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Economics 14

Lecture 21: Costs

relationship between output and resources
costs in the short run

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Relationship Between Output and Resources

A business firm is an organization that brings together different resources to produce a good or service and is controlled by a single management.

The goal of a business firm is to maximize profits. Profits are equal to the firm's revenues minus its economic costs.

Accounting costs consist of businesses direct, out-of-pocket costs. However, the the time and funds invested in a firm could have been used in some other business. The foregone return on the entrepreneur's time and money that could have been used in another business is an opportunity cost. This opportunity cost is part of the costs of doing business so we add it to accounting costs to get economic cost. A business can earn an accounting profit yet have zero economic profits. Remember that from now on, costs always include these opportunity costs and that cost always means economic cost.

In the short-run, the size of a firm's capital stock is fixed. They are unable to change it. Other resources, such as labor, are variable inputs in the short run. In the long-run, all input levels can be changed.

Assume that a firm uses two resources, labor and capital, to produce a good or service. Capital is a fixed resource while labor can be used in varying quantities.

Total Output

Total output is the maximum output that can be produced when variable resources are added to a fixed amount of capital.

Extra Output of the Group

Extra output of the group equals the additional units of output which result from using one more unit of the variable resource.

Here's an example of making these calculations:

				   Extra Output
number of workers   Total Output   of the Group
	0		 0
	1		15  		15	
	2		34		19	
	3		48		14	
	4		60		12	
	5		62		 2	
	6		60		-2	

The table above exhibits the law of diminishing returns: the addition of resources increases output but eventually does so at a decreasing rate. In other words, the extra output of the group must eventually fall.

Costs in the Short Run

There are two types of costs in the short-run:

1. fixed costs: those costs that do not change as output increases and are incurred even if no output is produced at all, e.g. interest, depreciation, fire insurance
2. variable costs: those costs that do increase as output increases

Total Costs (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)

Average Total Cost (ATC) ATC = TC/Q Average Fixed Cost (AFC) AFC = TFC/Q Average Variable Cost (AVC) AVC = TVC/Q

Marginal Cost (MC) is the change in total cost when the firm increases output by one unit.

Q	TFC	TVC	TC	AFC	AVC	ATC	   MC
0	35	0	35
1	35	24	59	35	24	59	59-35=24
2	35	40	75	17.5	20	37.5	75-59=16
3	35	60	95	11.7	20	31.7	95-75=20
4	35	85	120	8.8	21.2	30	120-95=25
5	35	116	151	7	23.3	30.2	151-120=31

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31