Chapter 8
Production and
Cost
Introduction to Economics (Combined
Version) 5th Edition
Costs and Profits
Microeconomic theory
is based on the
assumption that firms
are in business to
maximize profit.
• Profit is the difference
between the revenue a
firm earns by selling its
output and the
opportunity costs of
producing that output.
Introduction to Economics (Combined
Version) 5th Edition
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Explicit Costs
 Explicit costs are opportunity
costs that take the form of
explicit payments to suppliers of
factors of production and
intermediate goods.
 Examples:




Players’ salaries are an
explicit cost for a professional
football team.
workers’ wages
managers’ salaries
salespeople’s commissions
interest payments to banks and
other creditors
 fees for legal advice and other
services
 payments for energy and raw
material
Introduction to Economics (Combined
Version) 5th Edition
Implicit Costs
 Implicit costs are opportunity
costs of using resources
contributed by the firm’s
owners (or owned by the firm
itself as a legal entity) that are
not obtained under contracts
calling for explicit payments.
 Examples:
 Labor of a small-business owner
 Opportunity cost of smallbusiness owners’ own savings
invested in a business
 Opportunity cost of capital
invested by corporate
shareholders
The opportunity cost of the time of
a small-business owner who works
without a salary is an example of
an implicit cost.
Introduction to Economics (Combined
Version) 5th Edition
Normal Profit
 Table shows the implicit and
explicit costs of the imaginary
firm Fieldcom, Inc.
 Total revenue minus explicit costs
equals accounting profit.
 Subtracting implicit costs from
this quantity yields pure
economic profit.
 The opportunity cost of capital
contributed by the owners can
also be called normal profit.
Total Revenue
$600,000
Less explicit costs:
Wages and salaries
300,000
Materials and other 100,000
_________
Equals accounting profit $200,000
Less implicit costs:
Owners’ forgone salary 160,000
80,000
Opportunity cost
of capital
20,000
_________
= pure economic profit
$ 20,000
Introduction to Economics (Combined
Version) 5th Edition
Fixed and Variable Costs
• Variable costs: Costs of
inputs whose quantities can
be changed easily in the
short run
 Fixed costs: Costs of inputs
whose quantities can be
changed only in the long
run by increasing or
decreasing the size of the
firm’s plant
 Sunk costs: One-time costs
which, once made, cannot
be recovered if the firm
goes out of business
The costs of owning a
warehouse are a fixed cost for
a trucking firm.
Introduction to Economics (Combined
Version) 5th Edition
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Marginal Physical Product
 Marginal physical product of labor is the amount by which total
output increases or decreases when the quantity of labor
increases by one unit.
Introduction to Economics (Combined
Version) 5th Edition
Law of Diminishing Returns
According to the law of
diminishing returns, as
the amount of one
variable input is
increased while the
amounts of all other
inputs remain fixed, a
point will be reached
beyond which the
marginal physical product
of the input will decrease.
Introduction to Economics (Combined
Version) 5th Edition
Range of
Diminishing
Returns
Marginal Cost
Marginal Cost is the amount by which total variable costs (labor
costs, in this example) increase or decrease when the quantity of
output increases by one unit.
Introduction to Economics (Combined
Version) 5th Edition
Family of Cost
Curves
•
•
•
•
•
TC = TVC + TFC
ATC = TC/Q
AVC = TVC/Q
AFC = TFC/Q
MC = ΔTC/ ΔQ
Introduction to Economics (Combined
Version) 5th Edition
Marginal-Average Rule
 The marginal cost curve intersects the minimum points of the
average total cost and average variable cost curves.
Introduction to Economics (Combined
Version) 5th Edition
Long- and Short-Run Average Cost Curves
 The position of the short-run average total cost curve for a firm depends on
the size of the plant. Each plant size can be represented by a U-shaped shortrun average total cost curve. The firm’s long-run average cost curve is the
“envelope” of these and other possible short-run average total cost curves;
that is, it is a smooth curve drawn so that it just touches the short-run curves
without intersecting any of them.
Introduction to Economics (Combined
Version) 5th Edition
Economies and Diseconomies of Scale
 In any output range in which
long-run average cost
decreases as output increases,
the firm is said to experience
economies of scale.
 In any output range in which
long-run average cost
increases, the firm is said to
experience diseconomies of
scale.
 If there is any range of output
for which long-run average
cost does not change as
output varies, the firm is said
to experience constant
returns to scale in that range.
Introduction to Economics (Combined
Version) 5th Edition
Appendix to Chapter Eight
Costs and Output with Two Variable
Inputs
Introduction to Economics (Combined
Version) 5th Edition
An Isoquant
 An isoquantity line, or isoquant
shows various ways of producing a
given quantity of output.
 Here, Points P, Q, and R represent
various ways of growing the 200
bushels of corn.
 A movement downward along the
isoquant represents the
substitution of fertilizer for land
while output is maintained at 200
bushels per year.
 As fertilizer is substituted for land,
the isoquant becomes flatter
because of diminishing returns.
Introduction to Economics (Combined
Version) 5th Edition
Least-Cost Method of Production
 The price of fertilizer is assumed
to be $50 a ton and the rental
price of land $50 per year.
 A set of budget lines is drawn to
represent various levels of
spending on inputs.
 Line A ($400) does not provide
enough inputs to produce 200
bushels.
 Line C ($625) provides enough
inputs to grow 200 bushels of corn
using methods P or R.
 Line B ($500) permits the 200
bushels to be grown using method
Q, which is the least-cost method
given these input prices.
Introduction to Economics (Combined
Version) 5th Edition
Effect of a Change in Input Price
 Assume the price of land increases from $50 to $200 and the price of fertilizer
remains fixed at $50 a ton. The $500 budget line shifts from position B to position C
and now falls short of the 200-bushel isoquant. Increasing the amount spent on
variable inputs to $1,000 shifts the budget line up to position D, where it just
touches the isoquant at point R. Total variable cost of 200 bushels increases and
fertilizer is be substituted for land, which is now relatively more costly.
Introduction to Economics (Combined
Version) 5th Edition
From Isoquants
to Cost Curve
 Part (a) of this figure shows
100, 200, and 300 bushels
isoquants.
 Budget lines are based on
input prices of $50 an acre for
land and $50 a ton for fertilizer.
 As output expands, the firm
will move from T to Q and
then to W along the
expansion path.
 Part (b) of the figure plots the
amount of output and the
total variable cost for each of
these points, giving a total
variable cost curve.
Introduction to Economics (Combined
Version) 5th Edition