The Costs of Production
Principles of Microeconomics
Boris Nikolaev
Brainstorming costs
You run Ford Motor Company.
• List three different costs you have.
• List three different
business decisions
that are affected
by your costs.
In this chapter
• What is a production function? What is marginal
•
•
•
product? How are they related?
What are the various costs? 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”?
It’s business time.
• Firms are in the business of
making profits.
Profit = Total Revenue (TR) – Total Cost (TC)
the amount a
firm receives
from the sale of
its output
the market value
of the inputs a
firm uses in
production
Sneak Preview
MR=MC
Profits
• Are profits bad?
• What is the function of profits in a free market
economy?
• In a competitive market profits come not from
increase in price, but from decrease in the
cost of production. Why?
• Fortune 500 most profitable companies [see
here]
The Weed Trail [read here]
Profits and Insurance
• Recollect risk-aversion & uncertainty.
Corporate Profits after tax
CP/GDP
Marxist View
• The stagnating wages since the 1970s
–
–
–
–
–
Technology
World war II
Outsourcing
Women in the labor force
Immigration
• Problem of effective demand
– Work more hours
– Borrowing binge (mortgage debt, credit cards)
• Greatest profit boom (in the history of the world)
– Marginal productivity, wages, and profits
Productivity vs Wages
What do you do with the profits?
• CEO salaries [Forbes list]
• Mergers & Acquisitions
• Lend to employees (e.g. GM, IBM, etc.)
Costs
• Resources are scarce, productive, and have
alternative uses.
Explicit costs are the direct cash payments you
make to use resources you don’t own such as
wages, rent, insurance, taxes, etc.
Implicit costs is the opportunity cost of the
resource you own (the benefit you could have
extracted from it from its next best use). Do not
require direct cast payments.
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.
Economic vs Accounting Profit
• Accounting profit
= total revenue minus total explicit costs
• Economic profit
= total revenue minus total costs (including explicit
and implicit costs)
• Accounting profit ignores implicit costs,
so it’s higher than economic profit.
Example 1
The equilibrium rent on office space has just
increased by $500/month.
Determine the effects on accounting profit and
economic profit if:
a. you rent your office space
b. you own your office space
Answers
The rent on office space increases $500/month.
a. You rent your office space.
Explicit costs increase $500/month.
Accounting profit & economic profit each fall
$500/month.
b.You own your office space.
Explicit costs do not change,
so accounting profit does not change.
Implicit costs increase $500/month (opp. cost
of using your space instead of renting it)
so economic profit falls by $500/month.
Practice Question
Your current job pays $50K/year. You have $20K savings that earn you $3K
interest a year. You own a garage, which you rent for $12K/ year. You decide
to invest your savings and use your garage to start your own business.
Did you make a good economic decision?
Total Revenue
Explicit Costs
labor
food
Total Cost
$105K
$21K
$20K
$41K
Implicit Costs
salary
interest
rent
Total Implicit Cost
Accounting Profit
_____
Economic Profit / Loss______
_____
_____
_____
_____
Production in the Short Run
Q= f(L,K)
A production function shows the relationship
between the quantity of inputs used to produce a
good and the quantity of output of that good.
EXAMPLE 1: Production Function
Q
(no. of (bushels
workers) of wheat)
3,000
Quantity of output
L
2,500
0
0
1
1000
2
1800
3
2400
500
4
2800
0
5
3000
2,000
1,500
1,000
0
1
2
3
4
No. of workers
5
Marginal Product (MP)
• If you hire one more worker, your output rises by the
marginal product of labor.
• The marginal product of any input is the increase in
output arising from an additional unit of that input,
holding all other inputs constant.
• Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labor
• Marginal product of labor (MPL) = ∆Q
∆L
EXAMPLE 1: Total & Marginal Product
L
Q
(no. of (bushels
workers) of wheat)
∆L = 1
0
1
∆L = 1
∆L = 1
∆L = 1
∆L = 1
2
3
4
5
0
MPL
∆Q = 1000
1000
∆Q = 800
800
∆Q = 600
600
∆Q = 400
400
∆Q = 200
200
1000
1800
2400
2800
3000
EXAMPLE 1: MPL = Slope of Prod Function
Q
(no. of (bushels MPL
workers) of wheat)
0
0
1000
1
1000
800
2
1800
600
3
4
5
2400
2800
3000
400
200
MPL
3,000
Quantity of output
L
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why
500 production
the
function
gets flatter
0
as L0 increases.
1
2
3
4
No. of workers
5
Why MPL Is Important
• Recall one of the Ten Principles:
Rational people think at the margin.
• When you hire an extra worker,
– your costs rise by the wage he pays the worker
– your output rises by MPL
• Comparing them helps you decide whether he should
hire the worker.
Class demonstration
The Law of Diminishing Marginal
Returns
• Diminishing marginal product:
The marginal product of an input declines as
the quantity of the input increases (other
things equal).
• Why does it decline?
Practice Question
# fishermen
Fish caught
1
15
2
35
3
58
4
80
5
95
6
105
7
108
8
105
Input (L)
TP = f(L)
MP of labor
Assume that only one input (L) is relevant in production.
The wage / worker = $175 and one pound of fish is selling for $10
MRP
Let’s go back to our farm example…
• You must pay $1000 per month for the land,
regardless of how much wheat you grow.
• The market wage for a farm worker is $2000
per month.
• Your cots are related to how much wheat you
produce…
EXAMPLE 1: Your Costs
L
Q
Cost of
(no. of (bushels
land
workers) of wheat)
Cost of
labor
Total
cost
0
0
$1,000
$0
$1,000
1
1000
$1,000
$2,000
$3,000
2
1800
$1,000
$4,000
$5,000
3
2400
$1,000
$6,000
$7,000
4
2800
$1,000
$8,000
$9,000
5
3000
$1,000 $10,000
$11,000
EXAMPLE 1: Total Cost Curve
$12,000
Total
Cost
0
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
$10,000
Total cost
Q
(bushels
of wheat)
$8,000
$6,000
$4,000
$2,000
$0
0
1000
2000
3000
Quantity of wheat
Marginal Cost
• Marginal Cost (MC)
is the increase in Total Cost from
∆TC
producing one more unit: MC =
∆Q
EXAMPLE 1: Total and Marginal Cost
Q
(bushels
of wheat)
0
Total
Cost
$1,000
∆Q = 1000
1000
$3,000
∆Q = 800
∆Q = 600
∆Q = 400
∆Q = 200
1800
Marginal
Cost (MC)
$5,000
2400
$7,000
2800
$9,000
3000 $11,000
∆TC = $2000
$2.00
∆TC = $2000
$2.50
∆TC = $2000
$3.33
∆TC = $2000
$5.00
∆TC = $2000
$10.00
EXAMPLE 1: The Marginal Cost Curve
0
TC
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
$10
Marginal Cost ($)
Q
(bushels
of wheat)
$12
$8
MC usually rises
as Q rises,
as in this example.
$6
$4
$2
$5.00
2800
$9,000
3000 $11,000
$10.00
$0
0
1,000
2,000
Q
3,000
Why MC Is Important
• You are rational and want to maximize your profits. To
increase profit, should you produce more or less
wheat?
• To find the answer, you need to
“think at the margin.”
• If MC > MR then producing one more unit will decrease
profits.
Fixed and Variable Costs
• Fixed costs (FC) do not vary with the quantity of output
produced.
– In our example, FC = $1000 for land
– Other examples:
cost of equipment, loan payments, rent
• Variable costs (VC) vary with the quantity produced.
– In our example, VC = wages you pay workers
– Other example: cost of materials
• Total cost (TC) = FC + VC
EXAMPLE 2: Costs
FC
VC
TC
0 $100
$0 $100
1
100
70
170
2
100 120
220
3
100 160
260
4
100 210
310
5
100 280
380
FC
$700
VC
TC
$600
$500
Costs
Q
$800
$400
$300
$200
$100
6
7
100 380
100 520
480
620
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Marginal Cost
TC
MC
0 $100
1
2
3
4
5
6
7
170
220
260
310
380
480
620
$70
50
40
50
70
100
140
$200 Marginal Cost (MC)
Recall,
is $175
the change in total cost from
producing
one more unit:
$150
∆TC
MC =
∆Q
$100
Usually,
MC rises as Q rises, due
$75
to diminishing marginal product.
Costs
Q
$125
$50
Sometimes (as here), MC falls
$25
before rising.
$0
(In other0 examples,
1 2 3 MC
4 may
5 6be 7
constant.)
Q
EXAMPLE 2: Average Fixed Cost
FC
0 $100
1
2
100
100
AFC
n/a
$100
50
3
100 33.33
4
100
25
5
100
20
6
100 16.67
7
100 14.29
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
Costs
Q
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The firm is spreading its fixed
$50
costs over a larger and larger
$25
number
of units.
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Average Variable Cost
VC
AVC
0
$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
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity of output:
$150
Costs
Q
AVC
$125
= VC/Q
$100
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: Average Total Cost
Q
TC
0 $100
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
Average total cost
(ATC) equals total
cost divided by the
quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
EXAMPLE 2: Average Total Cost
TC
0 $100
1
2
170
220
ATC
$200
Usually,
as in this example,
$175
the ATC curve is U-shaped.
n/a
$150
$170
110
Costs
Q
$125
$100
3
260 86.67
4
310 77.50
5
380
76
$25
6
480
80
$0
7
620 88.57
$75
$50
0
1
2
3
4
Q
5
6
7
EXAMPLE 2: The Various Cost Curves Together
$200
$175
ATC
AVC
AFC
MC
Costs
$150
$125
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
Calculating costs
Fill in the blank spaces of this table.
Q
VC
0
1
10
2
30
TC
AFC
AVC
ATC
$50
n/a
n/a
n/a
$10
$60.00
80
3
16.67
4
100
5
150
6
210
150
20
12.50
36.67
8.33
$10
30
37.50
30
260
MC
35
43.33
60
Answers
Use
AFC
FC/Q
ATC
AVC
= TC/Q
VC/Q
MC
and
First,relationship
deduce
FC between
= $50 and
use
FCTC
+ VC = TC.
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
EXAMPLE 2: ATC and MC
$200
ATC is falling.
$175
When MC > ATC,
$150
ATC is rising.
$125
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
Costs
When MC < ATC,
ATC
MC
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
Cost in the 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).
EXAMPLE 3: LRATC with 3 factory sizes
Firm can choose
from three factory Avg
Total
sizes: S, M, L.
Cost
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.
ATCS
ATCM
ATCL
Q
A Typical LRATC Curve
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
How ATC Changes as
the Scale of Production Changes
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
Q
Sources of Economies of Scale
• Spread of “overhead,” fixed cost over bigger
production.
• Labor specialization.
• Technology.
• Learning by doing.
• Agglomeration economies.
Note on International Trade
• What goods are produced and where?
• David Ricardo (1800’s) – comparative
advantage.
• Heckscher & Ohlin (1920-30’s) – differences in
factor endowments. Example: Developed
countries export more capital intensive goods
(cars, airplanes, etc…) and import from
developing countries more labor intensive
goods (clothing, agricultural products, etc…)
• Empirical studies.
Krugman’s Model
Uses economies of scale to explain
international trade.
1. Mass production decreases average
cost (ES)
2. Consumers prefer diversity of
products
Each country specializes and then trades. This is how countries
with similar factor endowments engage in trade (e.g. Japan
sells Toyota to US, US sells GM to Germany, etc…)