Introduction -- Reading Assignment -- Discussion -- Lesson Assignments -- Answer Sheet -- Assignment Submission Directions

Economic Profit vs. Accounting Profit

To understand the difference between economic profit and accounting profit, you need to understand the difference between economic cost and accounting cost. Economic cost includes both implicit costs and explicit costs, but accounting cost is explicit costs only. Economic cost is larger than accounting cost.

Economic profit, then, is the difference between the firm's revenue and economic cost, and accounting profit is the difference between the firm's revenue and accounting cost. Therefore, economic profit is lower than accounting profit because implicit cost is included in the firm's total cost.

Short-Run vs. Long-Run Decisions

In economics, the firm is operating in the short run when at least one factor of production, such as the facility, is fixed. The firm operates in the long run when all factors of production are flexible. In other words, if a firm already has a production facility, the decision of how much to produce is a short-run decision. If a firm does not have any production facilities, the decisions of whether to produce or not, and how much to produce are long-run decisions.

Production and Cost in the Short Run

As mentioned above, the short run is when one of the factors of production is fixed. Usually, this factor of production is the firm's production facility. Think of a car wash business. The manager employs some workers (the flexible factor of production) to operate the already existing number of car washes, or equipment (the fixed factor of production). The graph below shows the number of clean cars the facility produces a day, given a fixed number of car washes and different number of workers:

Notice that with machines and five workers, total product is 20 clean cars. If the manager hires 5 more workers, total product increases by 12 clean cars. If the manager hires 5 more workers, total product increases by 6 clean cars. After this, five more workers increase total product by only 2 clean cars. In other words, the marginal product of labor of the 1st five workers is 20 clean cars, of the 2nd five workers is 12 clean cars, of the 3rd five workers is 6 clean cars, and of the 4th five workers, the marginal product of labor is 2 clean cars. Notice that we are assuming the number of car wash equipment constant.

Short-Run Total Cost (STC) and Short-Run Marginal Cost (SMC)

All the fixed costs and variable costs together make up the short-run total cost. In our example, the fixed cost is the cost of the car washes the plant installs, and the variable cost is the cost of workers the manager hires.

When producing one more unit of output in the short run, the change in production costs, or the STC, is the short-run marginal cost. Since fixed production costs do not change, we can say

SMC = (change in variable cost) / (change in output)

In the car wash example, let's assume that the cost of a worker is $20.00 a day, and the cost of the car wash equipment is $300.00 a day. If there is only one machine in the facility, the production costs of the car wash business are as follows:

Short-Run Average Cost Curves

There are three types of short-run average costs: average fixed cost (AFC), short-run average variable cost (SAVC), and short-run average total cost (SATC). The following table shows the average costs for our car wash example.

• AFC = (fixed cost) / (quantity produced)
• SAVC = (total variable cost) / (quantity produced)
• SATC = (total cost) / (quantity produced), or SATC = AFC + SAVC

Look at Figure 8.3 on page 170 in your textbook. When looking at a graph of short-run average costs, you should notice two things about the cost curves:

• The difference between SATC and SAVC is AFC. The vertical distance between SATC and SAVC is AFC.
• SATC is U-shaped (p. 170 of your textbook and the Active CD-ROM Chapter 8 explain the shape of this curve).

The Relationship Between Marginal and Average Costs

There are three basic truths about marginal and average costs:

• If marginal cost is less than average cost, average cost is decreasing.
• If marginal cost is greater than average cost, average cost is rising.
• If marginal cost equals average cost, average cost is at its minimum.

See page 171 in your textbook for additional examples.

Production and Cost in the Long Run

Unlike the short run, all factors of production may vary in the long run. As a result, there are no diminishing returns in the long run because we do not have to assume there are any fixed inputs, or fixed costs.

Since there are no fixed costs, all the variable costs make up the long-run total cost. Using the long-run total cost and the quantity of output, we can determine the long-run average cost of production (LAC):

LAC = (long-run total cost) / (quantity of output produced)

The Long-Run Average Cost Curve

The actual LAC curve tends to be L-shaped. The beginning of the curve where quantities are smaller has a negative slope, but the latter part of the curve where quantities are larger has a positive slope (see pg. 177 in your textbook for more details). There are a few reasons for the negative slope:

• indivisible inputs
  In some cases, inputs cannot be divisible. If, for example, a firm wants to cut back production by a certain percentage, it cannot scale down the amount of inputs by the same percentage. As a result, the long-run average cost increases when the firm cuts down production (i.e., the LAC curve slopes downward). Note that the exact opposite happens when a firm wishes to increase production.
• labor specialization
  In many cases, labor is not very productive at a low level of production (small scale). When a firm reduces output, it uses fewer workers. As a result of the low productivity of the remaining workers, the long-run average cost increases. Thus, the LAC curve slopes downward.
• economies of scale
  Scaling up the firm is usually associated with cost savings. The per unit cost of production decreases when the scale of production increases.

The LAC curve becomes horizontal at the point of minimum efficient scale (MES). This is the point where there are no more economies of scale--that is, increasing output no longer decreases the long-run average cost.

After MES, costs and outputs begin to increase relative to one another as a result of diseconomies of scale, and the LAC curve will slope upward. There are two reasons for diseconomies of scale and the positive slope of the LAC curve: problems with organization and higher costs of factors of production.

It would be helpful to remember the following points:

• If a firm starts below MES, increasing output decreases LAC. In this case, we say the firm experiences economies of scale.
• If a firm starts above MES, increasing output increases LAC. In this case, we say the firm experiences diseconomies of scale.

Back

Continue

Course Home | Intro and Lessons | Final Exam | Policies and Forms
University College at TTU | Email Us