Chapter 13
The Costs of Production
By Prof. Sharif Memon
The Costs of Production
The Law of Supply: xFirms are willing to produce and sell a greater quantity of a good when the price of the good is high. xThis results in a supply curve that slopes upward.
A Firms Total Revenue and Total Cost
x Total
x
Revenue
The amount that the firm receives for the sale of its output.
x Total
x
Cost
The amount that the firm pays to buy inputs.
A Firms Profit
Profit is the firms total revenue minus its total cost. Profit = Total revenue - Total cost
Costs as Opportunity Costs
A firms cost of production includes all the opportunity costs of making its output of goods and services.
Explicit and Implicit Costs A firms cost of production include explicit costs and implicit costs.
xExplicit
costs involve a direct money outlay for factors of production. xImplicit costs do not involve a direct money outlay.
Economic Profit versus Accounting Profit Economists measure a firms economic profit as total revenue minus all the opportunity costs (explicit and implicit). x Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs. In other words, they ignore the implicit costs. x When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
x
x
Economic profit is smaller than accounting profit.
Economic Profit versus Accounting Profit
How an Economist Views a Firm Economic profit Accounting profit How an Accountant Views a Firm
Revenue
Implicit costs Total opportunity costs
Revenue
Explicit costs
Explicit 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.
Marginal Product
sThe
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
Additional output Additional input
Diminishing Marginal Product
xDiminishing
marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. xExample: 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) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 0 1 2 3 4
Production function
5 Number of Workers Hired
Diminishing Marginal Product
x The
slope of the production function measures the marginal product of an input, such as a worker. x When the marginal product declines, the production function becomes flatter.
From the Production Function to the Total-Cost Curve
x The
relationship between the quantity a firm can produce and its costs determines pricing decisions. x The total-cost curve shows this relationship graphically.
Total-Cost Curve...
Total Cost
$80 70 60 50 40 30 20 10 0 20 40 60 80 100 120 140 Quantity of Output (cookies per hour)
Total-cost curve
Fixed and Variable Costs
x Fixed
costs are those costs that do not vary with the quantity of output produced. x Variable costs are those costs that do change as the firm alters the quantity of output produced.
Family of Total Costs
x Total
Fixed Costs (TFC) x Total Variable Costs (TVC) x Total Costs (TC)
TC = TFC + TVC
Family of Total Costs
Quantity Total Cost Fixed Cost Variable Cost
0 1 2 3 4 5 6 7 8 9 10
$ 3.00 3.30 3.80 4.50 5.40 6.50 7.80 9.30 11.00 12.90 15.00
$3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00
$ 0.00 0.30 0.80 1.50 2.40 3.50 4.80 6.30 8.00 9.90 12.00
Average Costs
x Average
costs can be determined by dividing the firms costs by the quantity of output produced. x The average cost is the cost of each typical unit of product.
Family of Average Costs
x Average
Fixed Costs (AFC) x Average Variable Costs (AVC) x Average Total Costs (ATC)
ATC = AFC + AVC
Family of Average Costs
Fixed cost FC AFC = = Quantity Q Variable cost VC AVC = = Quantity Q Total cost TC ATC = = Quantity Q
Family of Average Costs
Quantity AFC AVC ATC
0 1 2 3 4 5 6 7 8 9 10
$3.00 1.50 1.00 0.75 0.60 0.50 0.43 0.38 0.33 0.30
$0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00 1.10 1.20
$3.30 1.90 1.50 1.35 1.30 1.30 1.33 1.38 1.43 1.50
Marginal Cost
x Marginal
cost (MC) measures the amount total cost rises when the firm increases production by one unit. x Marginal cost helps answer the following question:
x
How much does it cost to produce an additional unit of output?
Marginal Cost
(Change in total cost) MC = (Change in quantity) = TC
Marginal Cost
Quantity Total Cost Marginal Cost Quantity Total Cost Marginal Cost
0 1 2 3 4 5
$3.00 3.30 3.80 4.50 5.40 6.50
$0.30 0.50 0.70 0.90 1.10
6 7 8 9 10
$7.80 9.30 11.00 12.90 15.00
$1.30 1.50 1.70 1.90 2.10
Total-Cost Curve...
$16.00 $14.00 $12.00
Total-cost curve
Total Cost
$10.00 $8.00 $6.00 $4.00 $2.00 $0.00 0 2 4 6 8 10 12
Quantity of Output (glasses of lemonade per hour)
Average-Cost and Marginal-Cost Curves...
$3.50 $3.00 $2.50
Costs
$2.00 $1.50 $1.00 $0.50 $0.00 0
MC AT C AVC
AFC
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.
xThis
reflects the property of diminishing marginal product.
Cost Curves and Their Shapes
$2.50
MC
$2.00
Costs
$1.50
$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.
x
x x
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 $2.50
Total Costs
$2.00 $1.50 $1.00 $0.50 $0.00 0 2 4 6 8 10 12
AT C
Quantity of Output (glasses of lemonade per hour)
Relationship Between Marginal Cost and Average Total Cost
x Whenever
marginal cost is less than average total cost, average total cost is falling. x 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.
xEfficient
scale is the quantity that minimizes average total cost.
Relationship Between Marginal Cost and Average Total Cost
$3.50 $3.00 $2.50
Costs
$2.00 $1.50 $1.00 $0.50 $0.00
MC AT C
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.
Three Important Properties of Cost Curves
x Marginal
cost eventually rises with the quantity of output. x The average-total-cost curve is Ushaped. x The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.
Costs in the Long Run
x 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. x In the long run fixed costs become variable costs.
x
Costs in the Long Run
Because many costs are fixed in the short run but variable in the long run, a firms long-run cost curves differ from its short-run cost curves.
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
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. x Diseconomies of scale occur when longrun average total cost rises as output increases. x Constant returns to scale occur when long-run average total cost does not vary as output increases.
x
