Principles of Economics
SBEQ / SBEC 1842
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
The Costs of Production
PowerPoint Slides prepared by:
Andreea CHIRITESCU
Eastern Illinois University
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are Costs?
Total revenue
Amount a firm receives for the sale of its
output
Total cost
Market value of the inputs a firm uses in
production
Profit
Total revenue minus total cost
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are Costs?
Costs as opportunity costs
The cost of something is what you give up
to get it
Firms cost of production
Include all the opportunity costs of making
its output of goods and services
Explicit costs
Implicit costs
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
What are Costs?
The cost of 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
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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.
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Production and Costs
Production function
Relationship between
Quantity of inputs used to make a good
And the quantity of output of that good
Gets flatter as production rises
Marginal product
Increase in output that arises from an
additional unit of input
Slope of the production function
2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Production and Costs
Diminishing marginal product
Marginal product of an input declines as
the quantity of the input increases
Total-cost curve
Relationship between quantity produced
and total costs
Gets steeper as the amount produced
rises
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10
Table 1
A Production Function and Total Cost: Carolines Cookie Factory
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11
Figure 2
Carolines Production Function and Total-Cost Curve
Quantity
of Output
(cookies
per hour)
Total
Cost
(a) Production function
Production
function
160
$90
70
120
60
100
50
80
40
60
30
40
20
20
10
1
Total-cost curve
80
140
(b) Total-cost curve
6 Number of
0
Workers Hired
20
40
60
80 100 120 140 160 Quantity
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, which reflects 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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12
Various Measures of Cost
Fixed costs
Costs that do not vary with the quantity of
output produced
Variable costs
Costs that vary with the quantity of output
produced
Total cost
Fixed cost + Variable cost
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13
Various Measures of Cost
Average fixed cost (AFC)
Fixed cost divided by the quantity of
output
Average variable cost (AVC)
Variable cost divided by the quantity of
output
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14
Table 2
The Various Measures of Cost: Conrads Coffee Shop
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15
Figure 3
Conrads Total-Cost Curve
Total Cost
$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
Here the quantity of output
produced (on the
horizontal axis) is from the
first column in Table 2, and
the total cost (on the
vertical axis) is from the
second column. As in
Figure 2, the total-cost
curve gets steeper as the
quantity of output
increases because of
diminishing marginal
product.
Total-cost curve
10
Quantity of Output
(cups of coffee per hour)
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16
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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17
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 = TC / Q
Increase in total cost
From producing an additional unit of output
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18
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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19
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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20
Figure 4
Conrads Average-Cost and Marginal-Cost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0
MC
ATC
AVC
AFC
1
10
Quantity of Output (cups of coffee per hour)
This figure shows the
average total cost (ATC),
average fixed cost (AFC),
average variable cost
(AVC), and marginal cost
(MC) for Conrads Coffee
Shop. All of these curves
are obtained by graphing
the data in Table 2. These
cost curves show three
features that are typical of
many firms: (1) Marginal
cost rises with the quantity
of output. (2) The averagetotal-cost curve is Ushaped. (3) The marginalcost curve crosses the
average-total-cost curve at
the minimum of average
total cost.
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21
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 averagetotal-cost curve at the minimum of
average total cost
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22
Figure 5
Cost Curves for a Typical Firm
Costs
$3.00
2.50
MC
2.00
1.50
ATC
1.00
AVC
0.50
AFC
0
6
8
10
Quantity of Output
12
14
Many firms
experience
increasing
marginal product
before diminishing
marginal product.
As a result, they
have cost curves
shaped like those
in this figure.
Notice that
marginal cost and
average variable
cost fall for a while
before starting to
rise.
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23
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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24
Figure 6
Average Total Cost in the Short and Long Runs
Average
Total
Cost
ATC in short run
with small factory
ATC in short run
with medium factory
ATC in short run
with large factory
ATC in long run
$12,000
10,000
Economies
of scale
0
Constant returns to scale
1,000
1,200
Diseconomies
of scale
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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25
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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26
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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27
Table 3
The Many Types of Cost: A Summary
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28
