CHAPTER 13: THE COSTS OF PRODUCTION

13.1 What Are Costs?

Total Revenue, Total Cost, and Profit
- Total revenue: the amount a firm receives for the sale of its output
- Total cost: the market value of the inputs a firm uses in production
- Profit = total revenue - total cost
Costs as Opportunity Costs
- Costs of production include all the opportunity costs of making its output
- Explicit costs: input costs that require an outlay of money by the firm (eg workers’ wages)
- Implicit cost: input costs that do not require an outlay of money by the firm (eg the forgone
income of hte possibility of working another profession)
- Total cost is the sum of explicit and implicit costs
The Cost of Capital as an Opportunity Cost
- An implicit cost of almost every business is the opportunity cost of the financial capital that has
been invested in the business
- Eg: paying $300,000 to buy the business, so loses $15,000 yearly that the $300,000
would have made in interest sitting in the bank
- Could also include loans
Economic Profit versus Accounting Profit
- Economic profit: total revenue minus total costs, including both explicit and implicit costs
- Usually smaller than accounting profit
- Accounting profit: total revenue minus total explicit cost

13.2 Production and Costs

The Production Function
- Production function: the relationship between the quantity of inputs used to make a good and the
quantity of output of that good
- Marginal product: the increase in output that arises from an additional unit of input
- Eg: when workers go from 1 to 2, output goes from 50 to 90: the marginal product of the
second worker is 40
- Diminishing marginal product: the property whereby the marginal product of an input declines as
the quantity of the input increases
From the Production Function to the Total-Cost Revenue
- Total cost curve: relationship between quantity produced (horizontal axis) and total costs (vertical
axis)
- Gets steeper as the amount produced rises, but production function gets flatter as
production rises
13.3 The Various Measures of Cost
Fixed and Variable Costs
- Fixed costs: costs that do not vary with the quantity of output produce (eg rent_
- Variable costs: costs that vary with the quantity of output produced
- Firm’s total costs = fixed + variable costs
Average and Marginal Cost
- Average total cost: total cost divided by the quantity of output
 - Can be expressed as the sum of average fixed cost and average variable cost
- Average fixed cost: fixed cost divided by the quantity of the output
- Average variable cost: variable cost divided by the quantity of output
- Tells us the cost of the typical unit
- Marginal cost: the increase in total cost that arises from an extra unit of production
- Change in total cost/change in quantity
Cost Curves and Their Shapes
- Rising Marginal costs (as Q increases)
- Reflects the property of diminishing marginal product
- U-Shaped Average Total Cost
- Average cost is the sum of average fixed cost and average variable cost
- Fixed cost always declines as output rises, because fixed cost is getting spread
over a larger number of units
- Average variable cost usually rises as output increases because of diminishing
marginal product
- Efficient scale: the quantity of output that minimizes average total cost (bottom of the U)
- Relationship between marginal cost and ATC
- Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising
- Think GPA where marginal cost is grade in next class and ATC is GPA
- The marginal-cost curves crosses the average-total-cost curve at its minimum
- At low levels of output, marginal cost is below average total cost, so average
total cost is falling
- After the two curves cross, marginal cost rises above average total cost
Typical Cost Curves
- All firms do not necessarily exhbitit the diminishing marginal product and rising marginal cost at
all levels of output
- For some firms, marginal product does not start to fall immediately after the first worker
is hired
- The three properties of cost curves above still hold true

13.4 Costs in the Short Run and in the Long Run

The Relationship between Short-Run and Long-Run Average Total Cost
- Many decisions fixed in the short-run but variable in the long run, thus a firm’s long-run cost
curves differ from its short-run cost curves
- Firms have greater flexibility in the long run, thus firm gets to choose which short-run
curve it wants
Economies and Diseconomies of Scale
- Economics of scale: the property whereby long-run average total cost falls as the quantity of
output increases
- Often arise because higher production levels allow specialization among workers
- Diseconomies of scale: the property whereby long-run average total cost rises as the quantity of
output increases
- Arise because of coordination problems
- Constant returns to scale: the property whereby long-run average total cost stays the same as the
quantity of output changes
- Explains why long-run average-total-cost curves are often U-shaped
- Low levels of production, the firm benefits from increases size because it can take
advantage of greater specialization
- At high levels of production, the benefits of specialization have already been realized,
and coordination problems become more severe as the firm grows larger