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Chapter 9
This chapter introduces many of the fundamental concepts in economics and covers a wide variety of topics. It
begins with the definition of economics; then the economic perspective is discussed. After that, the discussion
moves to the development of economic theory. The individual’s and society’s economizing problems are examined
using a budget line and production possibilities curves where economic growth is addressed. The Last Word deals
with common mistakes students make when thinking about economics.

Businesses and the Costs

of Production

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Economic Costs LO 1 Economic costs are the payments a firm must make, or incomes it must provide, to resource suppliers to attract those
resources away from their best alternative production opportunities. Payments may be explicit or implicit. (Recall the
opportunity-cost concept)
•Economic cost you
pay
eor
it Explicit costs are payments to non-owners for resources they supply. In the textbook’s T-shirt example, this would include the
cost of the T-shirts, clerk’s salary, and utilities, for a total of $63,000.
•The payment that must be made to obtain and
own Implicit costs are the money payments the self‑employed resources could have earned in their best alternative employment. In
retain the services of a resource
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say
the textbook’s T-shirt example, this would include forgone interest, forgone rent, forgone wages, and forgone entrepreneurial
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Accounting Profit and Normal Profit Economic or pure profits are total revenue less all costs (explicit and implicit including a normal profit). Economic profit

um
LO 1
will always be smaller than accounting profit, which excludes implicit costs. The normal profit is the return to the
entrepreneur and is the amount of money required by the entrepreneur to stay in that market.
𝐀𝐜𝐜𝐨𝐮𝐧𝐭𝐢𝐧𝐠 𝐩𝐫𝐨𝐟𝐢𝐭 = Revenue − explicit costs
𝐄𝐜𝐨𝐧𝐨𝐦𝐢𝐜 𝐩𝐫𝐨𝐟𝐢𝐭 = Accounting profit − implicit costs
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 Economic Profit versus Accounting

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Economic profit versus accounting profit. Economic profit is equal to total revenue less economic costs. Economic costs are
Profit LO 1 the sum of explicit and implicit costs and includes a normal profit to the entrepreneur. Accounting profit is equal to total
revenue less accounting (explicit) costs.

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mm Short Run and Long Run LO 2

Short run capita

The short run is a period of time that is too brief for a firm to alter its plant capacity, but can change output somewhat by
increasing or decreasing its variable inputs. The long run is a period of time that is long enough for the firm to adjust the
plant size as well as enter or leave the industry. All inputs are variable in the long run. One of the primary characteristics of
axed the long run is that it is enough time for firms to enter and exit the industry. Notice that the actual time associated with the
short and long run will differ among industries. Light industry and retailing (small t-shirt manufacturer) can adjust quickly
• Some variable inputs compared to heavy industry (an oil company) which may take years to change capacity.
• Fixed plant
Long run
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• All inputs are variable
• Firms can adjust plant size as well as
enter and exit industry

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Short Run Production Relationships LO 2

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The production relationships reflect how labor and output are related in the short run. The total product is the total quantity that is
produced. Marginal product (MP) is the amount that total product changes when labor changes by one unit. It reflects the change
in output when one more unit of labor is hired. Average product is the output that is produced per unit of labor.
Total product (TP)
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As successive increments of a variable resource are added to a fixed resource, the marginal product of the variable resource will
decrease. Essentially the fixed plant gets overcrowded with variable resources. If we focus on labor being the variable resource,
Law of Diminishing Returns 1 of 3 when there isn’t any labor, then the plant is underused because none of the machinery is being used, etc. When hiring one unit of
LO 2 labor, the machinery is still underused – there is machinery that is often idle as that one unit of labor has to perform all of the tasks.
As the firm continues to hire more and more labor, the TP is rising by increasing amounts because the machinery is being used
•Law of diminishing returns more and more to its capacity. However, at some point there will be so much labor that the fixed resources are over utilized and the
individuals will have to wait to use the necessary equipment. This is where we might see diminishing marginal returns – where the
• Resources are of equal quality TP is still increasing when hiring one more unit of labor, but it doesn’t increase as much as it did with the previous unit of labor.
• Technology is fixed proamion aim The table on the next slide presents a numerical example of the law of diminishing returns.
• Variable resources are added to fixed
resources
• At some point, marginal product will fall
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Mr The Law of Diminishing Returns 2 of 3

LO 2

e returns. Then TP continues to increase, but by smaller and smaller amounts. This is called diminishing a za
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You can see that at first TP is rising at an increasing rate, so MP is positive and getting larger. This is called increasing marginal
marginal returns. TP is still
positive and rising but it is now rising at a slower rate. MP measures the rate of change of TP. So, when the firm has hired so many
workers that it is overcrowded and impedes the workers’ abilities to produce, the TP starts to fall and MP becomes negative. AP
starts out increasing due to increasing marginal returns. Then, at some point, AP will begin to fall as a result of the effects of
diminishing marginal returns. It takes AP longer to reflect the diminishing marginal returns.

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The Law of Diminishing Returns 3 of 3 The law of diminishing returns states that as successive amounts of a variable resource (labor) are added to fixed amounts of other
resources (land or capital), beyond some point the extra, or marginal, product that can be attributed to each additional unit of the
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LO 2
variable resource will decline. In other words, as more of the variable inputs are added, the total product (output) that results will
eventually increase by diminishing amounts, reach a maximum, and then decline.
Marginal product is the change in total product associated with each new unit of labor. Average product is simply output per labor
unit. Note that marginal product intersects average product at maximum average product.
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 Short Run Production Costs LO 3
Fixed, variable, and total costs are the short‑run classifications of costs. In the short run, costs can be variable or fixed. Fixed cost
examples: rental payments, insurance premiums, interest payments. Variable cost examples: payments for materials, fuel, power,
•Fixed costs (TFC) transportation services, labor. Total cost is the sum of total fixed and total variable costs at each level of output.
• Costs that do not vary with output
•Variable costs (TVC) rue
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• Costs that do vary with output
•Total cost (TC)
• Sum of TFC and TVC
• TC = TFC + TVC

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or
Short Run Cost Curves LO 3
Total fixed cost (TFC) is independent of the level of output. Total cost is the sum of fixed cost and variable cost. Total variable cost
(TVC) changes with output.
Since the only thing that differentiates the TC and TVC is the constant fixed costs, the TC and TVC look very similar and are parallel to
each other. The total cost (TC) at any output is the vertical sum of the fixed cost and variable cost at that output.

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Per-Unit, or Average, Costs LO 3

These per-unit costs are useful in making comparisons to product price. Average fixed costs reflect the fixed costs per unit
produced whereas the average variable costs reflect the variable costs per unit produced. The average total costs can also be found
TFC by adding the AFC and AVC. Marginal costs play an extremely important role in the firm’s decision-making about how much they will
Average fixed cost: AFC =
Q produce. Marginal costs reflect the additional cost associated with producing one more unit of output. MC tells a firm how much it
will cost to increase output by 1 more unit. Marginal cost essentially measures the rate of change in the total costs.
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©McGraw-Hill Education.

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Short Run Cost Schedules LO 3

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This table shows total costs on the left and per-unit costs on the right for an individual firm in the short run. We know this is the
short run because there are fixed costs.
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Average Cost Curves LO 3 AFC falls as a given amount of fixed costs is apportioned over a larger and larger output. AVC initially falls because of increasing

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marginal returns but then rises because of diminishing marginal returns. Average total cost (ATC) is the vertical sum of average
variable cost (AVC) and average fixed cost (AFC). The only difference between the ATC and AVC is the AFC (remember ATC = AFC +
AVC or AFC = ATC - AVC), so the vertical distance between the ATC and AVC is the AFC. You want to get used to measuring AFC in
this way because at some point the AFC will no longer be included in the graphs.

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Marginal Cost LO 3 Shifts in the curves will occur if either resource prices or technology change. For example, if fixed costs increase, both AFC and
ATC shift up. If labor costs (or some other variable input costs) rise, then the AVC, ATC, and MC would shift up. This graph shows
the relationship of the marginal-cost curve to the average-total-cost and average-variable-cost curves. The marginal-cost (MC)
curve cuts through the average-total-cost (ATC) curve and the average-variable-cost (AVC) curve at their minimum points. When
MC is below average total cost, ATC falls; when MC is above average total cost, ATC rises. Similarly, when MC is below average
variable cost, AVC falls; when MC is above average variable cost, AVC rises. Marginal decisions are very important in determining
unit profit levels. In order to make marginal decisions, marginal revenue and marginal cost are compared. Marginal cost is a reflection of
conc marginal product and diminishing returns. When diminishing returns begin, the marginal cost will begin its rise.

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 The marginal-cost (MC) curve and the average-variable-cost (AVC) curve are mirror images of the marginal-product (MP) and
marginproanaineeraaina average-product (AP) curves. Assuming that labor is the only variable input and that its price (the wage rate) is constant, then when
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range.infoas when AP is falling, AVC is rising.
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Long Run Production Costs LO 4
An industry and the individual firms that are in it can make all desired resource adjustments in the long run. All resources are
nine variable, therefore all costs are variable in this time period.

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Firm Size and Costs LO 4 Any number of short-run optimum size cost curves can be constructed. The long-run average-total-cost curve is made up of
segments of the short-run cost curves (ATC-1, ATC-2, etc.) of the various-size plants from which the firm might choose. The long
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labor inner run cost curve is also called the planning curve. Each point on the bumpy planning curve shows the lowest unit cost attainable for
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©McGraw-Hill Education.
 The Long Run Cost Curve LO 4
©McGraw-Hill Education.
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©McGraw-Hill Education.
Diseconomies of Scale LO 4
•Diseconomies of scale
• Control and coordination problems
• Communication problems
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The long-run ATC curve just “envelopes” the short run ATCs. If the number of possible plant sizes is very large, the long-run
average-total-cost curve approximates a smooth curve. Economies of scale, followed by diseconomies of scale, cause the curve
to be U-shaped.
Economies of scale refers to the idea that, for a time, larger plant sizes will lead to lower unit costs. An increase in inputs where there
are economies of scale will lead to a more than proportionate increase in output. Labor specialization leads to economies of scale
put
because it makes use of special skills; proficiency is gained as the worker concentrates on one task and time is saved. Managerial
specialization leads to economies of scale because managers can manage more workers with no increased cost, and managers can
pureone specialize in their respective area of expertise. Efficient capital leads to economies of scale because high volume production warrants
the expensive large scale equipment. Other factors lead to economies of scale because costs such as design, development, and
advertising are spread out over larger quantities.
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Constant returns to scale will occur when ATC is constant over a variety of plant sizes. When there are constant returns to scale, an
increase in inputs will result in a proportionate increase in output.
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Diseconomies of scale may occur if a firm becomes too large, as illustrated by the rising part of the long run ATC curve. As the firm
expands over time, the expansion may lead to higher average total costs. With diseconomies of scale, an increase in inputs will
cause a less than proportionate increase in output.
Reasons that diseconomies of scale occur include the difficulty in controlling and coordinating large scale operations; large
bureaucracies lead to communication problems; workers may feel alienated and therefore may not work efficiently; and shirking, or
work avoidance, may be easier in a larger firm.
 Minimum Efficient Scale LO 4
Where MES occurs on an industry’s long-run ATC determines if there will be many or few producers and whether they will be large,
•Minimum efficient scale (MES) small, or different sizes. A natural monopoly is a rare situation where economies of scale extend beyond the market size. Therefore,
one large firm can provide the product more cheaply than a multi-firm market.
• Lowest level of output at which long run
average costs are minimized
• Can determine the structure of the
industry
• Natural monopoly
• Long run costs are minimized when only
one firm produces the product

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important
MES and Industry Structure 1 of 3
LO 4
This is a long-run ATC curve showing industries with an extended range of constant returns to scale. These industries will be
populated by firms of many different sizes. Small and large scale producers will coexist and be equally successful. MES occurs at
an output of q1.
Economies Constant returns Diseconomies
of scale to scale of scale
Average total costs

Ones Long-run
ATC

q1 q2
Output

©McGraw-Hill Education.

MES and Industry Structure 2 of 3

LO 4 Industries with economies of scale over a wide range of outputs will lead to a few large scale firms. Small firms cannot realize the
minimum efficient scale and will not be able to compete. The long-run ATC curve is lowest only when there is a large output.

Economies Diseconomies
of scale of scale
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Long-run
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ATC

Output

©McGraw-Hill Education.
 MES and Industry Structure 3 of 3 This is a long-run ATC curve where economies of scale exist, are exhausted quickly, and turn back up substantially. Here minimum
LO 4 efficient scale occurs at a very low level of output. This results in a large number of small producers.

Economies Diseconomies
of scale of scale

large
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number small
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Long-run
ATC

Output

©McGraw-Hill Education.

Applications and Illustrations LO 5 Rising gasoline prices will cause the short-run costs such as AVC, MC, and ATC all to rise for firms that use this type of energy as an
input. As a result, firms like FedEx will see substantial cost increases whereas firms that do not need to transport products physically
will not be affected by the rise in fuel costs.
Rising gasoline prices Start-up firms have been successful by lowering their ATC as they increased output and achieved economies of scale. This spreads
out R&D and advertising costs over a larger number of units. Some examples of these types of firms are Starbucks, Microsoft, and
Successful start-up firms Google.
Verson stamping machine The Verson stamping machine can make as many as 5 million auto parts per year. Though the machine is expensive, $30 million, it
can make parts quickly and cheaply. This machine is only warranted in factories with very large scale production. This would be for
The daily newspaper those companies that can achieve economies of scale by using the low-cost productive machine.
Aircraft and concrete plants Daily newspapers have experienced decreases in advertising revenues, falling subscriptions, and increases in their AFC. Advertising
revenue has shifted to the Internet and daily newspapers may be a thing of the past. If they raise the price of the newspaper, they
will sell fewer papers, but then the AFC rises too.
A commercial aircraft requires large scale production which easily achieves economies of scale and requires few production plants.
Concrete requires small scale production and therefore there are thousands of plants.

©McGraw-Hill Education.

3D Printers and Mass Customization 3D printers are inexpensive so nearly any household or business can afford one. This additive manufacturing method uses metal or
plastic particles that are fused together in the desired shape with a laser. No large factory is needed and no transportation is needed
to transport the finished product.
First industrial revolution began in 1700s
Mass production led to mass affordability
Second industrial revolution began late 1800s
Mass sales were necessary to spread R&D
costs
Third industrial revolution beginning now
Affordable mass customization with zero
transportation costs

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