Costs of production
A firm's cost curves follow from its production function. They determine how much it will produce at any price.
Explicit and implicit costs
Explicit costs are actual payments, such as wages, rent, and materials. Implicit costs are opportunity costs of resources the owner already has, such as the salary an owner gives up to run the business. Accounting profit subtracts only explicit costs; economic profit subtracts both.
Economic profit
If economic profit is zero, the firm earns just enough to cover all its opportunity costs: a normal profit. Positive economic profit means the business earns more than its resources could elsewhere, attracting entry. Negative economic profit means resources would do better elsewhere.
Fixed and variable costs
Fixed costs (FC) do not change with output in the short run: rent, insurance, equipment leases. Variable costs (VC) rise with output: materials, hourly wages, energy. Total cost (TC) is fixed plus variable cost. A firm must pay fixed costs even if it produces nothing.
Average and marginal cost
Average fixed cost (FC/Q) falls as output rises, spreading overheads. Average variable cost (VC/Q) and average total cost (TC/Q) are typically U-shaped. Marginal cost (MC) is the extra cost of one more unit. Because of diminishing returns, marginal cost eventually rises.
The MC-ATC relationship
Marginal cost crosses average total cost at its lowest point. If the next unit costs less than the average, the average falls; if it costs more, the average rises. It is like grades: a score below your average pulls it down, one above pulls it up.
Worked example
A firm has fixed cost 100. Variable cost: 1 unit, 50; 2 units, 90; 3 units, 140; 4 units, 200. Total cost: 150, 190, 240, 300. ATC: 150, 95, 80, 75. Marginal cost: 50, 40, 50, 60. MC first falls, then rises; ATC keeps falling while MC is below it.
Long-run costs and economies of scale
In the long run, firms choose their scale. The long-run average cost curve shows the lowest cost per unit at each output. Economies of scale (falling long-run average cost) come from specialisation, bulk buying, and spreading large fixed costs. Diseconomies of scale arise when firms get so big that coordination becomes costly.
Sunk costs
A sunk cost has already been paid and cannot be recovered, like non-refundable research spending. Rational decisions ignore sunk costs and look only at future costs and benefits. Continuing a failing project because 'we have spent so much already' is the sunk cost fallacy.
Key takeaways
Economic profit subtracts explicit and implicit costs; zero economic profit is normal profit. Fixed costs do not vary with output in the short run; variable costs do. Average total cost is U-shaped, and marginal cost crosses it at its minimum. Economies of scale lower long-run average cost; diseconomies raise it. Sunk costs should not affect decisions.
Flashcard
Actual payments
Check your understanding
An entrepreneur earns 80,000 dollars in accounting profit but gave up a 90,000-dollar salary. Her economic profit is: