ACTIVE LEARNING
13
1:
Brainstorming
The Costs of Production
You run Foxconn Electronics Inc. (鴻海).
List 3 different costs you have.
List 3 different
PRINCIPLES OF
ECONOMICS
business decisions
that are affected
by your costs.
FOURTH EDITION
N. G R E G O R Y M A N K I W
How would your
answers change if
you run 台北農產
運銷公司 instead?
Premium PowerPoint® Slides
by Ron Cronovich
2008 update
Modified by Joseph Tao-yi Wang
1
© 2008 South-Western, a part of Cengage Learning, all rights reserved
Total Revenue, Total Cost, Profit
In this chapter, look for the answers to
these questions:
What is a production function? What is marginal
We assume that the firm’s goal is to maximize
profit.
product? How are they related?
Profit = Total revenue – Total cost
What are the various costs, and how are they
related to each other and to output?
the amount a
firm receives
from the sale
of its output
How are costs different in the short run vs. the
long run?
What are “economies of scale”?
CHAPTER 13
THE COSTS OF PRODUCTION
2
CHAPTER 13
the market
value of the
inputs a firm
uses in
production
THE COSTS OF PRODUCTION
3
Explicit vs. Implicit Costs: An Example
Costs: Explicit vs. Implicit
You need $1,000,000 to start your business.
The interest rate is 5%.
Explicit costs – require an outlay of money,
e.g. paying wages to workers
Case 1: borrow $1,000,000
• explicit cost = $50,000 interest on loan
Implicit costs – do not require a cash outlay,
e.g. the opportunity cost of the owner’s time
Case 2: use $400,000 of your savings,
Remember one of the Ten Principles:
borrow the other $600,000
• explicit cost = $30,000 (5%) interest on the loan
• implicit cost = $20,000 (5%) foregone interest
you could have earned on your $400,000.
The cost of something is
what you give up to get it.
This is true whether the costs are implicit or
explicit. Both matter for firms’ decisions.
In both cases, total (exp + imp) costs are $50,000.
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THE COSTS OF PRODUCTION
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THE COSTS OF PRODUCTION
5
Economic Profit vs. Accounting Profit
Accounting profit
2:
Economic profit vs. accounting profit
ACTIVE LEARNING
The equilibrium rent on office space has just
increased by $5000/month.
= total revenue minus total explicit costs
Economic profit
Compare the effects on accounting profit and
economic profit if
= total revenue minus total costs (including
explicit and implicit costs)
a. you rent your office space
Accounting profit ignores implicit costs,
b. you own your office space
so it’s higher than economic profit.
CHAPTER 13
6
THE COSTS OF PRODUCTION
ACTIVE LEARNING
2:
The Production Function
Answers
A production function shows the relationship
The rent on office space increases $5000/month.
a. You rent your office space.
Explicit costs increase $5000/month.
Accounting profit & economic profit each fall
$5000/month.
between the quantity of inputs used to produce a
good, and the quantity of output of that good.
It can be represented by a table, equation, or
graph.
Example 1:
• Farmer Jack grows vegetables.
• He has 5 acres of land.
• He can hire as many workers as he wants.
b.You own your office space.
Explicit costs do not change,
so accounting profit does not change.
Implicit costs increase $5000/month (opp. cost
of using your space instead of renting it),
so economic profit falls by $5000/month.
8
Example 1: Farmer Jack’s Production Function
Q
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
9
Marginal Product
If Jack hires one more worker, his output rises
The marginal product of any input is the
increase in output arising from an additional unit
of that input, holding all other inputs constant.
2,000
1,500
Notation:
1,000
THE COSTS OF PRODUCTION
THE COSTS OF PRODUCTION
by the marginal product of labor.
2,500
0
CHAPTER 13
CHAPTER 13
3,000
Quantity of output
L
(no. of (bushels
workers) of veggie)
7
∆ (delta) = “change in…”
0
1
2
3
4
5
No. of workers
10
Examples:
∆Q = change in output, ∆L = change in labor
∆Q
Marginal product of labor (MPL) =
∆L
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THE COSTS OF PRODUCTION
11
EXAMPLE 1: MPL = Slope of Prod Function
Q
L
0
∆L = 1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
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(no. of (bushels MPL
workers) of veggie)
MPL
0
1
1000
2
1800
3
2400
4
2800
5
3000
Q
L
(no. of (bushels
workers) of veggie)
0
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
THE COSTS OF PRODUCTION
0
1000
1
1000
2
1800
800
3,000
MPL
Quantity of output
EXAMPLE 1: Total & Marginal Product
600
12
3
2400
4
2800
5
3000
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Why MPL Is Important
400
200
equals the
slope of the
2,500
production function.
2,000
Notice that
diminishes
as L increases.
MPL
1,500
1,000
This explains why
500
the
production
function
gets flatter
0
as L0 increases.
1
2
3
4
5
No. of workers
13
THE COSTS OF PRODUCTION
Why MPL Diminishes
Farmer Jack’s output rises by a smaller and
Recall one of the Ten Principles:
Rational people think at the margin.
smaller amount for each additional worker. Why?
When Farmer Jack hires an extra worker,
As Jack adds workers, the average worker has
• his costs rise by the wage he pays the worker
• his output rises by MPL
less land to work with and will be less productive.
In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
Comparing them helps Jack decide whether he
would benefit from hiring the worker.
Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
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THE COSTS OF PRODUCTION
14
CHAPTER 13
EXAMPLE 1: Farmer Jack’s Costs
EXAMPLE 1: Farmer Jack’s Costs
Farmer Jack must pay $10000 per month for the
L
Q
cost of
(no. of (bushels
land
workers) of veggie)
land, regardless of how much wheat he grows.
The market wage for a farm worker is $20000
per month.
So Farmer Jack’s costs are related to how much
wheat he produces….
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THE COSTS OF PRODUCTION
15
THE COSTS OF PRODUCTION
16
cost of
labor
Total
Cost
0
0
$10,000
$0
$10,000
1
1000
$10,000
$20,000
$30,000
2
1800
$10,000
$40,000
$50,000
3
2400
$10,000
$60,000
$70,000
4
2800
$10,000
$80,000
$90,000
5
3000
$10,000 $100,000 $110,000
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THE COSTS OF PRODUCTION
17
Marginal Cost
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Marginal Cost (MC)
$120,000
Q
(bushels
of veggie)
Total
Cost
$10,000
1000
$30,000
1800
$50,000
2400
$70,000
2800
$90,000
Total cost
0
is the increase in Total Cost from
producing one more unit:
$100,000
$80,000
MC =
$60,000
∆TC
∆Q
$40,000
$20,000
$0
0
2000
3000
18
THE COSTS OF PRODUCTION
0
Total
Cost
1800
2400
∆Q = 400
∆Q = 200
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2800
∆TC = $20000
$25.0
∆TC = $20000
$33.3
$20.0
∆TC = $20000
$50.0
$25.0
1800 $50,000
$70,000
$90,000
3000 $110,000
MC
1000 $30,000
$50,000
∆Q = 600
TC
$20.0
$30,000
∆Q = 800
$120
0 $10,000
∆TC = $20000
1000
Q
(bushels
of wheat)
Marginal
Cost (MC)
$10,000
∆Q = 1000
MC usually rises
as Q rises,
$80
as in this example.
$100
$60
$40
$33.3
2400 $70,000
$20
$50.0
2800 $90,000
∆TC = $20000 $100.0
THE COSTS OF PRODUCTION
19
THE COSTS OF PRODUCTION
EXAMPLE 1: The Marginal Cost Curve
EXAMPLE 1: Total and Marginal Cost
Q
(bushels
of veggie)
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Marginal Cost ($)
3000 $110,000
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1000
Quantity of vegetables
3000 $110,000
20
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$100.0
$0
0
1,000
2,000
3,000
Q
THE COSTS OF PRODUCTION
21
Fixed and Variable Costs
Why MC Is Important
Fixed costs (FC) – do not vary with the quantity of
Farmer Jack is rational and wants to maximize
output produced.
• For Farmer Jack, FC = $10,000 for his land
• Other examples:
cost of equipment, loan payments, rent
his profit. To increase profit, should he produce
more wheat, or less?
To find the answer, Farmer Jack
needs to “think at the margin.”
Variable costs (VC) – vary with the quantity
If the cost of additional wheat (MC) is less than
produced.
• For Farmer Jack, VC = wages he pays workers
• Other example: cost of materials
the revenue he would get from selling it,
then Jack’s profits rise if he produces more.
Total cost (TC) = FC + VC
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THE COSTS OF PRODUCTION
22
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THE COSTS OF PRODUCTION
23
EXAMPLE 2: Costs
Our second example is more general,
Q
applies to any type of firm,
producing any good with any types of inputs.
FC
VC
TC
$800
FC
$700
VC
TC
0 $100
$0 $100
$600
1
100
70
170
$500
2
100 120
220
3
100 160
260
4
100 210
310
5
100 280
380
6
100 380
480
7
100 520
620
Costs
EXAMPLE 2
$400
$300
$200
$100
$0
0
1
2
3
4
5
6
7
Q
24
THE COSTS OF PRODUCTION
EXAMPLE 2: Marginal Cost
TC
MC
0 $100
1
170
2
220
3
260
4
310
5
380
6
7
480
620
CHAPTER 13
$70
50
40
50
70
100
140
Q
MC =
$0
n.a.
1
70
$70
2
120
60
3
160 53.33
4
210 52.50
5
280 56.00
6
380 63.33
7
520 74.29
CHAPTER 13
100
$100
2
100
50
100
25
Sometimes
(as here), MC falls
$25
before rising.
5
100
20
6
100 16.67
(In other0 examples,
1 2 3 MC
4 may
5 6be 7
constant.)
Q
7
100 14.29
$0
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The
$50firm is spreading its fixed
costs over a larger and larger
$25
number of units.
$0
0
1
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Q
TC
0 $100
= VC/Q
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
1
THE COSTS OF PRODUCTION
2
3
4
Q
3
4
5
6
7
27
THE COSTS OF PRODUCTION
ATC
AFC
AVC
n.a.
n.a.
n.a.
1
170
$170
$100
$70
2
220
110
50
60
3
260 86.67 33.33
53.33
4
310 77.50
25
52.50
5
380
76
20
56.00
6
480
80 16.67
63.33
7
620 88.57 14.29
74.29
$100
0
2
EXAMPLE 2: Average Total Cost
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity
of output:
$150
AVC
$125
AFC
$125
Q
26
THE COSTS OF PRODUCTION
AVC
1
100 33.33
Costs
0
VC
n.a.
4
$50
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
AFC
3
EXAMPLE 2: Average Variable Cost
Q
FC
0 $100
∆TC
∆Q
$100
Usually,
$75 MC rises as Q rises, due
to diminishing marginal product.
$125
25
THE COSTS OF PRODUCTION
EXAMPLE 2: Average Fixed Cost
$200
Recall,
Marginal Cost (MC)
is $175
the change in total cost from
producing
one more unit:
$150
Costs
Q
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Costs
CHAPTER 13
5
6
7
28
CHAPTER 13
THE COSTS OF PRODUCTION
Average total cost
(ATC) equals total
cost divided by the
quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
29
EXAMPLE 2: Average Total Cost
ATC
0 $100
1
2
n.a.
170
$200
$175
$150
$170
220
$200
Usually,
as in this example,
$175
the ATC curve is U-shaped.
110
$150
ATC
AVC
AFC
MC
$125
$100
Costs
TC
Costs
Q
EXAMPLE 2: The Various Cost Curves Together
$125
$100
3
260 86.67
4
310 77.50
$50
$50
5
380
76
$25
$25
6
480
80
$0
7
620 88.57
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$75
$75
$0
0
1
2
3
4
5
6
7
0
1
2
3
Q
30
THE COSTS OF PRODUCTION
ACTIVE LEARNING
4
5
6
7
Q
3:
CHAPTER 13
ACTIVE LEARNING
Costs
31
THE COSTS OF PRODUCTION
3:
Answers
AFC
FC/Q
Use
ATC
= TC/Q
MC
and
First,relationship
AVC
deduce
VC/Q
FCbetween
= $50 and
use
FCTC
+ VC = TC.
Fill in the blank spaces of this table.
Q
VC
0
1
10
2
30
TC
AFC
AVC
$50
n.a.
n.a.
n.a.
$10
$60.00
16.67
100
5
150
6
210
MC
$10
80
3
4
ATC
150
20
30
36.67
12.50
37.50
30
260
8.33
60
35
43.33
Q
VC
TC
AFC
AVC
ATC
0
$0
$50
n.a.
n.a.
n.a.
1
10
60
$50.00
$10
$60.00
2
30
80
25.00
15
40.00
3
60
110
16.67
20
36.67
4
100
150
12.50
25
37.50
5
150
200
10.00
30
40.00
6
210
260
8.33
35
43.33
MC
$10
20
30
40
50
60
32
33
EXAMPLE 2: ATC and MC
EXAMPLE 2: Why ATC Is Usually U-Shaped
When MC < ATC,
$200
Eventually,
rising AVC
pulls ATC up.
Costs
Initially,
falling AFC
pulls ATC down.
$175
$175
$150
When MC > ATC,
$150
$125
ATC is rising.
$125
$100
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
$75
$50
$25
$0
0
1
2
3
4
5
6
7
ATC
MC
$200
ATC is falling.
Costs
As Q rises:
$100
$75
$50
$25
$0
0
1
Q
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THE COSTS OF PRODUCTION
2
3
4
5
6
7
Q
34
CHAPTER 13
THE COSTS OF PRODUCTION
35
EXAMPLE 3: LRATC with 3 factory Sizes
Costs in the Short Run & Long Run
Firm can choose
from 3 factory
sizes: S, M, L.
Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
Each size has its
own SRATC curve.
Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones)
using the most efficient mix of inputs for that Q
(e.g., the factory size with the lowest ATC).
36
THE COSTS OF PRODUCTION
CHAPTER 13
EXAMPLE 3: LRATC with 3 factory Sizes
To produce less
than QA, firm will
choose size S
in the long run.
Avg
Total
Cost
ATCS
ATCM
To produce
between QA
and QB, firm will
choose size M
in the long run.
CHAPTER 13
QA
ATCL
38
How ATC Changes As
the Scale of Production Changes
THE COSTS OF PRODUCTION
37
THE COSTS OF PRODUCTION
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
ATC
LRATC
So a typical
LRATC curve
looks like this:
Q
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THE COSTS OF PRODUCTION
39
Economies of scale occur when increasing
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
CHAPTER 13
Q
How ATC Changes As
the Scale of Production Changes
ATC
Diseconomies of
scale: ATC rises
as Q increases.
ATCL
Q
QB
THE COSTS OF PRODUCTION
Economies of
scale: ATC falls
as Q increases.
ATCM
A Typical LRATC Curve
LRATC
To produce more
than QB, firm will
choose size L
in the long run.
ATCS
The firm can
change to a
different factory
size in the long
run, but not in the
short run.
In the long run, ATC at any Q is cost per unit
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Avg
Total
Cost
production allows greater specialization:
workers more efficient when focusing on a
narrow task.
• More common when Q is low.
Diseconomies of scale are due to coordination
Q
40
problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
• More common when Q is high.
CHAPTER 13
THE COSTS OF PRODUCTION
41
CONCLUSION
CHAPTER SUMMARY
Implicit costs do not involve a cash outlay,
Costs are critically important to many business
decisions, including production, pricing, and
hiring.
yet are just as important as explicit costs
to firms’ decisions.
This chapter has introduced the various cost
Accounting profit is revenue minus explicit costs.
concepts.
Economic profit is revenue minus total (explicit +
implicit) costs.
The following chapters will show how firms use
these concepts to maximize profits in various
market structures.
CHAPTER 13
THE COSTS OF PRODUCTION
The production function shows the relationship
between output and inputs.
42
CHAPTER SUMMARY
The marginal product of labor is the increase in
CHAPTER 13
extra unit of production. The MC curve is usually
upward-sloping.
Average variable cost is variable cost divided by
output.
Marginal product usually diminishes as the input
increases. Thus, as output rises, the production
function becomes flatter, and the total cost curve
becomes steeper.
Average fixed cost is fixed cost divided by output.
AFC always falls as output increases.
Average total cost (sometimes called “cost per
Variable costs vary with output; fixed costs do not.
THE COSTS OF PRODUCTION
unit”) is total cost divided by the quantity of output.
The ATC curve is usually U-shaped.
44
•
•
•
•
•
•
at minimum average total cost.
When MC < ATC, ATC falls as Q rises.
When MC > ATC, ATC rises as Q rises.
In the long run, all costs are variable.
Economies of scale: ATC falls as Q rises.
Diseconomies of scale: ATC rises as Q rises.
Constant returns to scale: ATC remains constant
as Q rises.
THE COSTS OF PRODUCTION
CHAPTER 13
THE COSTS OF PRODUCTION
The Cost of Production
CHAPTER SUMMARY
The MC curve intersects the ATC curve
CHAPTER 13
43
CHAPTER SUMMARY
Marginal cost is the increase in total cost from an
output from a one-unit increase in labor, holding
other inputs constant. The marginal products of
other inputs are defined similarly.
CHAPTER 13
THE COSTS OF PRODUCTION
46
Opportunity Cost (Explicit / Implicit)
Accounting Profit vs. Economic Profit
Marginal Product
MC, TC = FC + VC, ATC = AFC+AVC
Economies of Scale (for LR)
Homework: Mankiw, Chp. 13,pp. 285-287,
Problem 3, 5, 9, 10, 11.
45