The Costs of

Production
WHAT ARE COSTS?
• The amount that firm pays to buy inputs is called
its total costs
• The Firm’s Objective
• The economic goal of the firm is to maximize
profits.
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
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.
• Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing
one alternative over another. Because by definition they are unseen, opportunity costs can be easily overlooked.
Understanding the potential missed opportunities foregone by choosing one investment over another allows for better
decision-making. Opportunity cost is the forgone benefit that would have been derived by an option not chosen.
• To properly evaluate opportunity costs, the costs and benefits of every option available must be considered and
weighed against the others.
• Considering the value of opportunity costs can guide individuals and organizations to more profitable decision-
making.

• Explicit and Implicit Costs

A firm’s cost of production include explicit costs and implicit costs.
• Explicit costs are input costs that require a direct outlay of money by the firm.
• Implicit costs are input costs that do not require an outlay of money by the firm.
• Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries,
rent, or materials.
• Implicit costs are a specific type of opportunity cost: the cost of resources already owned by the
firm that could have been put to some other use. For example, an entrepreneur who owns a
business could use her labor to earn income at a job.
Sunk cost
• Sunk costs are those which have already been
incurred and which are unrecoverable.
• In business, sunk costs are typically not included
in consideration when making future decisions,
as they are seen as irrelevant to current and
future budgetary concerns.
• Sunk costs are in contrast to relevant costs,
which are future costs that have yet to be
incurred.
Economic Profit versus Accounting
Profit
• Economists measure a firm’s economic profit as
total revenue minus total cost, including both
explicit and implicit costs.
• Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit 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.
 How an Economist How an Accountant
Views a Firm Views a Firm

Economic
Profit

Accounting
Profit
Implicit
Revenue Costs Revenue

Total
Opportunity
Explicit Costs Explicit
Costs Costs
Production Function and Total Cost: A Cookie Factory
PRODUCTION AND COSTS
• 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.
The Production Function

• Marginal Product
The marginal product of any input in the
production process is the increase in output that
arises from an additional unit of that input.
The Production Function
• 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.
 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

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.
Production Function and Total Cost: A Cookie Factory
 Total-Cost Curve
Total
Cost

$80 Total-cost
curve

70

60

50

40

30

20

10

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity

of Output
(cookies per hour)
 THE VARIOUS MEASURES OF COST
• Costs of production may be divided into
fixed costs 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 vary with
the quantity of output produced.
Fixed and Variable Costs

Total Costs
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• TC = TFC + TVC
The Various Measures of Cost
Fixed and Variable Costs

Average Costs
• Average costs can be determined by dividing the firm’s
costs by the quantity of output it produces.
• 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
Average Costs
The Various Measures of Cost
Fixed and Variable Costs

Marginal Cost
• Marginal cost (MC) measures the increase in total cost
that arises from an extra unit of production.
• Marginal cost helps answer the following question:
• How much does it cost to produce an additional unit of
output?
Marginal Cost
 Total-Cost Curves
Total Cost
$15.00 Total-cost curve
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 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
 Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 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.
Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 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.
• The bottom of the U-shaped ATC curve occurs at the
quantity that minimizes average total cost. This
quantity is sometimes called the efficient scale of
the firm.
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 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Cost Curves and Their Shapes

• 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.
• The marginal-cost curve crosses the average-total-cost
curve at the efficient scale.
• Efficient scale is the quantity that minimizes average total
cost.
Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Typical Cost Curves

It is now time to examine the

relationships that exist between the
different measures of cost.
Typical Cost Curves

• 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 SHORT RUN
AND 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.
• 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
Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

$12,000

ATC in long run

0 1,200 Quantity of
Cars per Day
Economies and Diseconomies of Scale

• Economies of scale refer to the property whereby long-

run average total cost falls as the quantity of output
increases.
• Diseconomies of scale refer to the property whereby
long-run average total cost rises as the quantity of output
increases.
• Constant returns to scale refers to the property whereby
long-run average total cost stays the same as the
quantity of output increases
 Average Total Cost in the Short and Long Run

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Class activity
Calculate the following
Total cost
Average total cost
Average fixed cost
Average variable cost
Marginal cost
Also graphically illustrate all the cost curves.
Quantity of Bagels (per Fixed Cost Variable Cost
hour)
Q FC VC
0 $2.00 $0.00
1 2.00 1.00
2 2.00 1.80
3 2.00 2.40
4 2.00 2.80
5 2.00 3.20
6 2.00 3.80
7 2.00 4.60
8 2.00 5.60
9 2.00 6.80
10 2.00 8.20
11 2.00 9.80
12 2.00 11.60
13 2.00 13.60
14 2.00 15.80