Business Economics

Lecture 4
Cost of Production

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 Learning Objective
• Accounting profits and economic profits
• Production Function
• Marginal product and marginal cost
• Fixed cost and variable cost
• Total cost and total average cost
• Long Run and short run
• Relationships between different cost curves

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 Objective of the firm
• 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.

• The economic goal of the firm is to maximize profits.

• Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

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 Explicit and Implicit costs
• A firm’s cost of production include
explicit costs and implicit costs.
 Explicitcosts involve a direct money
spending for factors of production.
 Implicit costs do not involve a direct money
spending.

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 Economic profits and accounting profits

 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. The implicit costs are ignored
 When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
 Economic profit is smaller than accounting
profit.

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 Economic Profit versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

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 A Production Function and Total Cost

Number of Output Marginal Cost of Cost of Total Cost of

Workers Product of Factory Workers Inputs
Labor
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

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 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.

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 Marginal Product

Marginal = Additional output

product Additional input

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 Marginal Product
• The marginal product is the increase in the
quantity of output obtained from an
additional unit of that input.

• Marginal product = Additional output

Additional input

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 Diminishing Marginal Product
 Diminishing marginal product :the marginal
product of an output 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 equipments.

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 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 12
 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.
 Productivity also declines.

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 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.

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 A Production Function and Total Cost

Number of Output Marginal Cost of Cost of Total Cost of

Workers Product of Factory Workers Inputs
Labor
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

Peter’s bakery Factory

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

70

60

50

40

30

20

10

0 20 40 60 80 100 120 140 Quantity of Output

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(bakery products per hour)
 Fixed cost and variable cost
• Costs of production may be divided into fixed costs and
variable costs.
 Fixed costs do not vary with the quantity of output
produced.
 Variable costs do change as the firm alters the quantity
of output produced.

 Total Fixed Costs (TFC)

 Total Variable Costs (TVC)
 Total Costs (TC)
TC = TFC + TVC
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 Family of Total Costs
Quantity Total Cost Fixed Cost Variable Cost
0 $ 3.00 $3.00 $ 0.00
1 3.30 3.00 0.30
2 3.80 3.00 0.80
3 4.50 3.00 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
10 15.00 3.00 12.00
 Average Cost
 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.
 Average Fixed Costs (AFC)
 Average Variable Costs (AVC)
 Average Total Costs (ATC)
ATC = AFC + AVC

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 Family of Average Costs

Fixed cost FC
AFC = =
Quantity Q
Variable cost VC
AVC = =
Quantity Q
Total cost TC
ATC = =
Quantity Q
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 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?
(Change in total cost)
MC =
(Change in quantity)

= TC
Q
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 Marginal Cost

Quantity Total Marginal Quantity Total Marginal

Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10
 Total-Cost Curve...
$16.00
Total-cost
$14.00 curve

$12.00

$10.00
Total Cost

$8.00

$6.00

$4.00

$2.00

$0.00
0 2 4 6 8 10 12
Quantity of Output
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Average-Cost and Marginal-Cost Curves...
$3.50

$3.00

$2.50

MC
$2.00
Costs

$1.50 ATC
AVC
$1.00

$0.50
AFC
$0.00
0 2 4 6 8 10 12

Quantity of Output
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 Marginal cost curve
• Marginal cost rises with the amount of output
produced.
 This reflects the property of diminishing
marginal product.

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 Cost Curves and Their Shapes
$2.50

MC
$2.00

$1.50
Costs

$1.00

$0.50

$0.00
0 2 4 6 8 10 12
Quantity of Output
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 Average total cost curve
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.
 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.

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 Cost Curves and Their Shapes
$3.50

$3.00

$2.50

$2.00
Total Costs

$1.50 ATC

$1.00

$0.50

$0.00
0 2 4 6 8 10 12
Quantity of Output
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Relationship between MC 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.
• The marginal-cost curve crosses the average-
total-cost curve at the efficient scale.
• Efficient scale is the quantity that minimizes
average total cost.

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 Relationship Between Marginal Cost and
Average Total Cost
$3.50

$3.00

$2.50

MC
$2.00
Costs

$1.50 ATC

$1.00

$0.50

$0.00
0 2 4 6 8 10 12

Quantity of Output
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 The Various Measures of Cost
Peter’s bakery cafe
Average Average Average
Quantity Total Fixed Variable Fixed Variable Total Marginal
of 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
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 Peter’s Cost Curves...
$20.00

$18.00

$16.00
Total Cost Curve
$14.00

$12.00
Total Cost

$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) 33
 Peter’s Cost Curves...
3.5

2.5
MC
2
Costs

1.5
ATC
AVC
1

0.5

AFC
0
0 2 4 6 8 10 12 14 16
Quantity of Output
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 3 important properties of cost curve
 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.

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 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.

 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.

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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
Cost small factory medium factory large factory

ATC in long run

0 Quantity37of
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.

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 Economies and Diseconomies of Scale
Average
Total
Cost
ATC in long run

Economies Constant Returns Diseconomies

of scale to scale of scale

0 Quantity of
Cars per Day
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 Summary
 The goal of firms is to maximize profit, which equals
total revenue minus total cost.
 It is important to include all the opportunity costs of
production.
 Opportunity costs can be explicit or implicit.
 A firm’s costs reflect its production process.
 Due to the property of diminishing marginal product, a
typical firm’s production function gets flatter as the
quantity of input increases.
 A firm’s total costs are divided between fixed and
variable costs.

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 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 rises with the quantity of output.
 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.
 A firm’s long-run cost curves differ from its short-run cost
curves.

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