The Costs of Production

Chapter 13

1
IN THIS CHAPTER
• Economic profit vs Accounting profit
• Explicit and Implicit costs

• Maximize profit
− Profit = Total revenue – Total cost
− Total cost = Fixed costs + Variable costs

• Production and cost

• Production function
• Diminishing marginal product → Cost increases
• Cost curves
• Concepts of AVERAGE and MARGINAL!
2
IN THIS CHAPTER
• Short run and long run
− Economies of scale
− Constant returns to scale
− Diseconomies of scale

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Maximize Profits

4
Maximize Profits

Law of Supply

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Total Revenue, Total Cost, and Profit
• Assumption:
− The goal of a firm is to maximize profit

• Total revenue, TR = P × Q
− The amount a firm receives for the sale of its output

• Total cost, TC
− The market value of the inputs a firm uses in production

• Profit = TR – TC
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EXAMPLE 1A: Adela’s gelato shop
Adela owns a small gelato shop on campus. She can make
15,000 pints of gelato a year, and sell them at $5 each. If
Adela’s total costs are $65,000 a year, how much profit the
shop brings in one year?

• Total revenue: TR = P × Q = $5 × 15,000 = $75,000

• Profit = TR – TC = $75,000 – $65,000 = $10,000

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Explicit and Implicit costs
• Total cost = Explicit + Implicit costs
• Explicit costs
− Input costs that require an outlay of money by the firm
(paying wages to workers)
• Implicit costs
− Opportunity costs
• “The cost of something is what you give up to get it.”
− Input costs that do not require an outlay of money by
the firm (opportunity cost of the owner’s time)
− Ignored by accountants
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Explicit and Implicit costs
• Economic profit
− Total revenue minus total cost
• Total costs includes both explicit and implicit costs

• Accounting profit
− Total revenue minus total explicit cost
• Usually larger than economic profit

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Figure 1 Economists versus Accountants

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EXAMPLE 1B: Costs for Adela’s gelato shop
Adela owns a small gelato shop on campus. Adela pays $20,000
a year for raw materials, and $12,000 in rent. Adela can work at
the local coffee shop for $25,000 a year. Identify and calculate
the explicit and implicit costs.
• Explicit costs: raw materials and rent
= $20,000 + $12,000 = $32,000

• Implicit cost: opportunity cost of the owner’s time

= $25,000

• Total costs = $32,000 + $25,000 = $57,000

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Production and Costs

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Production and Costs
• Assumption:
− Production in the short run
− Factory size is fixed
− To increase production: hire more workers

• 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
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EXAMPLE 2A: James’s popcorn truck
James has a popcorn truck (fixed resource) that he takes to
fairs and sporting events.
He can hire as many workers as he wants
• The quantity of output produced varies with the number
of workers
• If James hires only 1 worker, his truck will produce 30
buckets of popcorn per day
• If James hires 5 workers, his truck will produce 100
buckets of popcorn per day

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EXAMPLE 2A: James’s popcorn truck
• Production function
Q
L Q 100
workers buckets 90
0 0

Quantity of Output
75
1 30
2 55 55

3 75 30
4 90
5 100
0 1 2 3 4 5 L
Number of workers
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Marginal Product
• Marginal product
− Increase in output that arises from an additional unit of
input (In our example input is labor!)
− Other inputs constant
− Slope of the production function

• Marginal product of labor, MPL = ∆Q / ∆L

− If James hires one more worker, his output rises by the
marginal product of labor.

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EXAMPLE 2B: James’s total and marginal product
L Q MPL
workers buckets buckets
0 0
∆L = 1 ∆Q = 30 30
1 30
∆L = 1 ∆Q = 25 25
2 55
∆L = 1 ∆Q = 20 20
3 75
∆L = 1 ∆Q = 15 15
4 90
∆L = 1 ∆Q = 10 10
5 100

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Diminishing Marginal Product
• Diminishing marginal product
− Marginal product of an input declines as the quantity of
the input increases
− Production function gets flatter as more inputs are being
used
− The slope of the production function decreases

• Why???

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Diminishing Marginal Product

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 Active Learning 2: Diminishing MPL
L Q MPL
A. What is the marginal
workers buckets buckets
product of the second
0 0 worker?
∆L = 1 ∆Q = 30 30
1 30 25
∆L = 1 ∆Q = 25 25 B. What is the marginal
2 55 product of the fourth
∆L = 1 ∆Q = 20 20
3 75 worker?
∆L = 1 ∆Q = 15 15
4 90 15
∆L = 1 ∆Q = 10 10 C. Does this production
5 100 function exhibits
diminishing marginal
returns?
Yes
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Diminishing MPL
• Hiring one extra worker
− Increases output by MPL
− Increases costs by the wage paid

• “Rational people think at the margin”

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Production Function and Total-cost curve

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Cost curves

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Total Cost = Fixed Costs + Variable Costs
• Total cost, TC = FC + VC
− Total cost of producing a given amount of output

• Fixed costs, FC
− Do not vary with the quantity of output produced
− Incur even if production is zero

• Variable costs, VC
− Vary with the quantity of output produced

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EXAMPLE 2C: James’s popcorn truck costs
• Fixed cost
− James must pay $200 per day for the truck, regardless
of how much popcorn he produces

• Variable costs
− The market wage for popcorn makers is $50 per day

• So, James’s costs are related to how much popcorn the

truck produces

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EXAMPLE 2C: James’s popcorn truck costs

L Q Cost of Cost Total

workers buckets the truck of labor Cost
0 0 $200 $0 $200
1 30 $200 $50 $250
2 55 $200 $100 $300
3 75 $200 $150 $350
4 90 $200 $200 $400
5 100 $200 $250 $450

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EXAMPLE 2D: James’s total cost curve
Total Cost
Q Total $500
buckets Cost 450
0 $200 400
350
30 $250 300
55 $300 250
200
75 $350
90 $400
100 $450
0 30 55 75 90 100Q
Quantity of Output
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Total Cost Curve
• Relationship between quantity produced and total costs

• Gets steeper as the amount produced rises

− Diminishing marginal product
− Producing one additional unit of output requires a lot of
additional units of inputs: very costly

• Diminishing marginal product, not total production

decreasing!

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EXAMPLE 3: Angel’s knitted scarves business

Q FC VC TC
0 18 0 18
1 18 15 33
Angel paid $18 to rent
2 18 25 43
3 18 30 48
knitting space.
4 18 32 50 To produce more scarves,
5 18 36 54 Angel needs more yarn
6 18 44 62 and more workers
7 18 58 76
8 18 78 96
9 18 104 122
10 18 136 154
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EXAMPLE 3A: Angel’s FC, VC, and TC curves
Q FC VC TC Cost
0 18 0 18 $160
TC
1 18 15 33
120
2 18 25 43 VC
3 18 30 48 80

4 18 32 50
40
5 18 36 54
FC
6 18 44 62 0
0 2 4 6 8 10 Q
7 18 58 76 Quantity of output
8 18 78 96
9 18 104 122 The TC and VC curves are parallel
10 18 136 154 The FC curve is a horizontal line
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Average and Marginal Cost
• Average fixed cost, AFC = FC / Q

• Average variable cost, AVC = VC / Q

• Average total cost, ATC = TC / Q = AFC + AVC

− The cost of the typical unit produced
− Total cost divided by the quantity of output

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Average and Marginal Cost
• Marginal cost, MC = ΔTC / ΔQ
− Increase in total cost arising from an extra unit of
production
− Marginal cost = Change in total cost / Change in
quantity
− Increase in total cost
• From producing an additional unit of output

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Concept of Average and Marginal

Average Marginal
• One more unit!
• Introduction to economics
− A+ → GAP ↑
− C → GAP ↓
• If Marginal > Average → GAP ↑
• If Marginal < Average → GAP ↓

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Concept of Average and Marginal

Average Marginal
• One more unit!
− Hot→ Temperature ↑
− Cold → Temperature ↓
• If Marginal > Average → Temperature ↑
• If Marginal < Average → Temperature ↓

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EXAMPLE 3B: Angel’s average and marginal cost
Q FC VC TC AFC AVC ATC MC
0 $18 $0 $18 - - -
$15.0
1 18 15 33 $18.0 $15.0 $33.0
10.0
2 18 25 43 9.0 12.5 21.5
5.0
3 18 30 48 6.0 10.0 16.0
2.0
4 18 32 50 4.5 8.0 12.5
4.0
5 18 36 54 3.6 7.2 10.8
8.0
6 18 44 62 3.0 7.3 10.3
14.0
7 18 58 76 2.6 8.3 10.9
20.0
8 18 78 96 2.3 9.8 12.0
26.0
9 18 104 122 2.0 11.6 13.6
32.0
10 18 136 154 1.8 13.6 15.4
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EXAMPLE 3C: Angel’s AFC curve
Costs
Q FC AFC $ 35.0
0 18 -
30.0
1 18 18.0
2 18 9.0 25.0
3 18 6.0
20.0
4 18 4.5
5 18 3.6 15.0

6 18 3.0 10.0
7 18 2.6
5.0 AFC
8 18 2.3
9 18 2.0 0.0
10 18 1.8 0 2 4 6 8 10 Q
Quantity of output
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EXAMPLE 3C: Angel’s AVC and ATC curves
Q VC TC AVC ATC Costs
0 $0 $18 - - $ 35.0
Efficient scale:
1 15 33 15.0 33.0 30.0
quantity that
2 25 43 12.5 21.5 25.0 minimizes ATC
3 30 48 10.0 16.0
20.0 ATC
4 32 50 8.0 12.5
5 36 54 7.2 10.8 15.0

6 44 62 7.3 10.3 10.0 AVC

7 58 76 8.3 10.9
5.0
8 78 96 9.8 12.0
0.0
9 104 122 11.6 13.6
0 2 4 6 8 10 Q
10 136 154 13.6 15.4 Quantity of output

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Shape of Marginal cost and other cost curve
• 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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Efficient scale
• 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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EXAMPLE 3C: Angel’s marginal cost curve
Costs
$ 35.0
MC
30.0

25.0

20.0
ATC
15.0
AVC
10.0

5.0
AFC
0.0
0 2 4 6 8 10 Q
Quantity of output
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EXAMPLE 3D: Angel’s ATC and MC curves
Costs
$ 35.0
MC
When MC < ATC,
30.0 ATC is falling.
25.0
When MC > ATC,
20.0
ATC
ATC is rising.
15.0
The MC curve
10.0
crosses the ATC
5.0 curve at the ATC
0.0 curve’s minimum.
0 2 4 6 8 10 Q
Quantity of output
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Average-Cost and Marginal-Cost Curves

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Typical cost curves
• Marginal cost eventually rises with the quantity of output

• Average-total-cost curve is U-shaped

• Marginal-cost curve crosses the average-total-cost curve

at the minimum of average total cost

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Active Learning 3: Calculating costs
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 $50 n/a n/a n/a
$10
1 10 $10 $60.00
2 30 80
30
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30
60
6 210 260 8.33 35 43.33
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Active Learning 3: Answers
Use
First,relationship
AFC
ATC
AVC
deduce= TC/Q
FC/Q
VC/Q
FC between MC
= $50 and and
use FCTC
+ VC = TC.

Q VC TC AFC AVC ATC MC

0 $0 $50 n/a n/a n/a
$10
1 10 60 $50.00 $10 $60.00
20
2 30 80 25.00 15 40.00
30
3 60 110 16.67 20 36.67
40
4 100 150 12.50 25 37.50
50
5 150 200 10.00 30 40.00
60
6 210 260 8.33 35 43.33

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Costs in Short and Long Run

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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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Costs in Short and Long Run
• Short run, SR:
− Some inputs are fixed (e.g., factories, land)
− The costs of these inputs are FC
• Long run, LR:
− All inputs are variable (e.g., firms can build more
factories or sell existing ones)
• In the long run
− ATC at any Q is the cost per unit using the most
efficient mix of inputs for that Q (e.g., the factory size
with the lowest ATC)
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Average Costs in Short and Long Run

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LRATC with 3 factory sizes
To produce less than QA,
Avg
Total firm will choose size S in
Cost ATCS ATCM the long run.
ATCL
To produce between QA
and QB, firm will choose
LRATC size M in the long run.
To produce more than QB,
firm will choose size L in
Q
QA QB the long run.

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A typical LRATC curve

• In the real world, ATC

factories come in
many sizes, each with LRATC
its own SRATC curve.

• So a typical LRATC
curve looks like this:
Q

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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
• More common when Q is low

• Constant returns to scale

− Long-run average total cost stays the same as the
quantity of output changes

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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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Economies and diseconomies of scale

ATC
Economies of scale: ATC
falls as Q increases.
Constant returns to scale: LRATC
ATC stays the same as Q
increases.
Diseconomies of scale:
ATC rises as Q increases.

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A summary!!

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 CHAPTER IN A NUTSHELL
• 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.
− Explicit: wages a firm pays its workers
− Implicit: wages the firm owner gives up by working at
the firm rather than taking another job
• Economic profit takes both explicit and implicit costs into
account, whereas accounting profit considers only explicit
costs.
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CHAPTER IN A NUTSHELL
• A firm’s costs reflect its production process.
− Diminishing marginal product: production function gets
flatter as Q of an input increases
− Total-cost curve gets steeper as the quantity produced
rises.
• Firm’s total costs = fixed costs + variable costs.
− Fixed costs: do not change when the firm alters the
quantity of output produced.
− Variable costs: change when the firm alters the quantity
of output produced.
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 CHAPTER IN A NUTSHELL
• Average total cost is total cost divided by the quantity of
output.
• Marginal cost is the amount by which total cost rises if
output increases by 1 unit.
• Graph average total cost and marginal cost.
− Marginal cost rises with the quantity of output.
− Average total cost first falls as output increases and
then rises as output increases further.
− The MC curve always crosses the ATC curve at the
minimum of ATC
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 CHAPTER IN A NUTSHELL
• A firm’s costs often depend on the time horizon considered.
− In particular, many costs are fixed in the short run but
variable in the long run.
− As a result, when the firm changes its level of
production, average total cost may rise more in the
short run than in the long run.

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