The Costs of ProductionThe Costs of Production

Outline: – Study how firm’s decisions regarding prices and

quantities depend on the market conditions they face

– Firm’s costs are a key determinant of its production (supply curve) and its pricing decisions

– Firm’s objective therefore is to maximize its profits

– Profits= TR-TC

The Costs of ProductionThe Costs of Production

TR= Total Revenue= PxQ Total Revenue is the amount a firm

receives from the sale of its output Total cost is the amount a firm pays to

buy the units of production Economist’s interpretation of total cost

includes the opportunity cost of production as well

The Costs of ProductionThe Costs of Production

A firm’s opportunity costs can be obvious at times and not so obvious at other times

Explicit costs are input costs that require an outlay of money by the firm

Implicit costs are input costs that do not require an outlay of money by the firm

Economic Costs Versus Accounting Economic Costs Versus Accounting CostsCosts

Accountants measure explicit costs (as it involves money flows)

Economists use both explicit costs (wages, rent, cost of raw material) and implicit costs (foregone income) to arrive at the total cost of production

The cost of capital is an opportunity cost due to the foregone interest on savings (implicit cost)

Economic Profit Versus Accounting Economic Profit Versus Accounting ProfitProfit

Economic profit is the TR minus TC, including both explicit and implicit costs

Accounting profit is the TR minus total explicit cost

Therefore, economic profit is smaller than accounting profit

Economic Profit Versus Accounting Economic Profit Versus Accounting ProfitProfit

Economic profit

Implicit Costs

Explicit costs

Accounting profit

Explicit costs

TROC

TR

Economist’s view

Accountant's view

Production and Costs Production and Costs

What is the link between a firm’s production process and its total cost? – Fixed size of the firm – Labor is the only variable input– Decisions in the SR (# of labor to hire and

quantity of output to produce)

Production function is the relationship between the quantity of inputs used to make a good and the quantity of output of the good

Production and Costs Production and Costs

Marginal product is the increase in output that arises from an additional unit of input

Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases

The slope of the production function is given as the change in output for an additional input of labor.

Slope of the production function measures the marginal product of input

Production and Costs Production and Costs

# workers

Output/hour

MP of L Cost of factory

Cost of workers

TC of inputs

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

Wage=$10/ worker

Production function

0

20

40

60

80

100

120

140

160

0 1 2 3 4 5

# Workers hired

Ou

tpu

t/ h

ou

r

Output/hour

Production Function and Total Cost Production Function and Total Cost

Total cost curve shows the relationship between the quantity of output produced and the total cost of production

Production function gets flatter as the amount of input increases (diminishing Marginal Product)

Total cost curve gets steeper as the amount produced rises (production cost of a marginal unit of output increases)

Measures of Cost Measures of Cost

Total Cost (TC) =TFC+TVC Fixed Costs (TFC) are costs that do not vary with

the quantity of output (Q) produced Variable Costs (TVC) are costs that do vary with

the quantity of output produced Average Cost (ATC) = TC/Q Average Fixed Cost (AFC)= TFC/Q Average Variable Cost (AVC)= TVC/Q Marginal cost (MC)= change in TC/change in Q MC is the increase in total cost that arises from an

extra unit of production

Production and Costs Production and Costs

Cost of production has an impact on the firm’s production decisions

– Cost of producing a typical unit of output (ATC)

– Cost of producing an additional unit of output (MC)

Cost curves and their shapes – X-axis measures the quantity produced– Y-axis measures the cost of production

Q/hour TC FC VC AFC AVC ATC MC0 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 0.96 0.60

7 6.60 2.00 4.60 0.29 0.66 0.95 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 1.14 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

Cost Curves: Total Cost, Fixed Cost, Variable Cost

0

2

4

6

8

10

12

14

16

18

20

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14

Output/hour

Cos

t

Total cost Fixed Cost Variable cost

Average Costs

0

0.5

1

1.5

2

2.5

3

3.5

0 1 2 3 4 5 6 7 8 9 10 11 12 13

Output/ hour

Co

sts

AFC

AVC

ATC

MC

MC cuts ATC at its minimum point ATC is U-shaped

MC is less than ATC, ATC is falling

MC is greater than ATC, ATC is rising

Efficient scale of the firm

Typical Cost Curves Typical Cost Curves A firm’s cost curves exhibit the

following common features: – MC eventually rises with the quantity of

output– ATC is U-shaped– MC curve crosses the ATC at the minimum

of ATC

MC initially falls with increase in output but eventually rises as output increases- diminishing marginal product

Typical Cost Curves Typical Cost Curves AFC declines as output increases but AVC

increases as output increases- explains ATC’s U-shape

The bottom of the U-shape occurs at the quantity that minimizes ATC. This quantity of output is called the efficient scale of the firm

MC<ATC= ATC is falling MC>ATC= ATC is rising MC crosses ATC at the efficient scale of

the firm

Typical Cost Curves Typical Cost Curves

The combination of increasing and then decreasing MP also make the AVC U- shaped

Both MC and AVC fall initially before rising with increase in output

LR and SR costs LR and SR costs In the SR the firm has to continue on the

same cost curve chosen in the past In the LR the firm can choose to move to a

different cost curve as FC become variable

Economies of scale Economies of scale Economies of scale is the property whereby LR

ATC falls as the quantity of output increases– Specialization leads to higher output/worker

and lower ATC/unit of output Diseconomies of scale is the property whereby

LR ATC rises as the quantity of output increases– Coordination problems

Constant returns to scale is the property whereby LR ATC remains constant as the quantity of output changes