The Costs of Production
 Outline:
– Study how firm’s decisions regarding prices and
quantities depend on the market conditions they
face
– Firm’s costs are a key determinant of its
production (supply curve) and its pricing
decisions
– Firm’s objective therefore is to maximize its
profits
– Profits= TR-TC
The Costs of Production
 TR= Total Revenue= PxQ
 Total Revenue is the amount a firm
receives from the sale of its output
 Total cost is the amount a firm pays to
buy the units of production
 Economist’s interpretation of total cost
includes the opportunity cost of
production as well
The Costs of Production
 A firm’s opportunity costs can be
obvious at times and not so obvious at
other times
 Explicit costs are input costs that
require an outlay of money by the firm
 Implicit costs are input costs that do
not require an outlay of money by the
firm
Economic Costs Versus Accounting
Costs
 Accountants measure explicit costs
(as it involves money flows)
 Economists use both explicit costs
(wages, rent, cost of raw material) and
implicit costs (foregone income) to
arrive at the total cost of production
 The cost of capital is an opportunity
cost due to the foregone interest on
savings (implicit cost)
Economic Profit Versus Accounting Profit
 Economic profit is the TR minus TC,
including both explicit and implicit costs
 Accounting profit is the TR minus
total explicit cost
 Therefore, economic profit is smaller
than accounting profit
Economic Profit Versus Accounting Profit
Economic
profit
TR
Accounting
profit
Implicit Costs
OC
Explicit costs
Economist’s
view
TR
Explicit
costs
Accountant's
view
Production and Costs
 What is the link between a firm’s production
process and its total cost?
– Fixed size of the firm
– Labor is the only variable input
– Decisions in the SR (# of labor to hire and
quantity of output to produce)
 Production function is the relationship
between the quantity of inputs used to make
a good and the quantity of output of the
good
Production and Costs
 Marginal product is the increase in output that
arises from an additional unit of input
 Diminishing marginal product is the property
whereby the marginal product of an input
declines as the quantity of the input increases
 The slope of the production function is given
as the change in output for an additional input
of labor.
 Slope of the production function measures the
marginal product of input
Production and Costs
#
workers
0
1
2
3
4
5
Output
/hour
0
50
90
120
140
150
Wage=$10/ worker
MP of L Cost of
factory
30
50
30
40
30
30
30
20
30
10
30
Cost of
workers
0
10
20
30
40
50
TC of
inputs
30
40
50
60
70
80
Production function
160
140
120
Output/ hour
100
80
Output/hour
60
40
20
0
0
1
2
# Workers hired
3
4
5
Production Function and Total Cost



Total cost curve shows the relationship
between the quantity of output produced and
the total cost of production
Production function gets flatter as the
amount of input increases (diminishing
Marginal Product)
Total cost curve gets steeper as the amount
produced rises (production cost of a marginal
unit of output increases)
Measures of Cost








Total Cost (TC) =TFC+TVC
Fixed Costs (TFC) are costs that do not vary
with the quantity of output (Q) produced
Variable Costs (TVC) are costs that do vary with
the quantity of output produced
Average Cost (ATC) = TC/Q
Average Fixed Cost (AFC)= TFC/Q
Average Variable Cost (AVC)= TVC/Q
Marginal cost (MC)= change in TC/change in Q
MC is the increase in total cost that arises from
an extra unit of production
Production and Costs

Cost of production has an impact on the
firm’s production decisions
– Cost of producing a typical unit of output
(ATC)
– Cost of producing an additional unit of
output (MC)

Cost curves and their shapes
– X-axis measures the quantity produced
– Y-axis measures the cost of production
Q/hour TC
FC
VC
AFC
AVC
ATC
MC
0
2.00
2.00
0.00
-
-
-
1
3.00
2.00
1.00
2.00
1.00
3.00
1.00
2
3.80
2.00
1.80
1.00
0.90
1.90
0.80
3
4.40
2.00
2.40
0.67
0.80
1.47
0.60
4
4.80
2.00
2.80
0.50
0.70
1.20
0.40
5
5.20
2.00
3.20
0.40
0.64
1.04
0.40
6
5.80
2.00
3.80
0.33
0.63
0.96
0.60
7
6.60
2.00
4.60
0.29
0.66
0.95
0.80
8
7.60
2.00
5.60
0.25
0.70
0.95
1.00
9
8.80
2.00
6.80
0.22
0.76
0.98
1.20
10
10.20 2.00
8.20
0.20
0.82
1.02
1.40
11
11.80 2.00
9.80
0.18
0.89
1.07
1.60
12
13.60 2.00
11.60
0.17
0.97
1.14
1.80
13
15.60 2.00
13.60
0.15
1.05
1.20
2.00
14
17.80 2.00
15.80
0.14
1.13
1.27
2.20
Cost Curves: Total Cost, Fixed Cost, Variable Cost
20
18
Total cost
Fixed Cost
Variable cost
16
14
Cost
12
10
8
6
4
2
0
0
1
2
3
4
5
6
7
8
Output/hour
9
10
11
12
13
14
Average Costs
3.5
3
MC cuts ATC at its
minimum point
2.5
ATC is U-shaped
MC is greater than ATC,
ATC is rising
AFC
Costs
2
AVC
ATC
1.5
MC
1
Efficient scale of the
firm
0.5
MC is less than ATC, ATC is
falling
0
0
1
2
3
4
5
6
7
Output/ hour
8
9
10
11
12
13
Typical Cost Curves

A firm’s cost curves exhibit the
following common features:
– MC eventually rises with the quantity of
output
– ATC is U-shaped
– MC curve crosses the ATC at the minimum
of ATC

MC initially falls with increase in output but
eventually rises as output increasesdiminishing marginal product
Typical Cost Curves





AFC declines as output increases but AVC
increases as output increases- explains
ATC’s U-shape
The bottom of the U-shape occurs at the
quantity that minimizes ATC. This
quantity of output is called the efficient
scale of the firm
MC<ATC= ATC is falling
MC>ATC= ATC is rising
MC crosses ATC at the efficient scale of
the firm
Typical Cost Curves


The combination of increasing and then
decreasing MP also make the AVC Ushaped
Both MC and AVC fall initially before rising
with increase in output
LR and SR costs


In the SR the firm has to continue on the
same cost curve chosen in the past
In the LR the firm can choose to move to a
different cost curve as FC become variable
Economies of scale

Economies of scale is the property whereby LR
ATC falls as the quantity of output increases
– Specialization leads to higher output/worker
and lower ATC/unit of output
 Diseconomies of scale is the property whereby
LR ATC rises as the quantity of output increases
– Coordination problems
 Constant returns to scale is the property
whereby LR ATC remains constant as the
quantity of output changes