Micro Eco, Ch-5

PRODUCTION AND COSTS
Chapter: 05
THE FIRM’S OBJECTIVE
Revenue – Total
Organization Profit
Cost
Aim to Calculated
Earn Profit by
Explicit Cost (Tangible) Implicit Cost (In-tangible)

Ex: Utility Bills, Transport Ex: Owner’s salary, Owner’s
Expense, Furniture Expense Furniture
Two types of Profit:

Accounting Profit = Revenue – Explicit Cost
Economic Profit = Revenue – Explicit Cost – Implicit Cost
or Accounting Profit – Implicit Cost
ALL ABOUT COSTS AND PROFIT
Explicit cost is a cost that is incurred when an actual payment is made.

Implicit cost represents the value of resources used in production for
which no actual payment is made. This is incurred as a result of a firm
using its own resources that it owns or that the owners of the firm contribute to it.
a) Accounting Profit is the difference

between total revenue and explicit costs.
b) Economic Profit is the difference between

total revenue and total opportunity cost,
including both its explicit and implicit
components.
ZERO ECONOMIC PROFIT IS NOT AS
BAD AS IT SOUNDS.
 It is possible for a firm to earn both a positive accounting profit and a zero economic
profit.
 Zero Economic Profit/Normal Profit: A firm that earns normal profit is earning revenue
equal to its total costs (implicit and explicit). This is the level of profit necessary to keep
resources employed in a firm.
 A firm that makes zero economic profit is said to be earning normal profit.
 Zero economic profit means the owner has generated total revenues sufficient to cover
total opportunity costs.
Accounting Profit = Revenue – Explicit Cost = 2,00,000 – 1,00,000 = 100000

Economic Profit = Revenue – Explicit Cost – Implicit Cost = 2,00,000 – 1,00,000 –
1,00,000 = 0
MATH (EXPLICIT AND IMPLICIT COST)
 Mr. X is the owner of Zenith organization. The revenue the organization
earned in the month May, 2020 is tk. 200000. The costs in the month are
owner’s salary 50000, office furniture 25000, owner’s PC 42000,
employee salary 30000, and conveyance expense 5000.
a) Calculate both implicit (92000) and explicit costs (60000)
b) Calculate accounting profit (1,40,000) and economic profit
(48000)
 Price = tk. 20 per unit, quantity = 400 units, per unit cost = tk.15, implicit
cost = tk. 4000. (EC 6000) (R 8000) (AP 2000) (EP -2000)
a) Calculate accounting profit and economic profit.
b) Comment on your answer.
AP + Run the AP + Wait and AP - Close the

EP + Business EP 0/- Run EP - Business
PRODUCTION AND COST OF
PRODUCTION
 Production is a transformation of resources or inputs into goods and

services.
 Fixed Costs: Costs that do not vary with output; the costs associated
with fixed inputs. E.g. Rent. Because the quantity of a fixed input does
not change as output changes, neither do fixed costs. (Ex: machinery)
 Variable Costs: Costs that vary with output, the costs associated with
variable inputs. Because the quantity of a variable input changes with
output, so do variable costs. (Ex: thread)
 In short run some costs are fixed and some are variable, but in the
long run all costs are variable. (Ex: building)
RELATIONSHIP BETWEEN MPP AND MC
 Marginal Physical Product (MPP): The change in output that results from
changing the variable input by one unit, holding all other inputs fixed. (Per
input to output/ input output relation) Input – Output – Cost -
Revenue/profit.
 Marginal costs (MC): The change in total costs that results from a change
in output by one. .(Per unit Cost)
Relationship between MPP and MC: MPP MC , MPP MC

It’s a negative relationship.
THE LINK BETWEEN MPP AND MC
 Marginal cost is a reflection of the marginal physical product of the
variable input.
 As the marginal physical product curve rises, the marginal cost
curve falls; and as the marginal physical product curve falls, the
marginal cost curve rises.
 What the marginal cost curve looks like depends on what the
marginal physical product curve looks like.
 As MPP rises  productivity of the variable input increases (more

output being produced using same input)  costs decline  MC
falls
 Vice versa!
PRODUCTION IN THE SHORT RUN
(CONT)
 Law of Diminishing Marginal Returns: As even larger amounts of a
variable input are combined with fixed inputs, eventually the marginal
physical product of the variable input will decline.
 The law of diminishing marginal returns says that as more units of the
variable input are added, each one has fewer units of the fixed input to work
with; consequently, output rises at a decreasing rate.
Declining MPP
MPP MATH
Variable Input, Quantity of Output, Q Marginal Physical Product of MC
Labour (workers) (units) Variable Input
0 0 0
1th 18 18 25
2nd 37 19 23
3rd 57 20 20
4th 76 19 21
5th 94 ?18 23
6th 111 17 25
7th 127 ?16 27
8th 137 10 30
9th 133 -4 32
10th 125 -8 34
Here per labour salary is 120, and per product revenue 10.
• Calculate MPP for 5th and 7th labour.
• Would you hire the 4th worker even when you know MPP will fall to 19?
• Would you hire the 7th worker?
• Draw and explain the relationship between MPP and MC
SOLUTION
 Given Information,
 Labour salary is tk.120
 per product revenue 10
 Revenue earned by 4th labour = (19 x 10) = tk. 190

 Cost incurred by 4th labour = 120
 Profit = 190 - 120 = 70
Comment: here the profit is 70 which is more than 50% of cost. So we

would like to hire the 4th worker.
 P> 50% cost, equal to 50% of cost (hire)

 P< 50% cost (Situation)
 P = 0/- (no hire)
THE LINK BETWEEN MPP AND MC
COSTS OF PRODUCTION
 Cost two types (based on cost of production): Fixed cost (FC) and
Variable Cost (VC)
 The Average Fixed Cost (AFC) = TFC/Q
 The Average Variable Cost (AVC) = TVC/Q
 Total Cost (TC) = TFC + TVC
 The Average Total Cost (ATC) = TC/Q or ATC = AFC + AVC

COSTS OF PRODUCTION (MATH)
Quantity TFC AFC TVC AVC TC ATC
0 100 ? 0 ? ? ?
1 100 ? 50 50 ? ?
2 100 ? 80 40 ? ?
3 100 ? 100 33.33 ? ?
4 100 50 110 ? ? ?
5 100 ? 130 5 ? ?
6 100 ? 160 ? ? ?
7 100 ? 200 ? ? ?
8 100 ? 250 ? ? ?
9 100 ? 310 ? ? ?
10 100 ? 380 ? ? ?
a) Calculate AFC, AVC, TC, and ATC

b) Draw the curve for AFC, TFC, and ATC
COSTS OF PRODUCTION (MATH)
ONE MORE COST CONCEPT: SUNK COST
 Sunk Cost: A cost incurred in the past that cannot be changed by current
decisions and therefore cannot be recovered.
ECONOMISTS’ ADVICE: IGNORE SUNK COSTS

 Once a sunk cost in incurred, it cannot be recovered.
 Taking sunk costs into the decision making process leads to opportunity
costs being ignored, since everything (even time) has an opportunity
cost.
 Further, it leads to a risk of compounding the cost.
 Bottom line: A present decision can affect only the future, not the past.
Ignore sunk costs as they happened in the past.
ECONOMIES OF SCALE, DISECONOMIES OF
SCALE AND CONSTANT RETURNS TO SCALE
 Economies of Scale exist when inputs are increased by some percentage
and output increases by a greater percentage, causing unit costs to fall.
 Output > Input
 500000 > 300000 (Run)
 Constant Returns to Scale exist when inputs are increased by some
percentage and output increases by an equal percentage, causing unit
costs to remain constant.
 Output = Input
 300000 = 300000 (Wait and Run)
 Diseconomies of Scale exist when inputs are increased by some
percentage and output increases by a smaller percentage, causing unit
costs to rise.
 Output < Input
 100000 = 300000 (Close)
SHIFTS IN COST CURVES
 Taxes: affects variable costs. Because variable costs rise, total costs
rise, and their average curves are shifted upward. Because marginal
cost is the change in total cost divided by the change in output,
marginal cost rises. All curves shift up in taxes increase, vice versa.
T C ,T C (Positively Related)
 Input Prices: A rise or a fall in variable input prices causes a
corresponding change in the firm’s average total, variable, and
marginal cost curves. All curves shift up in input prices increase,
vice versa.
 IP C , IP C (Positively Related)
 Technological changes often bring either the capability of using
fewer inputs to produce a good or lower input prices. . All curves
shift down if positive technology change comes, vice versa.
T C ,T C (Negatively Related)

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PRODUCTION AND COSTS

Explicit Cost (Tangible) Implicit Cost (In-tangible)

Two types of Profit:

Explicit cost is a cost that is incurred when an actual payment is made.

a) Accounting Profit is the difference

b) Economic Profit is the difference between

Accounting Profit = Revenue – Explicit Cost = 2,00,000 – 1,00,000 = 100000

AP + Run the AP + Wait and AP - Close the

 Production is a transformation of resources or inputs into goods and

Relationship between MPP and MC: MPP MC , MPP MC

 As MPP rises  productivity of the variable input increases (more

 per product revenue 10

 Revenue earned by 4th labour = (19 x 10) = tk. 190

Comment: here the profit is 70 which is more than 50% of cost. So we

 P> 50% cost, equal to 50% of cost (hire)

 The Average Fixed Cost (AFC) = TFC/Q

 The Average Variable Cost (AVC) = TVC/Q

 Total Cost (TC) = TFC + TVC

 The Average Total Cost (ATC) = TC/Q or ATC = AFC + AVC

a) Calculate AFC, AVC, TC, and ATC

ECONOMISTS’ ADVICE: IGNORE SUNK COSTS

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