WHAT ARE COSTS?
• A Firm’s Objective
• The economic goal of a firm is to maximize profits.
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Total Revenue, Total Cost, and Profit
• Total Revenue
• The amount a firm receives for the sale of its output.
• Price times Quantity (TR)
• Total Cost
• The market value of the inputs a firm uses in production.
• Opportunity cost, implicit and explicit (TC)
Profit = TR- TC
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Costs as Opportunity Costs
• A firm’s cost of production includes all of 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.
• 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.
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Economic Profit versus Accounting Profit
• Economic profit is total revenue minus total cost,
including both explicit and implicit costs.
• Accounting profit is the firm’s total revenue minus
only the firm’s explicit costs.
• When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
• Joe’s Boat Factory Example.
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SHORT RUN AND LONG RUN
• In the short run, at least one factor of production (input)
is fixed (cannot be changed).
-fixed costs and variable costs
-kapital constrained (add workers to fixed kapital stock)
• In the long run, all factors of production (inputs) are
variable (can be changed).
-all costs are variable (increase entire scale of operation)
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SHORT RUN AND LONG RUN
• Firm is nearly always in the Short Run
-Long Run envelopes series of Short Runs
• Short Run/Long Run time periods vary across industry
-Kapital intensive industry is likely to be longer period
-Hot Dog Vendor vs. General Motors
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Fixed and Variable Costs (Short Run)
• 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.
Costs
Fixed Costs (FC)
Variable Costs (VC)
Total Costs (TC)
TC = FC + VC
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PRODUCTION AND COSTS
• The production function shows the relationship
between quantity of inputs used to make a good
and the quantity of output of that good.
• The marginal product of any input in the
production process is the increase in output that
arises from an additional unit of that input.
• MPL = change in output / change labor
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Production Function Characteristics
• 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, each
additional worker contributes less to production
because the firm has a limited amount of equipment.
-Kapital constrained
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Production Function and Total Cost: Hungry
Helen’s Cookie Factory
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Figure 2 Hungry Helen’s Production Function
Quantity of
Output
(cookies
per hour)
Production function
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
1
2
3
4
5Number of Workers Hired
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From the Production Function to the
Total-Cost Curve
• The firm uses inputs to produce output
-the production function
• The total-cost curve graphically shows the
relationship between the amount of output
produced by the firm and the cost associated with
this production.
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Marginal Cost
• Marginal cost (MC) measures the increase in total cost
that arises from an extra unit of production.
• How much does it cost to produce one additional unit?
(change in total cost) TC
MC 

(change in quantity)
Q
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Production Function and Total Cost: Hungry
Helen’s Cookie Factory
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Figure 3 Hungry Helen’s Total-Cost Curve
Total
Cost
Total-cost
curve
$80
70
60
50
40
30
20
10
0
10
20 30
40
50
60 70
Quantity
of Output
(cookies per hour)
80 90 100 110 120 130 140 150
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Marginal Cost Characteristics
• Marginal cost eventually rises as output increases.
• This reflects diminishing marginal product.
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Marginal Product and Marginal Cost
• A more likely story as a firm adds labor to a fixed
kapital stock….
• A firm will initially experience increasing marginal
product.
-teamwork and specialization, grow into factory
• But eventually a firm will experience decreasing
marginal product and rising marginal cost.
-grow out of factory
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Big Bob’s Production & Costs
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Figure 6 Big Bob’s Cost Curves
(a) Total-Cost Curve
Total
Cost
$18.00
TC
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0
2
4
6
8
10
12
14
Quantity of Output (bagels per hour)
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Big Bob’s Production Function?
Economies and Diseconomies of Scale (Long Run)
• 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
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Figure 7 Average Total Cost in the Short and Long Run
Average
Total
Cost
ATC in short
run with
small factory
ATC in short
ATC in short
run with
run with
medium factory large factory
ATC in long run
$12,000
10,000
Economies
of
scale
0
Constant
returns to
scale
1,000 1,200
Diseconomies
of
scale
Quantity of
Cars per Day
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Economies and Diseconomies of Scale
• If an industry exhibits economies of scale over a
large range then we would expect that market to
be served by one or at most a few large firms.
• If an industry exhibits diseconomies of scale early
on then we would expect that market to be served
by many small competing firms.
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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 costs are explicit while other costs are
implicit; total opportunity cost includes both.
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Summary
• A firm’s costs reflect its production process.
• A typical firm’s production function exhibits the
property of diminishing marginal product.
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Summary
• A firm’s total costs are divided between fixed
costs 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.
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Summary
• Marginal cost is the amount by which total cost
would rise if output were increased by one unit.
• The marginal cost eventually rises with the
quantity of output in the short run.
• Grow into factory, grow out of factory.
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