MCD2020 Microeconomics

Tutorial 7: Costs of Production

Chapter 13

Tutorial this week will focus on the learning objectives of Topic 6, which are:

1. Explain what items are included in a firm’s costs of production

2. Understand the difference between Accounting and economic costs/profits
3. Analyse the link between a firm’s production process and its total costs
4. Understand the meaning of average total cost and marginal cost and how they
are related
5. Explain the shape of a typical firm’s cost curves and reasons behind those
shapes
6. Explain the relationship between short-run and long-run costs

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 Q.1 Economic profit versus accounting profit

Katrina owns a dress shop. Her total costs (explicit and implicit) are $600,000
per year. The following contains further information regarding her business
• Explicit fixed costs are $150,000 per year
• All variable costs are explicit costs
• Katrina could earn $80,000 in her next best employment.
• Each dress sells for $400. This year, Katrina sold 2,000 dresses.

a) What are Katrina’s total fixed costs and total variable costs of production?
Explicit fixed costs = $150,000
Implicit fixed costs = 80,000
Total fixed costs = 230,000
Total variable costs = Total costs – Total fixed costs
600,000 – 230,000 = 370,000

b) What is Katrina’s total accounting profit?

Accounting profit = Total revenue – Total explicit costs
Total revenue = 2,000 x $400 = $800,000
Total explicit costs = $150,000 + 370,000 = 520,000
Accounting profit = $800,000 – $520,000 = 280,000

c) What is her economic profit?

Economic profit = Accounting profit – Total implicit costs
$280,000 – 80,000 = 200,000
Or
Total revenue – Total costs
$800,000 – 600,000 = 200,000
d) Explain the concept of economic profits
Economic profits are what the owners of the firm receive over and above what they
would have received from employing those resources in the next best available
opportunity. In this case the next best available opportunity for Katrina is her
alternative employment, which could have earned her $80,000. Accounting profit of
$280,000 is $200,000 better than the next available opportunity.

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Q.2 Production function

Sam’s company, Eco Friendly, produces t-shirts. The table below shows some data
that describes Eco Friendly’s total output. The numbers tell us how Eco Friendly’s
output of t-shirts changes as Sam employs more workers when using a fixed level
of plant and machines.

Workers Total Product Marginal Product

per day (t-shirts per day) (t-shirts per worker)
0 0
1 4 4
2 10 6
3 13 3
4 15 2
5 16 1

a) Use this data to

draw an appropriate
graph of Eco Friendly’s
production function.

b) Calculate the marginal product and fill in the last column in the table. Show the
marginal product on your diagram for part (a).

c) Eco Friendly’s production function is the relationship between input (number of

workers) and output (number of t-shirts). The production function gets flatter
as the number of workers increases because of the diminishing
marginal product (DMP)

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 d) Show on the diagram the range of the diminishing marginal product (DMP).

The marginal product initially increases but after the second worker the marginal
product will decrease and the production function becomes flatter because the
diminishing marginal product effect will set in

e) Why does the marginal product (MP) decrease when the company continues to
take on more workers
when the company continues to take on more workers, additional workers have to
share equipment, work in more crowded conditions and workers start getting in
each other’s way and MP decreases

Q.3 Calculating different costs, and graphing cost curves

Use the data from Question 2, Sam’s Eco-Friendly Company, and fill in the relevant
columns of the table below.
a) Assume that Sam rents a t-shirt machine for $25 a day and hires workers at a
wage rate of $25 a day. Complete the missing values of the table.

Output Margin Total Total Total Marginal Average Average Average

(t-shirts al Fixed variable Cost cost Fixed Variable Total
per day) Produ cost cost (TC) (MC) Cost Cost Cost
ct (TFC) (TVC) (per (AFC) (AVC) (ATC)
(MP) (per day) (per day) day)
0 0 25 0 25 0 - - -
1 4 4 25 25 50 6.25 6.25 6.25 12.5
2 10 6 25 50 75 4.17 2.50 5 7.5
3 13 3 25 75 100 8.33 1.92 5.77 7.69
4 15 2 25 100 125 12.50 1.67 6.67 8.33
5 16 1 25 125 150 25 1.56 7.81 9.38

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b) Following your calculations, draw an approximate diagram of short-run cost curves for
Sam’ s Eco Friendly company, and identify the efficient level of output (production
efficiency).

c) Use the diagram and the table to finish the paragraph below:

• The efficient level of output (production efficiency) of t-shirts is equal to 10 t-shirts,

since that is the quantity at which average total cost is the lowest (minimum).

• The U-shape of the average total cost, average variable cost and the marginal cost
curves is explained by the production function and marginal product. Due to the
increase in marginal product, MC, ATC and AVC decrease and when the DMP sets in,
they start to increase.

• AVC and ATC costs are falling when marginal cost is below them, and rising when
marginal cost is above them.

• A cost that does not depend on the quantity of t-shirts produced is the AFC.

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Q.4. Long -run costs, and economies and diseconomies of scale

Time period Capital Input units Labour input units Output units
1 1 1 100
2 1 2 120
3 1 3 160
4 1 4 210
5 1 5 230
6 2 10 500
7 3 15 750
8 6 30 1,000
a) Identify the time periods over which short-run decisions were made and give a
reason for your answer

The short-run decisions were made over the time-periods 1 to 5 because over this time
period there is one factor that has not changed

b) Identify the time periods over which long-run decisions were made and give a reason
for your answer

Long-run decisions were made over the time periods 6, 7 and 8 because there are no
fixed factors over these periods

c) Explain what has happened in the 5th time period

In the fifth period diminishing marginal product has set in. During previous periods
when one more worker was introduced the marginal product increased. In period 5
the marginal product of the last worker was 20 which is less than the marginal
product of 50 of the previous worker.

d) Explain what has happened in the 6th time period

In the sixth period all input factors were doubled and the outputs more than doubled.
This shows that the firm was experiencing economies of scale over this period.

e) Explain what has happened in the 8th time period

In the eighth period all inputs were doubled compared to the previous period but the
outputs less than doubled. This indicates that the firm was experiencing
diseconomies of scale over this period

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Q.5 Short-run versus long-run costs

a) Explain ATC in the long run, by circling or filling the correct words below

• Fixed cost in the short run does not change as the company changes its output,
for example, rent for the factory building.
• Variable cost in the short run does change as the company changes its quantity
of output, for example the cost of labour.
• The difference between the long-run and the short-run is that in the long run
the firm can change all of its costs, however in the short run the firm can only
change its variable costs.

b) Consider ATC in the long run. Define the following terms by circling or filling the
correct words:

• Economies of scale are where long run ATC is decreasing as the quantity of
output increases. Economies of scale are caused by specialization among the
workers which permits each worker to become better in their assigned tasks,
for example modern assembly line.
• Constant returns to scale are where in the long run ATC is constant as the
quantity of output increases.
• Diseconomies of scale are where long run ATC is increasing as the quantity of
output increases. Diseconomies of scale are caused by management /co-
ordination issues and not production issues. The stretched-out management
team become less effective at keeping costs down.