Supply and Production Costs

Supply and Production Costs

The Difference between Explicit and Implicit Costs

Economists and accountants view costs from different perspectives. Accountants consider explicit costs while economists consider both explicit and implicit. Distinguishing the difference between the two costs involves understanding their meaning. Explicit costs, as the name suggests, are those that have occurred and an exact figure is known. They are easy to identify considering a transaction has to take place for them to occur. They are considered the incurred costs while doing business, such as wages, medical equipment charges, administration charges and utility bills (Dewar, 2010).

On the other hand, implicit costs are hard to identify because they represent the foregone or opportunity costs of production. Implicit, as the word suggest means something implied or not directly expressed. A hospital foregoes such costs when it uses a resource in one way instead of another. For instance, if a hospital uses certain equipment for treating its patients, it foregoes profits it could earn from leasing the equipment (Dewar, 2010). The profits that could have been earned for leasing represent the implicit costs. Implicit costs are hard to measure because there are no actual payments (Marshall, 2013). Rather, it is usually an estimation of what could have been earned. Therefore, the main difference between explicit and implicit costs is that the former represents the incurred expenses, which are easy to measure while the latter represents those that are foregone. Additionally, explicit costs are used for both accounting and economics purposes while implicit are only utilized in economics when determining the best option to undertake.

Reasoning behind the U-Shaped, Long-run Average Cost Curve

The reasoning behind the U-shaped long-run average cost curve is that every cost of input is variable including physical space. The curve can be viewed as an envelope point for many short-run average total costs (McEachern, 2013). The major reason to its shape is the law of returns to scale. The negatively sloping parts of the long-run average cost curve represents economies of scale, as well as increasing returns to scale. On the other hand, the positively sloping part represents the decreasing returns to scale or dis-economies of scale (McEachern, 2013). The economies of scale mean that the hospital’s average costs fall when it becomes larger due to reasons such as specialization. Therefore, as the hospital receives more economies of scale, the long-run average cost curve shifts downwards due to reduced costs. When dis-economies of scale are incurred, it means the average cost of production goes up, which shifts the curve upwards. Its position is affected by several factors in the long-term that include all the input prices, case-mix of patients and quality (Marshall, 2013).

Law of Diminishing Marginal Returns

When an additional unit of production is added, it is assumed that it will increase marginal returns. Marginal returns refer to the additional output achieved with the increase of a single unit of production while the rest remain constant. As a firm continues to increase variable costs, it becomes more efficient, and work can be done faster and better since different employees can focus on one area of production while the rest take care of another. For instance, if one physician in a hospital attends to ten patients alone, when one is added, both could attend to 24 of them. This means the physician will increase output by 14 units, which represents the marginal returns. However, continued additional of the employees or other variable inputs does not always mean additional marginal returns.

In the above example, if more physicians are added to attend to the patients, it will reach a point where the fixed inputs cannot handle a higher capacity. Therefore, some physicians might remain idle for some time. In this case, the addition of an employee would mean low marginal returns because output will not change. The amount of patients each physician will attend to reduces, which bring about the diminishing marginal returns. This happens in the short-term when some inputs are fixed. In order to overcome such diminishing marginal returns, hospitals will have to expand their physical capacity to allow more patients, which will mean more output. Therefore, the law of diminishing marginal returns means the reduction in output per employee as the variable inputs are increased while fixed inputs remain constant (Dewar, 2010).

Economies and Dis-economies of Scale

Economies of scale refer to the added advantage of increasing in size, which is achieved through the synergetic effect. However, an increase in output after expansion does not always mean economies of scale. Rather, economies of scale are achieved when the level of input added achieves a higher level of output. For instance, if a firm increases its inputs by 20%, to achieve economies of scale the output has to increase by more than 20%. This can also be explained by a reduction in cost of production as inputs increase. Simply stated, economies of scale also mean greater cost efficiency as inputs increase (Dewar, 2010).

Conversely, when the increase in output is less than the level of input added, it results in dis-economies of scale. In the aforementioned example, if the output increased by just 10% while input was increased by 20%, it would result in dis-economies of scale. This means that instead of achieving higher cost efficiency as the organization increases its input, the average cost of production goes higher.

Table 5 Calculation

Given the following data, calculate the total fixed, total variable, and marginal costs at each level of production.

 

Quantity         Total Cost      Total Fixed    Total Variable      Average          Marginal

Cost                 Cost                Total                Cost

Cost

0                   $100

1                                                                    $20

2                                                                                                                    $30

3                                                                   $100

4                                                                                            $75

 

 

Quantity Total Cost Total Fixed Cost Total Variable Cost Average Total Cost Marginal Cost
0 $100 $100 0 0 0
1 $120 $100 $20 $120 0
2 $150 $100 $50 $75 $30
3 $200 $100 $100 $66.67 $50
4 $300 $100 $200 $75 $100

 

 

References

Dewar, D. M. (2010). Essentials of health economics. Sudbury, Mass: Jones and Bartlett Publishers.

Marshall, A. (2013). Principles of economics. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.

McEachern, W. A. (2013). Microeconomics: A contemporary introduction. New York, N.Y: Cengage Learning.

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