Chapter 6

The costs of production

Van Tran, Ph.D.

2024

Chapter 6. The cost of production

Content
1. What are costs
2. Production and Costs
3. The Various Measures of Cost
4. Costs in Short and Long Run

Principles of Economics, Van Tran, 2024 2

Chapter 6. The cost of production

References
Mankiw, N.G., 2018, Priciples of economics, Cengate Learning.
Chapter 13

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 Chapter 6. The cost of production @ 1. What are Costs?

1. What are Costs?

• Industrial organization
– The study of how firms’ decisions about prices and
quantities depend on the market conditions they face
• Assumption
– The goal of a firm is to maximize profit
• Profit
– Total revenue minus total cost

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Chapter 6. The cost of production @ 1. What are Costs?

1. What are Costs?

• Total revenue, TR = P × Q
– Amount a firm receives for the sale of its output
– Quantity of output the firm produces times the price at
which it sells its output
• Total cost, TC
– Market value of the inputs a firm uses in production

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Chapter 6. The cost of production @ 1. What are Costs?

1. What are Costs?

• Costs as opportunity costs

– The cost of something is what you give up to get it
• Firm’s cost of production
– Include all the opportunity costs of making its output of
goods and services
– Explicit costs
– Implicit costs

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 Chapter 6. The cost of production @ 1. What are Costs?

1. What are Costs?

• Explicit costs
– Input costs that require an outlay of money by the firm
• Implicit costs
– Input costs that do not require an outlay of money by the
firm
– Ignored by accountants
• Total costs
= Explicit costs + Implicit costs

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Chapter 6. The cost of production @ 1. What are Costs?

1. What are Costs?

• The cost of financial capital as an opportunity cost

– Implicit cost
– Interest income not earned on financial capital
• Owned as saving
• Invested in business
– Not shown as cost by an accountant

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Chapter 6. The cost of production @ 1. What are Costs?

1. What are Costs?

• Economic profit
– Total revenue minus total cost
• Total costs includes both explicit and implicit costs
• Accounting profit
– Total revenue minus total explicit cost
– Usually larger than economic profit

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 Figure 1
Economists versus Accountants

Economists include all opportunity costs when analyzing a firm, whereas accountants
measure only explicit costs. Therefore, economic profit is smaller than accounting profit.

Chapter 6. The cost of production @ 2. Production and costs

2. Production and costs

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Table 1
A Production Function and Total Cost: Grandma’s Farm
Output
(quantity
of grape (cost of farm
picked per Cost of + cost of
hour) Farm workers)

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 Figure 2
Grandma’s Production Function
Quantity
(a) Production function
of Output
Production
160 function
140
120
100
80
60
40
20

0 1 2 3 4 5 6 Number of
Workers Hired
The production function in panel (a) shows the relationship between the number of workers hired and the quantity of
output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1, and
the quantity of output produced (on the vertical axis) is from the second column. The production function gets flatter
as the number of workers increases, reflecting diminishing marginal product.

Figure 3
A Typical Production Function and Marginal Product
Output
(quantity
of grape
picked per Q = f (L)
hour)

Number of
Marginal Workers Hired
Product of
Labour

Number of
MPL Workers Hired

Chapter 6. The cost of production @ 2. Production and costs

2. Production and costs

• Diminishing marginal product

– Marginal product of an input declines as the quantity of the
input increases
– Production function gets flatter as more inputs are being
used
– The slope of the production function decreases

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 Chapter 6. The cost of production @ 2. Production and costs

2. Production and costs

• Total-cost curve
– Relationship between quantity produced and total costs
TC = PL  L + PK  K
– Gets steeper as the amount produced rises
• Diminishing marginal product
• Producing one additional unit of output requires a lot of
additional units of inputs
– Very costly

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Table 2
A Production Function and Total Cost: Grandma’s Farm
Output
(quantity
of grape (cost of farm
picked per Cost of + cost of
hour) Farm workers)

Figure 2
Grandma’s Production Function and Total-Cost Curve
Quantity Total
(a) Production function (b) Total-cost curve
of Output Cost
(cookies Production $90
per hour) Total-cost curve
160 function 80
140 70
120 60
100 50
80 40
60 30
40 20
20 10

0 1 2 3 4 6 Number of
5 0 20 40 60 80 100 120 140 160 Quantity
Workers Hired of Output
The production function in panel (a) shows the relationship between the number of workers hired and the quantity of
output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1, and
the quantity of output produced (on the vertical axis) is from the second column. The production function gets flatter
as the number of workers increases, reflecting diminishing marginal product. The total-cost curve in panel (b) shows
the relationship between the quantity of output produced and total cost of production. Here the quantity of output
produced (on the horizontal axis) is from the second column in Table 1, and the total cost (on the vertical axis) is
from the sixth column. The total-cost curve gets steeper as the quantity of output increases because of diminishing
marginal product.

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 Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

TC = PL  L + PK  K

• Fixed costs (FC)

– Costs that do not vary with the quantity of output produced
• Variable costs (VC)
– Costs that vary with the quantity of output produced
• Total cost (TC)
TC = Fixed cost + Variable cost

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Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

• Average fixed cost, AFC
– Fixed cost divided by the quantity of output

AFC = FC / Q

• Average variable cost, AVC

– Variable cost divided by the quantity of output

AVC = VC / Q

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Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

• Average total cost, ATC
– Total cost divided by the quantity of output
– Average total cost = Total cost / Quantity

ATC = TC / Q

– Cost of a typical unit of output

• If total cost is divided evenly over all the units produced

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 Table 3
A Production Function and Total Cost: Grandma’s Farm
Output
(quantity
of grape (cost of farm
picked per Cost of + cost of
hour) Farm workers)

Calculate MC, AFC, AVC, ATC ?

Table 4
The Various Measures of Cost: Conrad’s Coffee Shop

Figure 3
Conrad’s Total-Cost Curve

Total Cost
Here the quantity of output
$15.00 produced (on the
14.00 Total-cost curve horizontal axis) is from the
13.00
first column in Table 2, and
12.00
11.00 the total cost (on the
10.00 vertical axis) is from the
9.00 second column. As in
8.00 Figure 2, the total-cost
7.00
curve gets steeper as the
6.00
5.00 quantity of output
4.00 increases because of
3.00 diminishing marginal
2.00 product.
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity of Output

(cups of coffee per hour)

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 Figure 4
Cost Curves for a Typical Firm

Total cost
TC = PLL + PKK

VC = PLL

FC = PKK

Output quanity

Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

• Marginal cost (MC)
– Increase in total cost arising from an extra unit of
production
– Marginal cost = Change in total cost / Change in quantity
MC = ΔTC / ΔQ
– Increase in total cost
• From producing an additional unit of output

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Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

• Rising marginal cost curve
– Because of diminishing marginal product
• U-shaped average total cost curve
– ATC = AVC + AFC
– AFC – always declines as output rises
– AVC – typically rises as output increases
• Because of diminishing marginal product
– The bottom of the U-shape
• At quantity that minimizes average total cost

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 Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

• Efficient scale
– Quantity of output that minimizes ATC

• Relationship between MC and ATC

– When MC < ATC: average total cost is falling
– When MC > ATC: average total cost is rising
– The marginal-cost curve crosses the average-total-cost
curve at its minimum

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Figure 5
Conrad’s Average-Cost and Marginal-Cost Curves
Costs
This figure shows the average
$3.50 total cost (ATC), average fixed
3.25 cost (AFC), average variable
3.00 cost (AVC), and marginal cost
2.75
(MC) for Conrad’s Coffee
2.50
2.25
MC Shop. All of these curves are
2.00 obtained by graphing the data
1.75 ATC in Table 2. These cost curves
1.50 show three features that are
1.25
1.00 AVC typical of many firms: (1)
0.75 Marginal cost rises with the
0.50 quantity of output. (2) The
0.25 AFC average-total-cost curve is U-
0 1 2 3 4 5 6 7 8 9 10
shaped. (3) The marginal-cost
curve crosses the average-
Quantity of Output (cups of coffee per hour) total-cost curve at the
minimum of average total cost.

Chapter 6. The cost of production @ 3. The Various Measures of Cost

3. The various measures of cost

• Typical cost curves
– Marginal cost eventually rises with the quantity of output
– Average-total-cost curve is U-shaped
– Marginal-cost curve crosses the average-total-cost curve at
the minimum of average total cost

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 Figure 6
Average Cost Curves for a Typical Firm

Costs Many firms

$3.00 experience
increasing marginal
2.50 product before
MC
diminishing
2.00 marginal product.
As a result, they
have cost curves
1.50 ATC shaped like those
in this figure. Notice
1.00 AVC that marginal cost
and average
0.50 variable cost fall for
AFC a while before
starting to rise.
0 2 4 6 8 10 12 14
Quantity of Output

Chapter 6. The cost of production @ 4. Costs in Short and Long Run

4. Costs in Short and Long Run

• Many decisions
– Fixed in the short run
– Variable in the long run
• Firms – greater flexibility in the long-run
– Long-run cost curves
• Differ from short-run cost curves
• Much flatter than short-run cost curves
– Short-run cost curves
• Lie on or above the long-run cost curves

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Figure 7
Average Total Cost in the Short and Long Runs
Average ATC in short run
ATC in short run ATC in short run
Total with medium factory
with small factory with large factory
Cost
ATC in long run

$12,000

10,000
Diseconomies
Economies
Constant returns to scale of scale
of scale

0 1,000 1,200 Quantity of Cars per Day

Because fixed costs are variable in the long run, the average-total-cost curve in the
short run differs from the average-total-cost curve in the long run.

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 Chapter 6. The cost of production @ 4. Costs in Short and Long Run

4. Costs in Short and Long Run

• Economies of scale
– Long-run average total cost falls as the quantity of output
increases
– Increasing specialization among workers

• Constant returns to scale

– Long-run average total cost stays the same as the quantity
of output changes

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Chapter 6. The cost of production @ 4. Costs in Short and Long Run

4. Costs in Short and Long Run

• Diseconomies of scale
– Long-run average total cost rises as the quantity of output
increases
– Increasing coordination problems

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Table 4
The Many Types of Cost: A Summary

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