The AFC, AVC, AC, and MC schedules of Table 12.1 are graphed in

Figure 12-1.

Note that the values of the MC schedule (from column 8) are plotted

halfway between successive levels of output. Also note that while the

AFC curve falls continuously as output is expanded, the AVC, AC, and

MC curves are U-shaped. The MC curve reaches its lowest point at a low-

er level of output than either the AVC curve or the AC curve. Also, the

rising portion of the MC curve intersects the AVC and AC curves at their

lowest points. This will always be the case.

CHAPTER 12: Production Costs 107

Figure 12-1

Note!

The law of diminishing returns is the reason that

the marginal cost curve is U-shaped.

Long-Run Costs

In the long run, there are no ¬xed factors, and a ¬rm can build a plant of

any size. Once a ¬rm has constructed a particular plant, it operates in the

short run. A plant size can be represented by its short-run average cost

(SAC) curve. Larger plants can be represented by SAC curves, which lie

further to the right. The long-run average cost (LAC) curve shows the

minimum per-unit costs of producing each level of output when any de-

sired size of plant can be built. The LAC curve is thus formed from the

relevant segment of the SAC curves.

Example 12.3

Figure 12-2 shows four hypothetical plant sizes that a ¬rm could build in

the long run. Each plant is shown by a SAC curve. To produce up to 300

108 PRINCIPLES OF ECONOMICS

Figure 12-2

units of output, the ¬rm should build and utilize plant 1 (given by SAC1).

From 300 to 550 units of output, it should build the larger plant given by

SAC2, etc. Note that the ¬rm could produce an output of 400 with plant

1, but only at a higher cost than with plant 2. The irrelevant portions of

the SAC curves are dashed. The remaining (undashed) portions form the

LAC curve. By drawing many more SAC curves, we would get a

smoother LAC curve.

If in the long run we increase all factors used in production by a giv-

en proportion, there are three possible outcomes: (1) output increases in

the same proportion, so that there are constant returns to scale or constant

costs; (2) output increases by a greater proportion, giving increasing re-

turns to scale or decreasing costs; and (3) output increases in a smaller

proportion, giving decreasing returns to scale or increasing costs. In-

creasing returns to scale or economies of mass production may result be-

cause of division of labor and specialization in production. Beyond a cer-

tain size, however, management problems resulting in decreasing returns

to scale may arise.

Remember

The LAC curve derives its shape

from the possible SAC curves that a

¬rm has over ranges of outputs.

CHAPTER 12: Production Costs 109

Example 12.4

The LAC curve of Figure 12-2 at ¬rst shows increasing returns to scale.

Then for a small range of outputs (around 800 units), it shows constant

returns to scale. For larger outputs, we have decreasing returns to scale.

Whether and when this occurs in the real world depends on the ¬rm and

industry under consideration.

True or False Questions

1. Implicit costs are the costs of factors of production owned by the

¬rm.

2. The law of diminishing returns holds in both the short-run and

long-run periods.

3. TFC is constant regardless of the level of ¬rm output.

4. TC is zero when the ¬rm does not produce any output.

5. Decreasing costs refers to the situation wherein output increases

proportionately more than inputs.

Answers: 1. True; 2. False; 3. True; 4. False; 5. True

Solved Problems

Solved Problem 12.1 A ¬rm pays $200,000 in wages, $50,000 in inter-

est on borrowed money capital, and $70,000 for the yearly rental of its

factory building. If the entrepreneur worked for somebody else as a man-

ager she would earn at most $40,000 per year, and if she lent out her mon-

ey capital to somebody else in a similarly risky business, she would at

most receive $10,000 per year. She owns no land or building.

a. Calculate the entrepreneur™s economic pro¬t if she received

$400,000 from selling her year™s output.

b. How much pro¬t is the entrepreneur earning from the point of

view of the person on the street? To what is the difference in the results

due?

c. What would happen if the entrepreneur™s total revenue were

$360,000 instead?

Solution:

a. The explicit costs of this entrepreneur are $320,000 ($200,000 in

wages plus $50,000 in interest plus $70,000 in rents). Her implicit costs

110 PRINCIPLES OF ECONOMICS

are $50,000 ($40,000 in wages in her best alternative employment plus

$10,000 interest on her money capital). Thus, her total costs are $370,000.

Since the total revenue from selling the year™s output is $400,000, she

earns an economic pro¬t of $30,000 for the year.

b. The person on the street would instead say that this entrepreneur™s

pro¬t is $80,000 (the total revenue of $400,000 minus the out-of-pocket

expenditures, or explicit costs, of $320,000). However, $50,000 of this

$80,000 represents the normal return on the entrepreneur™s owned factors

and is appropriately considered a cost by the economist.

c. If the entrepreneur™s total revenue were $360,000, she would earn

less than a normal return on her owned factors (her wage and interest in

alternative employment) and it would be best to eventually go out of busi-

ness and work as a manager for and lend her money to someone else. This

shows that implicit costs are part of the costs of production because they

must be covered in order for the ¬rm to remain in business and continue

to supply the goods and services it produces.

Solved Problem 12.2

a. Why are the MC, AVC, and AC curves U-shaped?

b. Why does the MC curve intersect the AVC and AC curves at their

respective lowest points?

Solution:

a. As we start using variable factors with some ¬xed factors, we may

¬rst obtain increasing returns, but eventually diminishing returns will set

in. As a result, the MC, AVC, and AC curves ¬rst fall but eventually rise,

giving them their U shapes.

b. The MC curve always intersects the AVC and AC curves at their

respective lowest points because as long as MC is below AC, it pulls the

average down. When the MC is above AC, it pulls the average up. Only

when MC equals AC is AC neither falling nor rising (i.e., AC is at its low-

est point). This is logical. For example, if your grade on a quiz is lower

than your previous average, your average will fall and vice versa.

Chapter 13

Perfect

Competition

In This Chapter:

” Perfect Competition De¬ned