PRODUCTION AND ITS
COSTS




Principles of
Microeconomic Theory,
ECO 284
John Eastwood
CBA 213
523-7353

e-mail address:
John.Eastwood@nau.edu

http://jan.ucc.nau.edu/~jde
1
ALL ABOUT COSTS
Explicit and Implicit Costs
 Accounting Profit and Economic Profit
 Sunk Costs

2
Explicit and Implicit Costs

Explicit Costs
An explicit cost is incurred when an actual
monetary payment is made.

Implicit Costs
Implicit costs are the value of the resources used
in the production of a good for which no monetary
payment is made.
3
Accounting Profit and Economic
Profit
Accounting Profit
= Total Revenue - total explicit costs
 Economic Profit
= Total Revenue - opportunity costs
 Opportunity Costs
= Explicit costs + Implicit costs

4
Normal Profit
When a firm's revenue just covers its
opportunity costs, it is earning a zero
economic profit.
 This is also known as a normal profit.
 Total Cost (TC) includes all opportunity
costs, including a normal profit.

5
Sunk Costs

Costs incurred in the past that cannot be
changed by current decisions and cannot be
recovered are said to be "sunk."
6
PRODUCTION AND COSTS IN
THE SHORT RUN
The Short-Run Production Function
 Inputs And Costs In The Short Run
 Total, Average and Marginal Costs

7
Production Functions
. . . express the relationship between the
quantity of the inputs and the maximum
quantity of output (q) that can be produced
with those inputs.
 The quantities of some inputs are variable
in the short run (e.g., labor, materials)
 The quantity of other inputs (e.g., capital,
land) are fixed in the short run.

8
Short-Run Production Function
(a.k.a. TPL)

. . . expresses the relationship between the
quantity of the labor and the maximum
quantity of output (q) that can be produced,
holding the quantity of other inputs (e.g.,
capital, land) constant.
9
Total, Marginal, and Average
Physical Products of Labor
TP  q  f ( K , L, N )
q q 2  q1

MPP L 
L L2  L1
q
APP L 
L
10
Example:q=Sand Output (Tons/Day)
L=Labor (8-hr. worker-shifts/day)
L
0
1
2
3
4
5
6
q APPL MPPL
-0
10
22
36
13
52
14
70
86 14.33
--
q
MPP L 
L
16
18
16
q
APP L 
L
11
Table 1: q= Sand (Tons/Day) L=Labor
(8-hr. worker-shifts/Day)
L
6
7
8
9
10
11
12
q
86
100
112
122
130
137
143
MPPL
APPL
16
14.33
14
14.28
12
14.00
10
13.55
8
13.00
7
12.45
6
11.92
q
MPP L 
L
q
APP L 
L
13
Table 1: q= Sand (Tons/Day) L=Labor
(8-hr. worker-shifts/Day)
L
13
14
15
16
17
18
19
q
148
152
155
157
158
158
157
APPL
MPPL
11.38
5
10.85
4
10.33
3
9.81
2
9.29
1
8.78
0
8.26
-1
q
MPP L 
L
q
APP L 
L
14
The Average - Marginal Rule
When the marginal magnitude (e.g. product,
cost, or utility) exceeds the average
magnitude, the average must rise.
 When the marginal magnitude is less than
the average magnitude, the average must
fall.
 Marginal curve intersects average curve at a
maximum or minimum.

15
From Definitions to Cost Curves

The Law of Diminishing Marginal Returns
–
As more units of a variable input are combined
with fixed inputs, eventually the marginal
physical product of the variable input will
decline.
16
Inputs And Costs In The Short Run
Fixed And Variable Inputs
 Fixed and Variable Costs
 Total Cost = Total Fixed Cost + Total
Variable Cost
 TC= TFC + TVC

17
Example: w=wage; q= Sand (Tons/Day);
L=Labor (8-hr. worker-shifts /Day)
L
0
1
2
3
4
5
6
q TVC
0
10
22
36
52
70
86
TC
0 100
50 150
100 200
w = $50/worker-shift
TVC = wL($/day)
TFC = $100/day
TC = TFC + TVC
18
Example: w=wage; q= Sand (Tons/Day);
L=Labor (8-hr. worker-shifts /Day)
L
7
8
9
10
11
12
13
q TVC
100
112
122
130
137
143
148
350
400
450
500
550
600
650
TC
450
500
550
600
650
700
750
w = $50/worker-shift
TVC = wL($/day)
TFC = $100/day
TC = TFC + TVC
20
Example: w=wage; q= Sand (Tons/Day);
L=Labor (8-hr. worker-shifts /Day)
L
14
15
16
17
18
19
q TVC
152
155
157
158
158
157
700
750
800
850
900
950
TC
800
850
900
950
1000
1050
w = $50/worker-shift
TVC = wL($/day)
TFC = $100/day
TC = TFC + TVC
21
Average Cost Concepts
Average Fixed Cost, AFC=TFC/q
 Average Variable Cost, AVC=TVC/q
 Average Total Cost, ATC=TC/q
 where q = the quantity of output.

22
Marginal Cost, MC:

The change in total cost that results from a
one unit change in output.
TC TVC TVC 2  TVC1
MC 


q
q
q 2  q1
23
Example: w=wage; q= Sand (Tons/Day);
L=Labor (8-hr. worker-shifts /Day)
q TVC
0
0
10
50
22
100
36
150
52
200
70
250
86
300
100
350
112
400
TC
100
150
200
250
300
350
400
450
500
AVC
-5.00
4.54
4.17
3.85
3.57
3.49
AFC
-10.00
4.55
2.78
1.92
1.43
1.16
ATC
-15.00
9.09
6.95
5.77
5.00
4.65
MC
-5.00
4.17
3.57
3.13
2.78
3.13
3.57
0.89
4.46
4.17
24
Example: w=wage; q= Sand (Tons/Day);
L=Labor (8-hr. worker-shifts /Day)
q TVC
122
450
130
500
137
550
143
600
148
650
152
700
155
750
157
800
158
850
TC
500
600
650
700
750
800
850
900
950
AVC
3.69
3.85
4.01
4.20
4.39
4.60
4.84
5.10
5.38
AFC
0.82
0.77
0.73
0.70
.068
0.66
0.65
0.64
0.63
ATC
4.51
4.62
4.74
4.90
5.07
5.26
5.49
5.74
6.01
MC
5.00
6.25
7.14
8.33
10.00
12.50
16.67
25.00
50.00
26
Average - Marginal Rule (Again)
When the marginal magnitude exceeds the
average magnitude, the average must rise.
 When the marginal magnitude is less than
the average magnitude, the average must
fall.
 MC cuts AVC and ATC at their lowest
points.

27
Total Costs Shown as Areas
TC at a given quantity, q, equals the area of
the rectangle formed by the origin, q, and
ATCq (along both the y-axis and on the
curve.
 Rectangles formed by AVC and AFC at q
show TVC and TFC.

28
AVC and APPL are Related

As APPL rises, AVC decreases; as APPL
falls, AVC increases.
Assume labor is the only variable input:
TVC wL
w
w
AVC 



q
q
q
APP L
L
29
Diminishing Marginal Returns
and Marginal Cost

MC and MPP are related. As MPP rises, MC
decreases; as MPP falls, MC increases.
Assume labor is the only variable input:
TVC wL
w
w
MC 



q
q
q
MPP L
L
30
PRODUCTION AND COSTS IN
THE LONG RUN
Least-cost production
 Long run average (total) cost.
 Returns to Scale
 Economies of Scope
 Technological Change

31
Equal MPP per Dollar
In the long run, all inputs may vary. For
example, K may be substituted for L.
 Least-cost production requires that each
resource is equally productive at the margin:

MPP L MPP K MPP N


w
i
n
32
The Long-Run Average Total
Cost Curve (LRATC)
Each possible plant size has a unique shortrun ATC curve.
 LRATC shows the lowest average cost at
which the firm can produce any given level
of output.

33
How LRATC Changes with the
Scale of the Firm
Economies of Scale
(a.k.a. Increasing returns to scale) LRATC
has a negative slope.
 Constant Returns to Scale
LRATC has a slope = 0.
 Diseconomies of Scale
(a.k.a. Decreasing returns to scale) LRATC
has a positive slope.

34
Constant Returns to Scale

Say we double all inputs and get double the
output
–
–
–
–

q = f(K,L), and f(2K,2L)=2q
LRATC=LRTC/q
With w & i constant, LRTC doubles.
LRATC ($/unit) is the same at q and 2q.
This is Constant Returns to Scale, CRS.
35
Increasing Returns to Scale

Say we double all inputs and get more than
twice the output
–
–
–
–

q = f(K,L), but f(2K,2L)>2q
With w & i constant, LRTC doubles.
Output more than doubles.
LRATC = LRTC/q ($/unit) falls
This is Increasing Returns to Scale, IRS
(a.k.a. Economies of Scale)
36
Decreasing Returns to Scale

Say we double all inputs, but get less than
twice the output
–
–
–
–

q = f(K,L), but f(2K,2L)<2q
With w & i constant, LRTC doubles.
But output less than doubles.
LRATC = LRTC/q ($/unit) rises
This is Decreasing returns to scale (a.k.a.
Diseconomies of Scale )
37
LRATC is the Planning Curve

Optimum Plant Size
–

What is the most efficient scale of operations?
Minimum Efficient Scale
–
What is the smallest plant that will be
competitive?
38
COST CURVES SHIFT WHEN
Input prices change
 The production function shifts

–
–

Technological progress occurs
The quantity of fixed inputs changes
Taxes change
39
Input Prices
Higher prices for fixed inputs shift
TFC, TC, AFC, and ATC up.
 Higher prices for variable inputs shift
TVC, TC, AVC, ATC, and MC up.

40
Technological progress affects
costs in two ways:
It may improve the production process
 It may lower input prices

41
Taxes
. . . on fixed inputs
 . . . on variable inputs, output, revenue,
profit, etc.

42
Isocosts and Isoquants
Isocost means one cost.
 Isocost lines are similar to budget lines.
 Isoquant means one quantity.
 Isoquants are similar to indifference curves.

43
Isocost lines show bundles of (L,K)
of equal cost







Let TC = Total Cost
L = quantity of L
w = price of L
K = quantity of K
k = price of K
The y-intercept equals:
The slope equals the
relative price of L
($/unit L)/ ($/unit K)=
units of K per unit of L
TC  wL  kK
kK  TC  wL
TC w
 L
K
k
k
44
Changes in the Isocost Line
Increases in TC shift the Isocost out.
 The vertical intercept increases when
TC increases.
 Changes in relative factor prices
rotate the budget line. The slope
equals the relative price of L (w/k) . A
lower w yields a smaller |slope|.

45
Isoquant Curves
One isoquant through each point.
 Each isoquant slopes down to the right.
 Isoquants further from the origin show
higher quantities of output.
 Isoquants never cross.
 Isoquants are bowed toward the origin.

46
Slope of an Isoquant
at a point equals - MRTSLK
 MRTSLK is the Marginal Rate of Technical
Substitution of K for L.
 MRTSLK = # of units of K the firm must add
to replace one unit of L.

47
Along an Isoquant , Output is
constant
q  MPP L L  MPP K K
0  MPP L L  MPP K K
 MPP K K  MPP L L
K
MPP L

L
MPP K
48
Least-Cost Production


. . . occurs once the firm reaches the lowest possible
isocost attainable given its output goal.
At that point, the slopes of the isocost and the isoquant are
equal.
w
MPP L
 
k
MPP K
49
Equal MPP per Dollar

w MPP L

k MPP K
MPP K MPP L

k
w
The tangency of the
Isocost and the
Isoquant imply that
K and L are equally
efficient at the
margin.
50
Diminishing Returns (Again)
In Figure 11, on page 189, illustrates this
concept using isoquants.
 K is fixed in the SR,
 As more L is added, the MPPL eventually
falls.

51
Product and Process Technology
Better product
technology results in
new or improved
products.
 Better process
technology shifts the
production function
upward.

q
TPnew
TPold
q2
q1
0
L2 L1
L
52
Factors that shift TP up



Better process
technology.
More of the fixed
factors of production.
Workers’ skills
improved.
q
TPnew
TPold
q2
q1
0
L2 L1
L
53
Technology and
Industrial Evolution
Mass production tech. allowed the use of
task-specific capital and relatively lowskilled labor.
 Early development of this technology gave
the US an edge in manufacturing.
 Other factors added to our comparative
advantage: abundant N; long history of HS
education; no bombs hit us in WWII.

54
Henry Ford’s Model T
The car was an advance in product
technology.
 Ford’s mass production techniques
advanced process technology.
 Large amounts of capital were combined
with labor

–
–
resulting in a high MPPL,
and correspondingly high wages.
55
Strategy: Task-specific capital &
low skilled labor
Long production runs can make this
strategy profitable.
 Much of the competition in the auto
industry focused on product technology -adding features, changing styles -- rather
than on reducing costs, and cutting price.

56
Success -- for a while
The auto industry’s methods were copied by
many other corporations.
 Even today, US firms often lead in
developing new products (e.g., VCRs and
fax machines).

57
Comparative Advantage Lost
Our CA could not last forever.
 Technology and capital travel easily across
international borders.
 Other countries copied our products and our
production techniques.

58
Mass Production Migrates
Task-specific capital requires only low
skilled labor.
 Many of these countries had lower wages.
 The CA in auto manufacturing and other
industries began to shift abroad.
 US producers could compete only by
lowering wages, or producing overseas.

59
Better Process Technology
R&D focused on developing process
technology to reduce costs has enabled
Germany and Japan to pay high wages.
 Using general capital and skilled labor,
firms develop new products quickly and
profitably over short production runs.
 Requires skilled labor -- US skills lag
others.

60