much more in real terms. Lastly we could argue for a progressive tax, where the rich pay a larger proportion of income. The second concept is that of horizontal equity, where people of similar means pay a similar amount. This again is difficult to measure because the needs of individuals and families differ so much. For examples a young person who earns a certain amount and another one who earns the same, may have different needs because they either have health problems, have to take care of their aging parents or families. Tax Incidence is a term that describes who bears the tax burden and it is not always clear. For example a tax on one luxury good seems vertically equitable, but it may be that the demand for that good will go down and workers who make it will suffer loss of wages and jobs.
Also costs can be divided into fixed and variable costs. Fixed costs do not vary
depending on amount produced. For example a plant is built once and no matter how much the company produces it will still be one plant. On the other hand variable costs vary with amount produced for example the cost of flour will increase if a bakery decides to produce more bread. Another important distinction is between average and marginal costs. Average costs are total costs divided by total output and
decrease with output, but marginal costs are the costs of an additional unit of output and increase with production output. Therefore a firm’s total cost function gets steeper as the quantity produced rises.
13.1. What Are Costs?
The difference in explicit and implicit costs determines the difference in accounting and economic profit.
There is a difference between how an accountant and economist views costs. Firstly, you probably already know that a firm has inputs and outputs. The amount of money customers give it for its outputs or products is called total revenue, the amount the firm pays others for its inputs is called total costs and the difference between the two is called total profit. An accountant will only see total costs as cash transactions that the firm had to make, so simply pay for something with real money, like buy machinery or pay workers’ wages. These are explicit costs. However and economists, who wants to study the firms decision-making process will also consider implicit costs, which are opportunity costs that the firm did not pay for with real currency. For example, an owner of a firm may have a different skill for which he could get a wage, that is an implicit cost and if that wage would be high enough relative to the profits his firm is making he might decide that his firm is too costly (even though profitable) close down and go work for a high salary.
Another cost that the economist would include is the opportunity cost of capital. Every firm has financial investments, if for example, to open a factory 300 000$ were invested and the risk free interest rate is 5%, the investor could have made 15 000$ in that year simply from interest. This 15 000$ is part of costs that an economist would include.
However, if the owner has only 100 000$ and borrows 200 000$ he has to pay 10 000$
a year in interest expense, this is a cost the accountant will take notice of. The economist will still count the whole 15 000$.
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13.2. Production and Costs
The production function depicts the relationship between the number of workers and output, while the total-cost curve depicts the relationship between output and total costs.
Introducing two new curves: production and total-costs. The production function is the relationship between the number of workers (x-axis) and their output (y-axis). The total-cost curve depicts the relationship between the total output (x-axis) and total costs (y-axis). Both of these curves usually have a bended shape. The production function slope is the marginal product, which is the amount by which production increases when an extra labourer is added. So if 2 labourers made 4 products and now the 3rd is hired and they all make 6 products then the marginal product is 2. Most production curves are curved due to diminishing marginal product. This is when an additional worker adds fewer units produced than the previous additional worker. So, if 2 labourers made 4 products and then 3 labourers made 6 products and now 4
labourers make 7 products, the additional marginal products of the 4th worker is 1 unit, while the 3rd brought 2 units, therefore the marginal product is diminishing. As for the total-cost curve same principal applies only in reverse. The more the factory is
producing means that it is more crowded and using all of its capacity, therefore
producing an additional unit will cost more than the previous ones. This means that the total cost curve gets steeper as oppose to the production function, which gets flatter.
13.3. The Various Measures of Costs
Basic explanations of fixed, variable, total, average and marginal costs.
Looking at the total cost curve we can see that it normally starts above zero on the y-axis. The number from which it starts represents the amount of fixed costs the
company has. Fixed costs are costs that do not depend on the quantity produced. While the slope of the curve depends on variable costs, so the costs incurred with each unit.
The firm’s total costs are its fixed costs plus variable costs times the quantity of goods.
Another important measure of costs is average costs, which is total costs divided by the total amount of goods produced. These costs will answer the question of how much on average does one unit cost. We can also calculate average fixed costs, by dividing all the fixed cost by the total amount produces. Even though fixed costs stay fixed with
quantity they are important in calculating the optimal amount to produce. Average variable costs are the total variable cost divided by the total amount. Variable costs are not the same as average variable costs, because and additional unit does not
necessarily have the same costs as the one before. The costs of one additional unit are
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called marginal costs and are counted by dividing the change in total costs by the change in quantity.
All of these costs are represented in curves. Normally the marginal cost curve will be increasing, since normally marginal product decreases. Average total costs are usually U-shaped, because average fixed cost decline with quantity and average variable costs increase with quantity. The bottom of this U-shaped curve is often called the efficiency scale, since it represents the lowest possible average costs for the firm. If adding
another unit of production decreases average total costs than the average total cost curve is falling at that point, if adding an extra unit increases total costs then the curve is sloping upward. This means that where the marginal cost curve is below the average cost curve the ATC is falling and where the MC curve is above the ATC curve there the ATC is moving up. These curves cross at the minimum average total costs. This
represents the usual cost curves, but they are not necessarily so. For example marginal costs may decrease with added units due to economies of scale.
13.4. Costs in the Short Run and in the Long Run
Explanation and relationship between short-run and long-run average cost curves.
A firm cannot adjust the size of its factory and amount of machinery it has on a
day-to-day basis, in other words it cannot change its fixed costs in the short run, but it can do so in the long run. This is why the long run and short run average cost curves differ. The long run average cost curve is a much flatter U-shape and all of the short-run curves lie on top of it. When these long run curves decline with amount produced we say that there are economies of scale, which means that producing larger amounts is more efficient and cheaper than small amounts. If the opposite is true than we say that here are diseconomies of scale and that smaller amounts are optimal. If the long run curve is flat than we say that there are constant economies of scale.