Chapter+13+Emily+K

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How do the different costs of a firm connect to one another?
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Yes, you have reached the notorious chapter - the chapter that contains all the different costs you will ever need to know. You may be wondering now, why care so much about costs? Well, costs are crucial to learning economics because understanding the different costs will help you see why a firm makes certain decisions. To warn you ahead, this chapter may look a little heavy on economic terms (meaning memorization). But don't be scared, because this section really is not nearly as complicated as it seems, if you pay attention. 

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**Total Revenue** Total revenue is the amount a firm receives from selling products. It is not necessarily what the firm gets to keep, though. Revenue refers to the pure income from sales. However, the firm has to consider how much it has spent producing the goods. Total cost is the total amount spent on the production of the output. This must be subtracted from the total revenue in order to find the firm's profit. The profit refers to the money that a firm actually gets to keep. It is what the firm has earned. You can find profit by subtracting total cost from total revenue.
 * Total Cost**
 * Profit**

= Economists See Things Differently =



Explicit Cost vs. Implicit Cost
**Explicit cost** is a cost that requires the firm to pay money. **Implicit cost** is a cost that does not require the firm to give up money, but rather opportunity (like opportunity cost!). Some examples of explicit cost are the money used to pay for workers, machines, and ingredients for the product. Some examples of implicit cost are time and the money that one could have earned by investing rather than starting a business.



Economists Profit vs. Accounting Profit
<span style="font-family: Verdana,Geneva,sans-serif;"> There is a difference between what we commonly call as profit, and what economists call profit. An **economic profit** is the amount of money left over when implicit cost and explicit cost are subtracted from total revenue. On the other hand, an **accounting profit** is simply the total revenue minus total explicit cost.

= Relationship Between Cost and Production = <span style="font-family: Verdana,Geneva,sans-serif;">The **diminishing marginal product** is a property that states that the marginal product of an input decreases ans the quantity input increases. However, this isn't true for every level of production. In fact, at first, every extra input added may produce more marginally, resulting in an increasing marginal product. Sooner or later at higher levels of production, however, every increase in input will lead to a decrease in marginal product. This is because if there are too many inputs trying to work together to produce, they may get in each others' way and result in inefficiency. It is very important that you fully understand this concept. Later, you will see that everything connects back to diminishing marginal product.

<span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">Costs, Costs, Costs...
<span style="font-family: Verdana,Geneva,sans-serif;"> In this chapter, you will see that there are a LOT of different costs, all of which you must know by heart, in order to understand oncoming chapters. Although it may seem overwhelming at first, if you spend just a little bit of time, they will be easy to memorize. Fixed costs are costs that never change. A firm will <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">always have fixed cost even if production is zero <span style="font-family: Verdana,Geneva,sans-serif;">. However, it is crucial that you understand that fixed cost only exists in the short run. In the long run, everything becomes variable cost. This is because in the long run, you can change anything and potentially everything with your firm - buying a new machine, expanding the factory, or even shrinking the factory. So fixed cost stays still in the short run, and disappears in the long run. Variable costs are the costs that come with the actual production of a good. This cost <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">varies according to the quantity of output produced <span style="font-family: Verdana,Geneva,sans-serif;">. The more produced, the higher the variable cost will be. Total cost is literally the <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">total of both fixed and variable costs <span style="font-family: Verdana,Geneva,sans-serif;">. This should be very simple to remember. But because fixed cost disappears in the long run, total cost becomes just variable cost in the long run. Marginal cost is the <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">increase in total cost that comes from one extra unit of production <span style="font-family: Verdana,Geneva,sans-serif;">. So for example, it could be the difference between the cost of producing three units and the cost of producing four. You can calculate marginal cost by dividing the difference in total cost by the difference in quantity. Marginal cost increases in the end, as quantity increases. This is due to diminishing marginal product, which basically says that it costs more and more to produce one marginal product. Average fixed cost is easy, because all you need to do to calculate it is divide fixed cost by quantity produced. Average variable cost is variable cost divided by quantity produced. Average total cost is total cost divided by quantity produced.
 * Fixed costs**
 * Variable costs**
 * Total cost**
 * Marginal cost**
 * Average fixed cost**
 * Average variable cost**
 * Average total cost**

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=<span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">The Graph That Holds Them All =

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<span style="font-family: Verdana,Geneva,sans-serif;">This graph contains all the different costs that you will need to know for this chapter. Notice how the shapes and positions of the costs are all different? You will need to know why and how these cost curves look like what they do.

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<span style="font-family: Verdana,Geneva,sans-serif; font-size: 120%;">First <span style="font-family: Verdana,Geneva,sans-serif;">, let's talk about the <span style="font-family: Verdana,Geneva,sans-serif; font-size: 130%;">average fixed cost <span style="font-family: Verdana,Geneva,sans-serif;">, because that's easy. You know fixed cost stays the same all the time. So average fixed cost (fixed cost divided by quantity of output) would reduce with increasing quantity of output because it is getting divided by a larger and larger number as quantity increases. Thus, the <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">average fixed cost graph slopes downward <span style="font-family: Verdana,Geneva,sans-serif;">. ======

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<span style="font-family: Verdana,Geneva,sans-serif;"> <span style="font-family: Verdana,Geneva,sans-serif; font-size: 120%;">Secondly <span style="font-family: Verdana,Geneva,sans-serif;">, there is the <span style="font-family: Verdana,Geneva,sans-serif; font-size: 130%;">average total cost <span style="font-family: Verdana,Geneva,sans-serif;">. It makes a U-shape, because as you learned, the cost of producing decreases for the first few units but <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">eventually increases due to diminishing marginal product <span style="font-family: Verdana,Geneva,sans-serif;">. Thus, the average variable cost points upward.

<span style="font-family: Verdana,Geneva,sans-serif; font-size: 120%;">Thirdly <span style="font-family: Verdana,Geneva,sans-serif;">, let's look at the <span style="font-family: Verdana,Geneva,sans-serif; font-size: 130%;">average total cost <span style="font-family: Verdana,Geneva,sans-serif;">. The <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">average total cost curve is higher than both the average fixed cost and the average variable cost curves. <span style="font-family: Verdana,Geneva,sans-serif;"> This is obvious because the total cost is the sum of the fixed cost and the variable cost. Average total cost curve must therefore always be higher than both AVC and AFC. It also makes the U-shape like average variable cost, for the same reason of diminishing marginal product. First, cost seems to decrease with each additional output, but eventually it costs more and more to produce that extra unit of product.

<span style="font-family: Verdana,Geneva,sans-serif; font-size: 120%;">Lastly <span style="font-family: Verdana,Geneva,sans-serif;">, we have the <span style="font-family: Verdana,Geneva,sans-serif; font-size: 130%;">marginal cost curve <span style="font-family: Verdana,Geneva,sans-serif;">. Marginal cost curve also eventually slopes upward because of, again, the property of diminishing marginal product. What is important about the marginal cost curve is that it <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">always intersects average variable cost and average total cost curves at their minimum, <span style="color: #000000; font-family: Verdana,Geneva,sans-serif;">which is called the **efficient scale** <span style="font-family: Verdana,Geneva,sans-serif;">. This happens because when marginal cost is lower than average total cost, the average total cost is falling. Once marginal cost exceeds average total cost, the average total cost is increasing.

= From Short Run to Long Run =

Short Run, Long Run, and Total Cost
<span style="font-family: Verdana,Geneva,sans-serif;">When you make goals for yourself, you make short-term goals (finishing that novel, acing the Econ quiz) and long-term goals (losing weight, going to a good college, becoming a teacher). In Economics, we also think short-term and long-term; just like you won't be able to lose 5kg in a couple of days or become a teacher in a matter of weeks, a firm cannot accomplish immense goals in the short run. In other words, in the short run, with the limited time, there is only a limited number of actions that a firm can take. However, in the long run, there is nothing the firm cannot do, because time is sufficient for the firm to make any changes it wants to. For example, in the long run, a firm may decide to buy more machines, expand the factory, or change the item of production, all of which are impossible in the short run. This brings us to the conclusion that <span style="color: #008000; font-family: Verdana,Geneva,sans-serif;">in the long run, fixed cost disappears - everything becomes variable costs <span style="font-family: Verdana,Geneva,sans-serif;">. This is true, because in the long run, you may decide to cut down on the machines or decrease factory size or build a completely new sector of the firm. Thus, nothing is fixed in the long run because the firm's costs are liable to change. <span style="font-family: Georgia,serif;"> <span style="font-family: Verdana,Geneva,sans-serif;"> You may want to ask - how do you define short run and long run? The answer is that there is no set answer. Economists don't have specific definitions like "short run" implying one month and "long run" implying a year. It all depends on the firm, and the line between the short run and long run is rather vague.

Economies of Scale and Diseconomies of Scale
<span style="font-family: Verdana,Geneva,sans-serif;">There is a last concept that you need to learn in this chapter. The economies of scale and diseconomies of scale describe how costs of firms behave in the long run. First, **economies of scale** is the property where the average total cost falls in the long run as quantity of output increases. Conversely, the **diseconomies of scale** is the property where the average total cost rises in the long run with increasing quantity of output. There is also the **constant returns to scale**. As you may have guessed, in constant returns to scale, the average total cost stays constant in the long run as quantity output increases.

= Conclusion = <span style="font-family: Verdana,Geneva,sans-serif;"> Congratulations. Now you have learned all the costs that you need to know in order to analyze a firm's decision making process. In this chapter you have learned all the different ways to categorize a firm's cost. You've also learned how each of the cost connects to one another. If there is one thing you need to remember from this chapter, though, it would be the concept of diminishing marginal cost. It connects to all the costs and the shape of their curves. The concept will also come in handy later when you learn about the marginal product of factors of production. So, it's really important that you remember these terms and concepts, because the knowledge you have gained here will definitely make you more powerful in the oncoming chapter.



<span style="display: block; font-family: Verdana,Geneva,sans-serif; text-align: center;">Why does the marginal cost curve slope downward? Give a real life example of why this might occur.
Answer: The marginal cost curve slopes downward because marginal cost decreases as quantity increases. The main reason for this phenomenon is the concept of diminishing marginal cost. While the cost might decrease for the additional output of the first few units, eventually the cost increases as quantity of output increases. In real life, the example can be found in a firm that keep adding workers. At first, the additional worker will work efficiently with the first worker, decreasing the cost of production for the firm. However, as more and more workers are added, the efficiency drops. The workers may get in each others way, and the rate of production will decrease. This means that marginal cost will increase, because while the wages of the workers count as variable costs, the rate of production is low.

= =  <span style="font-family: Verdana,Geneva,sans-serif;"> <span style="font-family: Verdana,Geneva,sans-serif;"> **efficient scale:** minimum point of average total cost, where marginal cost curve and average total cost curve intersect <span style="font-family: Verdana,Geneva,sans-serif;"> **diseconomies of scale:** property where the average total cost rises in the long run with increasing quantity of output
 * total revenue:** the amount a firm receives from selling products
 * total cost: t**otal amount spent on the production of the output
 * profit:** total revenue minus total cost
 * explicit costs:** cost that requires the firm to pay money
 * implicit costs:** cost that does not require the firm to give up money, but rather opportunity
 * economic profit:** amount of money left over when implicit cost and explicit cost are subtracted from total revenue
 * accounting profit:** simply the total revenue minus total explicit cost
 * production function:** the relationship between the quantity of input and the quantity of output
 * marginal product:** the increase in output from the production of an additional unit
 * diminishing: marginal product:** a property that states that the marginal product of an input decreases ans the quantity input increases. However, this isn't true for every level of production
 * fixed costs:** costs that never change, regardless of the quantity produced
 * variable costs:** costs that changes with changes in production
 * average total cost:** total cost divided by quantity produced
 * average fixed cost:** fixed cost divided by quantity produced
 * average variable cost:** variable cost divided by quantity produced
 * marginal cost:** <span style="color: #000000; font-family: Verdana,Geneva,sans-serif;">increase in total cost that comes from one extra unit of production
 * economies of scale:** <span style="color: #000000; font-family: Verdana,Geneva,sans-serif;"> rate of extra taxes paid for each additional dollar of one's income
 * constant returns to scale:** property where average total cost stays constant in the long run as quantity output increases.