPPORTUNITY COSTS • Bill owns a farm worth $1m. His yearly revenue is $100,000 and his expenses are $60,000. The current interest rate is 5% for savings. What is Bill’s accounting profit and what is his economic profit? Accounting profit Economic profit $$40,000 -($10,000) OPPORTUNITY COSTS • Chen runs her own business. She receives no wage or salary. She could work full-time for $25,000pa. Her business revenue for last year was $30,000 and her expenses $10,000. What is her accounting profit and her economic profit? Accounting profit Economic profit $20000 -($5000) OPPORTUNITY COSTS • Tao must travel from Mode Price $ Hours Wellington to Auckland for business. Tao is paid Plane $150 1 $20 per hour and he must travel in work Car $100 6 time. Prices and times Bus $70 10 are: Plane is cheapest. If we consider Which is opportunity costs, total cost for plane cheapest? travel is $170 – much cheaper than the other options. Economic costs in more detail • Rent- Economic return to land (return to any factor that is in fixed supply) • Wages- Economic return to labour. It includes all ways people a compensated for providing their time, efforts and skills. (except for enterprise) • Interest- Economic return on capital. • Profit- Economic return to enterprise for taking risk. It is the reward to those who run the risk of failure when they bring together all the other factors of production Do this Now • Last year Mona had a job as a manager for a fishing company, which paid her $65,000 a year, • She had $80,000 in savings, which gave her a rate of return of 10%. • She thought she could do better by going fishing herself, so gave up her job and invested $80,000 of her own money in buying a fishing boat and quota. • By the end of the first year she had sold $140,000 worth of fish and her costs of running the business had been $70,000. She expected the costs to be quite high in the first year, because she was getting the business established, but though these would fall in future years. • 1. Calculate her accounting profit • 2. Calculate her economic profit • 3. Which are always greater? Economic or accounting profits? Explain Answers! • 1. Calculate her accounting profit Revenue - Accounting costs 140,000 – 70,000 = 70,000 • 2. Calculate her economic profit Revenue – Economic Costs (accounting costs + opportunity costs) 140,000 – 70,000 – 65,000- (80,000 x0.10) = -3000 • 3. Which are always greater? Economic or accounting profits? Explain • Accounting profits are equal to Revenue minus accounting costs. Economic profits are equal to revenue minus accounting costs and opportunity costs. Thus Accounting profits will always be greater than Economic profits due to economic profits taking into account an extra cost, opportunity costs. Fixed costs are costs that do not vary with output Q FC VC TC 0 100 1 100 2 100 3 100 Fixed costs are costs that do not vary with output Q FC VC TC Variable costs are costs 0 100 0 that increase as output increases 1 100 30 2 100 50 3 100 80 Fixed costs are costs that do not vary with output Q FC VC TC Variable costs are costs 0 100 0 100 that increase as output increases 1 100 30 130 Total costs = Fixed + 2 100 50 150 Variable costs 3 100 80 180 FC, VC & TC Fixed costs are costs that do not TC vary with output Costs($) Variable costs are costs VC that increase as output increases FC Total costs = Fixed + Variable costs Quantity Average and Marginal Cost Outpu Total Average Marginal AC = TC/Q t (Q) Cost Cost Cost 0 100 - - 1 200 200 100 2 320 160 120 3 420 140 100 4 640 160 220 5 1100 220 460 Average and Marginal Cost Outpu Total Average Marginal AC = TC/Q t (Q) Cost Cost Cost 0 100 - - MC = TC2 - TC1 1 200 200 100 2 320 160 120 3 420 140 100 4 640 160 220 5 1100 220 460 Starter Activity • Group of 1 • Group of 2 • Group of 3 • Group of 4 In 2 mins in your groups you are to divide the coloured blocks into their separate colours. You CANNOT tip the blocks out. You have 1min to think about how you are going to do this most efficiently before the time starts. Starter Activity Number of people in the Total Product Marginal Product group (Workers) 1 2 3 4 We will assume all groups are equally skilled, so the marginal product is the difference between group one’s total and group two’s total product. Graph the number of workers on the horizontal axis against the number of blocks sorted on the vertical axis. What do you notice? Something to think about • If we were washing dishes at a restaurant (with no dishwasher), then two people are probably more efficient than one. • Why? • Each can specialise – one can wash and the other can dry. • What if we added a third person? • This person could put the dishes away • But what would happen if there was only one sink and a fourth person came to help? • Output might increase but not as much as when the third person came along. Short-run costs In economics we distinguish between various time periods - ie short and long run. The short run, which our particular concern, is a period when at least one input to the production process is fixed. This means that in the short fig run all production will be subject to the law of diminishing return. Diminishing Returns The law of diminishing returns states that where additional units of a variable input are added to a fixed amount of another input, the additional output, or marginal product, will eventually fall. Diminishing Returns Fixed Input Variable Input Capital Labour AC MC Cement Mixer Bricklayers TP (Q) MP Returns (per brick) (per brick) 1 0 0 1 1 70 70 Increasing 6 6 1 2 210 140 Increasing 4 3 1 3 420 210 Increasing 3 2 1 4 630 210 Constant 2.67 2 1 5 770 140 Diminishing 2.73 3 1 6 840 70 Diminishing 3 6 Fixed Input Variable The additional output(MP) input eventually falls Costs ($) 120 marginal Q TC MC costs cost is the TC 0 12 As marginal 100 1 22 10 ‘difference’ it is generally 6 shown between the other 2 28 values. This procedure is 80 3 33 5 also used in graphing the 4 40 7 marginal cost curve. 60 5 52 12 6 72 20 7 103 31 40 20 0 0 1 2 3 4 5 6 7 Q Costs ($) Deriving marginal 120 costs Q TC MC 0 12 TC 100 10 1 22 6 2 28 80 5 3 33 7 4 40 12 60 5 52 20 6 72 31 40 7 103 Diminishing MC returns set 20 in here 0 0 1 2 3 4 5 6 7 Q Costs ($) Deriving marginal 120 costs Q TC MC 0 12 TC 100 10 1 22 6 2 28 80 5 3 33 7 4 40 12 60 5 52 20 6 72 31 DTC = 12 40 7 103 DQ = 1 20 0 0 1 2 3 4 5 6 7 Q The Shape of the MC curve Costs($) MC MC decreases initially because Note: always of increasing plot the MC returns curve at the mid-point! MC increases because of diminishing returns Quantity The Shape of Average Cost Curves Costs($) FC are constant so AFC will continually decline as FC are spread over increasing output FC AFC Quantity The Shape of Average Cost Curves Costs($) AC AC decreases because of short run economies: •Technical •Marketing •Managerial AFC Quantity •Financial The Shape of Average Cost Curves Costs($) AC AC increases as short run diseconomies set in. AFC Quantity The Shape of Average Cost Curves Costs($) AC The difference AVC between AC and AVC is equal to AFC AFC Quantity Marginal Cost & Average Cost MC Costs($) AC If MC<AC then AC will be decreasing Quantity Marginal Cost & Average Cost MC Costs($) AC If MC>AC then AC will be increasing Quantity Marginal Cost & Average Cost MC Costs($) AC MC cuts AC at its minimum point - this is the technical optimum Quantity Marginal Cost & Average Variable Cost MC Costs($) AC MC also cuts AVC AVC at its minimum point Quantity Break Even & Shut Down MC Costs($) AC A firm must AVC cover AC if it is to break even Break even point This is the break is where AR=AC. even point Where the price is enough to cover Quantity all costs and the firms make normal profits. Break Even & Shut Down MC Costs($) In the SR a AC firm can AVC survive if P > AVC This is the shut down point Quantity A firm’s Supply curve is derived from the MC curve above the The Supply Curve shut-down point MC =S Why do you Costs($) think the AC supply curve is AVC upwards sloping? Because of diminishing returns! Producing higher levels of output results in progressively less efficient resource combinations. Because of this the firm will Quantity only supply a larger quantity at higher prices. Testing the Law of diminishing Returns in a Paper Chain Factory This class is about to turn into a factory that manufactures paper chains A paper chain is made by taking two long narrow strips of paper folding one into a ring and stapling the ends together Then folding the other into a ring and connecting it to the first ring to make a chain. Two loops of paper stapled together make a chain. The longer the chain the more productive your workers are. Goal- Make the longest possible paper chain in a fixed amount of time using fixed amount of resources. Labour is going to be your only variable resource. Resources • Land resources - Two desks pushed together this is the factory floor (only place where paper chains can be produced) • Box of paper • Capital resources (your tools) include only two pairs of scissors and two staplers. • In the short run land and Capital cannot be varied so you CANNOT use more than these resources given. • Labour resources, consist of the members of your class. • We will start with just one worker for 1min and add in another when that 1min is up until we have at least 8 people working in the factory. • One member of the class will be the designated time keeper and will tell the others when the 1min time is up. After each min we will have time to record in a table the # of workers, total product Marginal Product and Average Product. Number of Total Product Marginal Average workers Product Product 1 2 3 4 5 6 7 8 At the end of each rounds if there are any unstapled chains or linked these are taken away. They cannot be used for the next round. We will graph these lines at the end of the class. In 2 groups (split the class in half) answer these questions 1. Analyse the relationship between total and marginal product 2. Determine whether your paper chain factory ever experienced increasing return and whether it ever experienced diminishing returns 3. Discuss the reasons for the changes in total product during each round of production 4. Discuss the meanings of marginal and average product and determine how they changed as workers were added to your factory floor. 5. What is the relationship between marginal product and average product? 6. Decide whether the law of diminishing returns applied to your factory If so why? If not, why not?
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