In this chapter, look for the answers to these
questions:
• What is a production function? What is
marginal product? How are they related?
• What are the various costs, and how are they
related to each other and to output?
• How are costs different in the short run vs. the
long run?
• What are “economies of scale”?
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The Costs of Production
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WHAT ARE COSTS?
• The Market Forces of Supply and Demand
– 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.
• According to the Law 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.
• The Firm’s Objective
– The economic goal of the firm is to maximize
profits.
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© 2007 Thomson South-Western
Total Revenue, Total Cost, and Profit
Costs as Opportunity Costs
• Total Revenue
• A firm’s cost of production includes all the
opportunity costs of making its output of goods
and services.
• Explicit and Implicit Costs
• The amount a firm receives for the sale of its output
= Price x Quantity (P x Q)
• Total Cost
• The market value of the inputs a firm uses in
production.
• Profit is the firm’s total revenue minus its total
cost.
• Profit = Total revenue - Total cost
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• 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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1
Explicit vs. Implicit Costs: An Example
Economic Profit versus Accounting Profit
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
• explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
• explicit cost = $3000 (5%) interest on the loan
• implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
• Economists measure a firm’s economic profit as
total revenue minus total cost, including both
explicit and implicit costs.
• Accountants measure the accounting profit as
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.
• Economic profit is smaller than accounting
profit.
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Figure 1 Economists versus Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
PRODUCTION AND COSTS
• The Production Function
Economic
profit
– The production function shows the relationship
between quantity of inputs used to make a good and
the quantity of output of that good.
Accounting
profit
Implicit
costs
Revenue
Revenue
Total
opportunity
costs
Explicit
costs
• Marginal Product
– The marginal product of any input in the production
process is the increase in output that arises from an
additional unit of that input.
∆Q
–
MP =
∆L
Explicit
costs
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© 2007 Thomson South-Western
EXAMPLE 1:
L (no. of
workers)
∆L = 1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
Total & Marginal Product
Q (bushels
of wheat)
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
Table 1 A Production Function and Total Cost: Hungry
Helen’s Cookie Factory
MPL
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
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© 2007 Thomson South-Western
2
Why MPL Is Important
The Production Function
• 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 at a
firm, each additional worker contributes less and
less to production because the firm has a limited
amount of equipment.
• Recall one of the Ten Principles:
Rational people think at the margin.
• When Farmer Jack hires an extra worker,
• his costs rise by the wage he pays the worker
• his output rises by MPL
• Comparing them helps Jack decide whether he
would benefit from hiring the worker.
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Why MPL Diminishes
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Figure 2 Hungry Helen’s Production Function
• Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
E.g., Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
• If Jack increases workers but not land, the average
worker has less land to work with, so will be less
productive.
• In general, MPL diminishes as L rises whether the
fixed input is land or capital (equipment, machines,
etc.).
Quantity of output
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
0
1
2
3
4
5
6
7
Number of Workers Hired
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© 2007 Thomson South-Western
From the Production Function to the
Total-Cost Curve
The Production Function
• Diminishing Marginal Product
• The slope of the production function measures the
marginal product of an input, such as a worker.
• When the marginal product declines, the production
function becomes flatter.
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• The relationship between the quantity a firm
can produce and its costs determines pricing
decisions.
• The total-cost curve shows this relationship
graphically.
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3
Table 1 A Production Function and Total Cost: Hungry
Helen’s Cookie Factory
Figure 2 Hungry Helen’s Total-Cost Curve
Total
Cost
100
90
80
70
60
50
40
30
20
10
0
0
10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Quantity
of Output
(cookies per hour)
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© 2007 Thomson South-Western
THE VARIOUS MEASURES OF
COST
• Costs of production may be divided into fixed costs
and variable costs.
– 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.
• Total Costs
– Total Fixed Costs (TFC)
– Total Variable Costs (TVC)
– Total Costs (TC)
– TC = TFC + TVC
Fixed and Variable Costs
• 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 Costs
•
•
•
•
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC
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Average and Marginal Costs
AFC =
AVC =
Average and Marginal Costs
• Marginal Cost
Fixed cost FC
=
Quantity
Q
• Marginal cost (MC) 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?
Variable cost VC
=
Quantity
Q
ATC =
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Total cost TC
=
Quantity
Q
M C =
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(c h a n g e in to ta l c o s t)
∆ TC
=
(c h a n g e in q u a n tity )
∆ Q
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Table 2 The Various Measures of Cost: Thirsty Thelma’s
Lemonade Stand
Thirsty Thelma’s Lemonade Stand
Note how Marginal Cost changes with each change in Quantity.
Quantity
Total
Cost
0
1
2
3
4
5
$3.00
3.30
3.80
4.50
5.40
6.50
Marginal
Cost
Quantity
—
$0.30
0.50
0.70
0.90
1.10
6
7
8
9
10
Total
Cost
$7.80
9.30
11.00
12.90
15.00
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$1.30
1.50
1.70
1.90
2.10
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Figure 4 Thirsty Thelma’s Average-Cost and Marginal-Cost
Curves
Figure 3 Thirsty Thelma’s Total-Cost Curves
Total Cost
Costs
Total-cost curve
$15.00
$3.50
14.00
3.25
13.00
3.00
12.00
2.75
11.00
2.50
10.00
2.25
9.00
MC
2.00
8.00
1.75
7.00
1.50
ATC
5.00
1.25
AVC
4.00
1.00
3.00
0.75
2.00
0.50
6.00
AFC
0.25
1.00
0
Marginal
Cost
1
2
3
4
5
6
7
Quantity
of Output
(glasses of lemonade per hour)
8
9
10
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0
1
2
3
4
5
6
7
8
Quantity
of Output
(glasses of lemonade per hour)
9
10
© 2007 Thomson South-Western
Cost Curves and Their Shapes
Cost Curves and Their Shapes
• Marginal cost rises with the amount of output
produced.
• The average total-cost 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 ATC curve occurs
at the quantity that minimizes average total
cost. This quantity is sometimes called the
efficient scale of the firm.
• This reflects the property of diminishing marginal
product.
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5
Cost Curves and Their Shapes
Cost Curves and Their Shapes
• Relationship between Marginal Cost and
Average Total Cost
• 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.
• The marginal-cost curve crosses the average-totalcost curve at the efficient scale.
• Efficient scale is the quantity that minimizes average total
cost.
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Typical Cost Curves
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Figure 5 Cost Curves for a Typical Firm
• It is now time to examine the relationships that
exist between the different measures of cost.
Marginal Cost declines at first and then
increases due to diminishing marginal product.
Costs
AFC, a short-run concept, declines throughout.
$3.00
Note how MC hits both ATC and AVC at their
minimum points.
MC
2.50
2.00
1.50
ATC
AVC
1.00
0.50
0
2
4
6
8
10
12
AFC
14
Quantity of Output
© 2007 Thomson South-Western
© 2007 Thomson South-Western
Costs
Typical Cost Curves
Fill in the blank spaces of this table.
• 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-totalcost curve at the minimum of average total cost.
Q
0
1
2
3
4
5
6
VC
10
30
100
150
210
TC
$50
AFC
n.a.
AVC
n.a.
$10
ATC
n.a.
$60.00
20
150
16.67
12.50
36.67
37.50
260
8.33
80
30
35
43.33
MC
$10
30
60
35
© 2007 Thomson South-Western
© 2007 Thomson South-Western
6
COSTS IN THE SHORT RUN AND
IN THE LONG RUN
Costs in the Short Run & 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, all fixed costs become variable
costs.
• 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.
• Short run:
Some inputs are fixed (e.g., factories, land). The
costs of these inputs are FC.
• Long run:
All inputs are variable
(e.g., firms can build more factories, or sell existing
ones)
• In the long run, ATC at any Q is cost per unit using
the most efficient mix of inputs for that Q (e.g., the
factory size with the lowest ATC).
© 2007 Thomson South-Western
EXAMPLE 3: LRATC with 3 Factory Sizes
EXAMPLE 3: LRATC with 3 Factory Sizes
Firm can choose
from 3 factory
sizes: S, M, L.
Avg
Total
Cost
ATCS
Avg
ATCM
ATCL
Each size has its
own SRATC curve.
The firm can
change to a
different factory
size in the long
run, but not in the
short run.
Q
© 2007 Thomson South-Western
ATC
So a typical
LRATC curve
looks like this:
To produce less than Total
QA, firm will choose Cost
size S
in the long run.
To produce between
QA
and QB, firm will
choose size M
in the long run.
To produce more
than QB, firm will
choose size L
in the long run.
ATCS
ATCM
ATCL
LRATC
QA
Q
QB
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Economies and Diseconomies of Scale
A Typical LRATC Curve
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
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LRATC
Q
© 2007 Thomson South-Western
• 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.
© 2007 Thomson South-Western
7
Figure 6 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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8