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Copyright © 2004 South-Western/

The Costs of Production




The Market Forces of Supply andDemand

Supply and demand are the two words that

economists use most often.

Supply and demand are the forces that make

market economies work.

Modern microeconomics is about supply,

demand, and market equilibrium.




WHAT ARE COSTS?

According to the Law of SupplyLaw 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.




WHAT ARE COSTS?

The Firm¶s Objective

The economic goal of the firm is to maximize

profits.




Total Revenue, Total Cost, and Profit

Tot al Revenue

The amount a firm receives for the sale of its

output.

Tot al C ost

The market value of the inputs a firm uses in

production.




Total Revenue, Total Cost, and Profit

Pr ofit is the firm¶s total revenue minus its total

cost.

Profit = Total revenueProfit = Total revenue -- Total costTotal cost




Costs as Opportunity Costs

A firm¶s cost of pr oduction 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.

Expl icit costs are input costs that require a direct outlay of money by the firm.

Impl icit costs are input costs that do not require an outlay

of money by the firm.




Economic Profit versus Accounting Profit

Economists measure a firm¶s economic pr ofit as

total revenue minus total cost, including both

explicit and implicit costs.

Accountants measure the accounting pr ofit 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.



Figure 1 Economic versus Accountants

Copyright © 2004 South-Western

Revenue

Total

opportunitycosts

How an Economist

Views a Firm

How an Accountant

Views a Firm

Revenue

Economicprofit

Implicitcosts

Explicitcosts

Explicitcosts

Accountingprofit



Table 1 A Production Function and Total Cost:Hungry Helen¶s Cookie Factory

Copyright©2004 South-Western




PRODUCTION AND COSTS

The Production Function

The pr oduction f unction shows the relationship

between quantity of inputs used to make a good and

the quantity of output of that good.





Marginal Product

The mar g inal pr oduct of any input in the

production process is the increase in output that

arises from an additional unit of that input.





Diminishing Marginal Product

Diminishing mar g inal pr oduct 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.



Figure 2 Hungry Helen¶s Production Function


Quantity of

Output(cookies

per hour)

150

140

130

120

110

100

90

80

70

60

50

40

30

20

10

Number of Workers Hired0 1 2 3 4 5

Production function




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 tot al-cost cur ve shows this relationship

graphically.



Table 1 A Production Function and Total Cost:Hungry Helen¶s Cookie Factory




Figure 3 Hungry Helen¶s Total-Cost Curve


Total

Cost

$80

70

60

50

40

30

20

10

Quantity

of Output(cookies per hour)

0 10 20 30 15013011090705040 1401201008060

Total-costcurve




THE V ARIOUS MEASURES OFCOST

Costs of production may be divided into fi xed

costs and var iable costs.

Fixed costsFixed costs are those costs that do not vary

with the quantity of output produced.

Variable costsVariable costs are those costs that d o var y with

the quantity of output produced.




Fixed and Variable Costs

Total Costs

Total Fixed Costs (TF C )

Total Variable Costs (TV C )

Total Costs (T C )

T C = TF C + TV C



Table 2 The Various Measures of Cost: ThirstyThelma¶s Lemonade Stand






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 ( A F C )

Average Variable Costs ( AV C )

Average Total Costs ( AT C )

AT C = A F C + AV C




Average Costs

AFCFC

Q! !

Fixed cost

Quantity

AVCVC

Q! !Variable cost

uantity

ATCTC

Q! !

Total cost

uantity



Table 2 The Various Measures of Cost: ThirstyThelma¶s Lemonade Stand






Marginal Cost

M ar g inal cost ( M C ) 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?

MC TCQ

! !(change in total cost)(change in quantity)

(

(




Marginal CostThirsty Thelma¶s Lemonade Stand

Quantity TotalCost

MarginalCost

Quantity TotalCost

MarginalCost

0 $3.00 1 3.30 $0.30 6 $7.80 $1.30

2 3.80 0.50 7 9.30 1.503 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



Figure 5 Thirsty Thelma¶s Average-Cost and Marginal-CostCurves


Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0 1 432 765 98 10

MC

ATC

AVC

AFC




Cost Curves and Their Shapes

The average totalaverage total--costcost 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 AT C curve occurs

at the quantity that minimize s aver age tot al

cost . This quantity is sometimes called the

e fficient scale of the firm.





Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output


0 1 432 765 98 10

ATC





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 scaleefficient scale. Efficient scale is the quantity that minimizes average total

cost.





Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output


0 1 432 765 98 10

ATC

MC




Typical Cost Curves

It is now time to examine the

relationships that exist between the

different measures of cost.




Big Bob¶s Cost Curves




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 ANDIN 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 SHORT RUN ANDIN 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.



Figure 7 Average Total Cost in the Short and Long Run


Quantity of

Cars per Day

0

AverageTotal

Cost

1,200

$12,000

ATC in shortrun with

small factory


medium factory


large factory

ATC in long run




Economies and Diseconomies of Scale

E conomie s of scale refer to the property

whereby long-run average total cost falls as the

quantity of output increases.

Diseconomie s of scale refer to the propertywhereby long-run average total cost rises as the

quantity of output increases.

C on st ant r et ur n s to scale refers to the propertywhereby long-run average total cost stays the

same as the quantity of output increases



Figure 7 Average Total Cost in the Short and Long Run


Quantity of

Cars per Day

0

AverageTotal

Cost

1,200

$12,000

1,000

10,000

Economies

of scale


small factory


medium factory


large factory ATC in long run

Diseconomiesof

scale

Constant

returns toscale




Linkage Between Cost, Revenueand Output Through Optimization

Total Revenue: is the total amount of money received by a firm

from goods and services sold during a certain time period.

TR= P X Q

Average R evenue: is the revenue earned per unit of output sold.AR= TR/Q




Linkage Between Cost, Revenueand Output Through Optimization

M arginal Revenue: is a revenue a firm gains in

producing one additional unit of a commodity.

It is calculated by determining the difference

between the total revenues earned before andafter a unit increase in production. Thus:

M Rq= TRq-TRq-1

M R= ¨ TR/¨Output




Break Even Analysis

It examines the relation between total revenue,

total costs and total profits of a firm at different

levels of ouput.

It is basically about determining profits at various projects levels of sales, identifying the

breakeven point, and making managerial

decision regarding the relationship betweenlikely sales and the breakeven point.




Break Even Analysis

F rom the above diagram:

1. On the vertical axis cost and revenue is

calculated

2. On the horizontal axis ³output/production

(units) is calculated

3. You draw the total cost curve (TC in the

diagram) which shows the total cost associatedwith each possible level of output.




Break Even Analysis

4. The fixed cost curve (FC) which shows the

costs that do not vary with output level, and

finally the total revenue line which show the

total amount of revenue received at each outputlevel, given the price you will be charging.

5. The break even points (E) is the point of

intersection between the total cost curve (TC)and a total revenue curve ( TR )




Break Even Analysis

6. The gap between total costs line and revenue

line beyond the breakeven point represents the

level of profit (or loss). If the gap is such that

TC line is above is above the TR line, the areawould represents loss, if the TR line is above

TC line, would represents profit.




Break even analysis depends on the following

variables:

The fixed production costs for a product.

The variable production costs for a product.

The product's unit price.

The product's expected unit sales [sometimes

called projected sales.]




Break Even Analysis

On the surface, break-even analysis is a tool to

calculate at which sales volume the variable and

fixed costs of producing your product will be

recovered. Another way to look at it is that the break-even point is the point at which your

product stops costing you money to produce

and sell, and starts to generate a profit for your company.




Break Even Analysis

You can also use break even analysis to solve

managerial problems:

setting price levels

targeting optimal variable/ fixed cost

combinations

determining the financial attractiveness of

different strategic options for your company




Break Even Analysis

Break Even Point = Fixed Costs/Price ±

Variable Costs

XYZ C or por ation ha s cal culat ed that it ha s fi xed costs

that con sist of its lea se, depr eciation of its a ssets ,executive salar ie s , and pr o per t y t axe s. Those fi xed

costs add up to $60,000. Their pr oduct is the A/ C s.

Their var iable costs a ssociat ed with pr oducing the

A/ C s ar e r aw mat er ial, f actor y labor , and sale s commission s. V ar iable costs have been cal culat ed to

be $0.80 per unit. The pr oduct is pr iced at $2.00 each




Given this information, we can calculate the

breakeven point for XYZ Corporation¶s

product, the A/C.

Fixed Costs/Price ± Variable Costs

$60,000/$2.00 - $0.80 = 50,000 units

XYZ Corporation has to produce and sell 50,000

units in order to cover their total expenses,fixed and variable. At this level of sales, they

will make no profit but will just breakeven.




What Happens to the Break even Point if

Sales Change?

What if your sales change? For example, if the

economy is in a recession, your sales mightdrop. If sales drop, then you won¶t sell enough

to make your breakeven point. In the example

of XYZ Corporation, you might not sell the50,000 units necessary to breakeven.




In that case, you would not be able to pay all

your expenses. What can you do in this

situation?

If you look at the breakeven formula, you cansee that there are two solutions. You can either

raise the price of your product or you can find

ways to cut your costs, your fixed and/or your variable costs




Let¶s say you find a way to cut the cost of your

overhead or fixed costs by reducing your own

salary by $10,000. That makes your fixed costs

drop from $60,000 to $50,000. The breakeven point is, holding other variables the same,:




$50,000/$2.00-$0.80 = 41,666 units

Predictably, cutting your fixed costs drops your

breakeven point.If you reduce your variable costs by

cutting your costs of goods sold to $0.60 per unit, thenyour breakeven point, holding other variables the

same, becomes:

60,000/$2.00-$0.60=42,857 units

From this analysis, you can see that if you can reduce thecost variables, you can lower your breakeven point

without having to raise your price




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 do not change

when the firm alters the quantity of output produced; variable costs do change as the firm

alters quantity of output produced.




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.

Average cost first falls as output increases andthen rises.



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.

In particular, many costs are fixed in the shortrun but variable in the long run.

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