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					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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