ECO 2023 Microeconomics
Chapter 8: Costs of Production
Economic Costs
 Costs exists because resources are scarce and have alternative
uses
 When society uses a combination of resources to produce a
particular product, it foregoes all alternative opportunities to
use those resources for other purposes.
 The measure of the economic cost or the opportunity cost of
any resource used to produce a good is the value or worth the
resource would have in its best alternative.
Economic costs (opportunity costs) are those payments a firm must
make or income it must provide to resource suppliers to attract the
resources away from alternative production.
Payments to resource suppliers are:
Explicit Costs - are monetary payments to nonowners of the
firm for the resources they supply.
 Rent
 Labor
 Materials
 Utilities
Implicit Costs – costs of self-owned, self-employed resources.
 Salary of owner not taken
 Capital invested by owners
 Foregone rent, interest, wages
 Not seen in accounting profit analysis
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Normal Profit as a cost
The costs of production all the costs – explicit and implicit, including
a normal profit – required to attract and retain resources in a specific
line of production.
Normal profit: what the entrepreneur expects to earn from the
production of a specific good
Economic profit:
 Firms earn more than the normal return on investment that they
expected.
 Total revenue – economic costs (implicit + explicit costs)
 Since economic costs include normal profit the residual is
economic profit which goes to the entrepreneur
 Considered pure profit = total revenue – economic costs
 Even if economic profit is ZERO, firms still get a return on
investment
 Accounting profit = total revenue – explicit costs
 Economic profit = total revenue – total costs
Short Run and Long Run
 When the demand for a firm’s product changes, the
firm’s profitability may depend on how quickly, it can
adjust the amounts of the various resources it employs.
 It can easily and quickly adjusts the quantity and
employed of hourly labor, raw materials but needs more
time to adjust its plant capacity.
Short Run - is a period too brief for a firm to alter its plant
capacity, yet long enough to permit a change in the degree to
which the fixed plant is used.
Long run – is a period long enough for that firm to adjust the
quantities of all the resources its employs, including plant
capacity.
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Short-run Production Relationships
 A firm’s costs of producing a specific output depend not
only on the price of needed resources but also on the
quantities of resources needed to produce that output.
 Resource supply and demand determine the resource
prices
 The technological aspects of production specifically the
relationship between inputs and outputs, determine the
quantity of resources needed.
Total product (TP) – is the total quantity, or total output, of a
particular good produced.
Marginal product (MP) – is the extra output or added product
associated with adding a unit of a variable resource, in this case
labor, in the production process.
MP = Change in total product
Change in input
Average Product (AP) – labor productivity, is output per unit
of labor input
AP = Total product
Input
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Law of Diminishing Marginal Returns
It states that as successive units of a variable resource are added to a
fixed resource, beyond some point the extra, or marginal, product
attributable to each additional unit of the variable resource will
decline.
Units of
Variable
Input
0
Total
Product
Marginal
Product
0
10
1
10
15
2
Average
Product
Increasing
Marginal
Returns
25
10
12.50
20
3
45
15.00
15
4
60
10
5
Diminishing
Marginal
Returns
70
15.00
14.00
5
6
75
12.50
0
7
75
-5
8
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Fall 2007
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Negative
Marginal
Returns
10.71
8.75
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Total Product
Curve
Total
Product
Q/La bor
Increasing
Marginal
Product
Diminishing
Marginal Returns
Negative
Marginal
Returns
Average Product
Q/Labor
Marginal Product
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Short-run Production
Fixed costs – are those costs, which in total do not vary with changes
in output.
-are associated with the very existence of a firm’s plant and
therefore must be paid even if its output is zero.
-depreciation on building
-insurance and property taxes
Variable costs – are those costs that change with the level of output.
-include payments for materials, fuel, power, transportation
services, most labor, and similar variable resources.
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Formulas
Total Costs = Fixed Costs + Variable Cost
Variable costs = Variable cost per unit x units
At zero output then:
Total costs = Fixed costs
Average Fixed Costs (AFC) = Total Fixed Costs
Output (Q)
Average Variable Costs (AVC) = Total Variable Costs
Output (Q)
Average Total Costs (ATC) = Total Costs
Output (Q)
Marginal Costs (MC) = additional cost of producing 1 more unit of
output.
MC = change in Total Cost
Change in Quantity
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Example:
Total
TFC
Product
0
100
TVC
TC
0
100
AFC
AVC
ATC
MC
90
1
100
90
190
100
90
190
80
2
100
170
270
50
85
135
70
3
100
240
340
33.33
80
113.33
60
4
100
300
400
25
75
100
70
5
100
370
470
20
74
94
80
6
100
450
550
16.67
75.00
91.67
80
7
100
540
640
14.29
77.14
91.43
90
8
100
650
750
12.50
81.25
93.75
110
9
100
780
880
11.11
86.67
97.78
130
10
100
930
1030
10
93
103
150
The marginal cost curve intersects the average total cost curve at the
ATC curve’s minimum point.
Costs
Total Cost
Total Variable Costs
Total Fixed Costs
Output
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Long Run Production Costs
In the long run, an industry and the individual firms it
comprises can undertake all desired resources adjustments. The
firm can alter its plant capacity; it can build a larger plant or
revert to a smaller plant.
Long Run Cost Curve
Total cost will be higher at the greater levels of
production; the cost per unit of output will be less.
The long run ATC curve for the enterprise is made up of
segments of the short-run ATC curves for the various
plant sizes, which can be constructed.
Long run ATC
The long run ATC curve shows the least average total cost at which
any output can be produced after the firm has had time to make all
appropriate adjustments in its plant size.
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Fall 2007
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ECO 2023 Microeconomics
Chapter 8: Costs of Production
Economics of scale
 Explain the downward sloping part of the long run
ATC curve
 Economies of mass production
 Capital intensive firms
 As plant size increases, a number of factors will
for a time lead to lower average costs of
production
 Labor specialization
 Managerial specialization
 Efficient capital
Diseconomies of Scale
 Caused by the difficulty of efficiently controlling and
coordinating a firm’s operations, as it becomes a largescale producer.
 Alienation of workers
Constant Returns to Scale
Long-run average costs do not change as output changes.
Example: textbooks
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Fall 2007
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