Economics

:
The Costs of Production
 The Costs of Production

The Law of Supply:

Firms are willing to produce and sell a
greater quantity of a good when the
price of the good is high.
This results in a supply curve that
slopes upward.
 The Firm’s Objective

The economic goal of the

firm is to maximize
profits.
A Firm’s Total Revenue and Total Cost

Total Revenue
The amount that the firm receives for the
sale of its output.
Total Cost
The amount that the firm pays to buy
inputs.
 A Firm’s Profit

Profit is the firm’s total revenue minus its

total cost.

Profit = Total revenue - Total cost

 Costs as Opportunity Costs

A firm’s cost of production

includes all the opportunity costs
of making its output of goods and
services.
 Explicit and Implicit Costs

A firm’s cost of production include

explicit costs and implicit costs.
Explicit costs involve a direct money
outlay for factors of production.
Implicit costs do not involve a direct
money outlay.
Economic Profit versus Accounting Profit

Economists measure a firm’s economic profit

as total revenue minus all the opportunity
costs (explicit and implicit).
Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit costs. In other words, they ignore the
implicit costs.
Economic Profit versus Accounting Profit

When total revenue exceeds both

explicit and implicit costs, the firm earns
economic profit.
Economic profit is smaller than
accounting profit.
 Economic Profit versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economi
c profit
Accounting
profit
Implici
Revenue t
costs Revenue
Total
opportunity
costs
Explici Explicit
t costs
costs
 A Production Function and Total Cost

Number of Out put Marginal Cost of Cost of Total Cost of

Workers Product of Fact Wor k er I nput s
Labor ory s

0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
 The Production Function

The production function shows the

relationship between quantity of
inputs used to make a good and the
quantity of output of that good.
 Marginal Product

The marginal product of any input in

the production process is the
increase in the quantity of output
obtained from an additional unit of
that input.
 Marginal Product

Marginal = Additional output

Additional
product input
 Diminishing Marginal Product
Diminishing marginal product is the property
whereby the marginal product of an input
declines as the quantity of the input increases.
Example: As more and more workers are
hired at a firm, each additional worker
contributes less and less to production because
the firm has a limited amount of equipment.
 A Production Function...
Quantity of
Output
(cookies
per
hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0 1 2 3 4 5 Number of Workers Hired
 Diminishing Marginal Product

The slope of the production function

measures the marginal product of
an input, such as a worker.
When the marginal product declines,
the production function becomes
flatter.
From the Production Function to the Total-
Cost Curve

The relationship between the quantity

a firm can produce and its costs
determines pricing decisions.
The total-cost curve shows this
relationship graphically.
 A Production Function and Total Cost

Number of Out put Marginal Cost of Cost of Total Cost of

Workers Product of Fact Wor k er I nput s
Labor ory s

0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80

Hungry Helen’s Cookie Factory

 Total-Cost Curve...
Total
Cos Total-
t curve
cost
$80

70

60

50

40

30

20
0
20 40 60 80 100 120 140 Quantity of Output
10
The Various Measures of Cost

Costs of production may be

divided into fixed costs
and variable costs.
 Fixed and Variable Costs

Fixed costs are those costs that do not

vary with the quantity of output
produced.
Variable costs are those costs that do
change as the firm alters the quantity
of output produced.
 Family of Total Costs

Total Fixed Costs (TFC)

Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
 Family of Total Costs
Quantity Total Fixed Variable
Cost Cost Cost
0 $ 3.00 $3.0 $ 0.00
1 3.30 0 0.30
2 3.80 3.0 0.80
3 4.50 0 1.50
4 5.40 3.00 2.40
5 6.50 3.00 3.50
6 7.80 3.00 4.80
7 9.30 3.00 6.30
8 11.00 3.00 8.00
9 12.90 3.00 9.90
 Average Costs

Average costs can be determined by

dividing the firm’s costs by the
quantity of output produced.
The average cost is the cost of each
typical unit of product.
 Family of Average Costs

Average Fixed Costs (AFC)

Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC
Family of Average Costs

Fixed cost FC
AFC = =
Quantity

Variable
AVC =
cost VC
=
 Family of Average Costs
Quantity AFC AVC ATC
0 — — —
1 $3.00 $0.30 $3.30
2 1.50 0.40 1.90
3 1.00 0.50 1.50
4 0.75 0.60 1.35
5 0.60 0.70 1.30
6 0.50 0.80 1.30
7 0.43 0.90 1.33
8 0.38 1.00 1.38
9 0.33 1.10 1.43
10 0.30 1.20 1.50
 Marginal Cost

Marginal cost (MC) measures the

amount total cost rises when the firm
increases production by one unit.
Marginal cost helps answer the
following question:
How much does it cost to produce an
additional unit of output?
 Marginal Cost

( Change in t ot al
MC=
cost ) ( Change in
quant i t y)

= TC
Q
 Marginal Cost

Quantity Tot Margi Quantity Tot Margi

al nal al nal
Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.3 6 $7.8 $1.30
0 0
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.0 1.70
0
4 5.40 0.90 9 12.9 1.90
0
 Total-Cost Curve...
$16 .0
0 Total-
$14 .0 curve
cost
0
$12 .0
0
Total Cost

$10 .0
0

$8.
00

$6.
00

$4.
$0.
00
00 0 2 4 6 8 10 12

$2. Quantity of Output

00 (glasses of lemonade per hour)
 Average-Cost and Marginal-Cost Curves...
$
3.50

$
3.00

$ M
$
2.50
Cost

2.00
C
s

$
1.50 AT
$
1.00 AVC
$ C
0.50 AFC
$
0.00 0 2 4 6 8 10 12

Quantity of Output
(glasses of lemonade per hour)
Cost Curves and Their Shapes

Marginal cost rises with the

amount of output produced.
This reflects the property of
diminishing marginal product.
 Cost Curves and Their Shapes
$ 2.
50
M
$ 2.
00
C
$ 1.
50
Cost
s

$ 1.
00

$ 0.
50

$ 0.
00 0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
 Cost Curves and Their Shapes

The average total-cost curve is U-shaped.

At very low levels of output average total cost is
high because fixed cost is spread over only a few
units.
Average total cost declines as output increases.
Average total cost starts rising because average
variable cost rises substantially.
 Cost Curves and Their Shapes

The bottom of the U-shape occurs at

the quantity that minimizes average
total cost. This quantity is sometimes
called the efficient scale of the firm.
 Cost Curves and Their Shapes
$
3.50

$
3.00
Total Costs

$
2.50

$ AT
$
1.50
2.00 C
$
1.00

$
0.50
$
0.00 0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Relationship Between Marginal Cost and
Average Total Cost

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.
Relationship Between Marginal Cost and
Average Total Cost

The marginal-cost curve crosses

the average-total-cost curve at
the efficient scale.
Efficient scale is the quantity that
minimizes average total cost.
 Relationship Between Marginal Cost and
Average Total Cost
$
3.50

$
3.00

$ M
$
2.50
Cost

2.00
C
s

$
1.50 AT
$ C
1.00

$
0.50
$ 0.00
0 2 4 6 8 10 12

Quantity of Output
(glasses of lemonade per hour)
The Various Measures of Cost

It is now time to examine the

relationships that exist between the
different measures of cost.
The Various Measures of Cost Big Bob’s Bagel
Bin
Aver age Aver age Aver age
Quant it y Tot Fixe Var Fixe Var Tot Mar
of al d iable d iable al ginal
Bagels Cost Cost Cost Cost Cost Cost Cost
0 $2.00 $2.00 $0.00
1 $3.00 $2.00 $1.00 $2.00 $1.00 $3.00 $1.00
2 $3.80 $2.00 $1.80 $1.00 $0.90 $1.90 $0.80
3 $4.40 $2.00 $2.40 $0.67 $0.80 $1.47 $0.60
4 $4.80 $2.00 $2.80 $0.50 $0.70 $1.20 $0.40
5 $5.20 $2.00 $3.20 $0.40 $0.64 $1.04 $0.40
6 $5.80 $2.00 $3.80 $0.33 $0.63 $0.97 $0.60
7 $6.60 $2.00 $4.60 $0.29 $0.66 $0.94 $0.80
8 $7.60 $2.00 $5.60 $0.25 $0.70 $0.95 $1.00
9 $8.80 $2.00 $6.80 $0.22 $0.76 $0.98 $1.20
10 $10.20 $2.00 $8.20 $0.20 $0.82 $1.02 $1.40
11 $11.80 $2.00 $9.80 $0.18 $0.89 $1.07 $1.60
12 $13.60 $2.00 $11.60 $0.17 $0.97 $1.13 $1.80
13 $15.60 $2.00 $13.60 $0.15 $1.05 $1.20 $2.00
14 $17.80 $2.00 $15.80 $0.14 $1.13 $1.27 $2.20
 Big Bob’s Cost Curves...
$20.00

$18.00

$16.00
Total Cost Curve
$14.00
Total Cost

$12.00

$10.00

$8.00

$6.00

$4.00

$2.00

$0.00
0 2 4 6 8 10 12 14 16
Quantity of Output
( bagels per hour)
 Big Bob’s Cost Curves...
3.5

2.5
MC
2
Costs

1.5
ATC
1
AVC

0.5

AFC
0
0 2 4 6 8 10 12 14 16
Quantity of Output
Three Important Properties of Cost Curves

Marginal cost eventually rises with

the quantity of output.
The average-total-cost curve is U-
shaped.
The marginal-cost curve crosses the
average-total-cost curve at the
minimum of average total cost.
 Costs in the Long Run

For many firms, the division of total costs

between fixed and variable costs depends
on the time horizon being considered.
In the short run some costs are fixed.
In the long run fixed costs become variable
costs.
 Costs in the Long Run

Because many costs are fixed in

the short run but variable in the
long run, a firm’s long-run cost
curves differ from its short-run
cost curves.
Average Total Cost in the Short and Long Runs...

Average ATC in short ATC in short ATC in short

Total run with run with run with
small factory medium factory large factory
Cost

ATC in long run

0 Quantity of
Cars per Day
Economies and Diseconomies of Scale

Economies of scale occur when long-run

average total cost declines as output
increases.
Diseconomies of scale occur when long-
run average total cost rises as output
increases.
Constant returns to scale occur when
long-run average total cost does not vary
as output increases.
 Economies and Diseconomies of Scale
Average
Total

Cost ATC in long run

Economies Constant Returns Diseconomie

of scale to scale s
of scale
0 Quantity of
Cars per Day
 Summary
The goal of firms is to maximize profit,
which equals total revenue minus total
cost.
When analyzing a firm’s behavior, it is
important to include all the opportunity
costs of production.
Some opportunity costs are explicit
while other opportunity costs are
implicit.
 Summary
A firm’s costs reflect its production process.
A typical firm’s production function gets
flatter as the quantity of input increases,
displaying the property of diminishing
marginal product.
A firm’s total costs are divided between
fixed and variable costs. Fixed costs don’t
vary with quantities produced; variable
costs do.
 Summary
Average total cost is total cost divided
by the quantity of output.
Marginal cost is the amount by which
total cost would rise if output were
increased by one unit.
The marginal cost always rises with
the quantity of output.
 Summary
The average-total-cost curve is U-
shaped.
The marginal-cost curve always
crosses the average-total-cost curve at
the minimum of ATC.
A firm’s costs often depend on the
time horizon being considered.
Graphical
Review
 Economic Profit versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economi
c profit
Accounting
profit
Implici
Revenue t
costs Revenue
Total
opportunity
costs
Explici Explicit
t costs
costs
 A Production Function...
Quantity of
Output
(cookies
per
hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0 1 2 3 4 5 Number of Workers Hired
 Total-Cost Curve...
Total
Cos Total-
t curve
cost
$80

70

60

50

40

30

20
0
20 40 60 80 100 120 140 Quantity of Output
10
 Total-Cost Curve...
$16 .0
0 Total-
$14 .0 curve
cost
0
$12 .0
0
Total Cost

$10 .0
0

$8.
00

$6.
00

$4.
$0.
00
00 0 2 4 6 8 10 12

$2. Quantity of Output

00 (glasses of lemonade per hour)
 Average-Cost and Marginal-Cost Curves...
$
3.50

$
3.00

$ M
$
2.50
Cost

2.00
C
s

$
1.50 AT
$
1.00 AVC
$ C
0.50 AFC
$
0.00 0 2 4 6 8 10 12

Quantity of Output
(glasses of lemonade per hour)
 Cost Curves and Their Shapes
$ 2.
50
M
$ 2.
00
C
$ 1.
50
Cost
s

$ 1.
00

$ 0.
50

$ 0.
00 0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
 Cost Curves and Their Shapes
$
3.50

$
3.00
Total Costs

$
2.50

$ AT
$
1.50
2.00 C
$
1.00

$
0.50
$
0.00 0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
 Relationship Between Marginal Cost and
Average Total Cost
$
3.50

$
3.00

$ M
$
2.50
Cost

2.00
C
s

$
1.50 AT
$ C
1.00

$
0.50
$ 0.00
0 2 4 6 8 10 12

Quantity of Output
(glasses of lemonade per hour)
 Big Bob’s Cost Curves...
$20.00

$18.00

$16.00
Total Cost Curve
$14.00
Total Cost

$12.00

$10.00

$8.00

$6.00

$4.00

$2.00

$0.00
0 2 4 6 8 10 12 14 16
Quantity of Output
( bagels per hour)
 Big Bob’s Cost Curves...
3.5

2.5
MC
2
Costs

1.5
ATC
1
AVC

0.5

AFC
0
0 2 4 6 8 10 12 14 16
Quantity of Output
Average Total Cost in the Short and Long Runs...

Average ATC in short ATC in short ATC in short

Total run with run with run with
small factory medium factory large factory
Cost

ATC in long run

0 Quantity of
Cars per Day
 Economies and Diseconomies of Scale
Average
Total

Cost ATC in long run

Economies Constant Returns Diseconomie

of scale to scale s
of scale
0 Quantity of
Cars per Day