The Costs of Production
The Law of Supply:
Firms are willing to
produce and sell
a greater quantity
of a good when
the price of a
good is high, due
to typical
productivity and
cost behaviour.
Principles of Microeconomics : Ch.13
Supply
First Canadian Edition
Total Revenue, Total Cost, Profit
assume that the firm’s goal is to
maximize profit.
 We
Profit = Total revenue – Total cost
TR-the amount a firm receives from the sale of its
output
TC-the market value of the inputs a firm uses in
production
Principles of Microeconomics : Ch.13
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Costs as Opportunity Costs
 The
firm’s costs include Explicit Costs and
Implicit Costs:
– Explicit Costs: costs that involve a direct
money outlay for factors of production.
– Implicit Costs: costs that do not involve a
direct money outlay (e.g. opportunity
costs of the owner’s own inputs used implicit wages, implicit rent, cost of
capital).
Principles of Microeconomics : Ch.13
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Costs as Opportunity Costs
 Accountants
measure the explicit costs but
often ignore the implicit costs.
 Economists include all opportunity costs
when measuring costs.
 Accounting
Profit = TR - Explicit Costs
 Economic Profit = TR - Explicit Costs Implicit Costs
Principles of Microeconomics : Ch.13
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Explicit vs. Implicit Costs: An Example
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.
Principles of Microeconomics : Ch.13
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Marginal Product
 The
marginal product of any input is the increase in
output arising from an additional unit of that
input, holding all other inputs constant.
 E.g., if Farmer Jack hires one more worker,
his output rises by the marginal product of labour.
 Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labour
 Marginal
product of labour (MPL) = delta Q/delta L
Principles of Microeconomics : Ch.13
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Why MPL Diminishes
 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.).
Principles of Microeconomics : Ch.13
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Short-Run vs. Long-Run
Two different time horizons are
important when analyzing costs.
Short-Run: Time period over which
some inputs are variable (labour,
materials) and some inputs are fixed
(plant size).
Long-Run: Time period over which all
inputs are variable, including plant size.
Principles of Microeconomics : Ch.13
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Short-Run Costs
Costs of production may be divided into
two categories in the short-run:
Fixed Costs:
–Those costs that do not vary with the
amount of output produced.
Variable Costs:
–Those costs that do vary with the
amount of output produced.
Principles of Microeconomics : Ch.13
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Marginal Cost
 Marginal
Cost (MC)
is the increase in Total Cost from
producing one more unit:
 MC = delta TC/delta Q
Principles of Microeconomics : Ch.13
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The Shape of Short-Run Cost
Curves
 Short-run
cost behaviour is based on the
productivity of the inputs (resources).
 As the firm continues to expand output,
in a fixed plant-size situation, eventually
the marginal product of each successive
worker hired will decrease.
 The diminishing marginal product causes
the marginal cost to increase in the shortrun. This in turn affects the behaviour of
average total cost.
Principles of Microeconomics : Ch.13
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The Shape of Typical Cost Curves
U-Shaped Average Total Cost (ATC):
– At low levels of output, as the firm
expands production, ATC declines.
– At higher production levels, as output is
increased, ATC increases.
– The bottom of the U-Shape occurs at the
quantity that minimizes average total
cost.
– This is called the Efficient Size of the firm.
Principles of Microeconomics : Ch.13
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The Relationship Between Marginal
Cost and Average Total Cost
is ATC U - shaped?
 When marginal cost is less than average
total cost, average total cost is falling.
 Why
MC < ATC
ATC
 When
marginal cost is greater than average
total cost, average total cost is rising.
MC > ATC
Principles of Microeconomics : Ch.13
ATC
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The Relationship Between Marginal
Cost and Average Total Cost
Cost ($’s)
MC
Principles of Microeconomics : Ch.13
ATC
The marginal cost
curve always crosses
the average total cost
curve at the minimum
average total cost!
Quantity
First Canadian Edition
Costs in the Short Run & Long Run
 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).
Principles of Microeconomics : Ch.13
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Long-Run Costs
$
Per
Unit
LRATC Curve
Econ.
of
Scale
Constant
Returns to
Scale
Disecon
. of
Scale
Scale of Operation (Q)
Principles of Microeconomics : Ch.13
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How ATC Changes as
the Scale of Production Changes
 Economies
of scale occur when increasing
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
problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
– More common when Q is high.
– Constant returns to scale if more output neither
increases or decreases cost. (flat portion of
LRATC)
Principles of Microeconomics : Ch.13
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