Production and Costs
The How Question?
• From the circular flow diagram, resource markets
determine input or resource prices.
• Profit-maximizing firms select the production technology,
given the input prices, to select the combination of input
that minimize the cost of producing any given output level.
• This helps answer the second condition for economic
efficiency.
• Economic efficiency – maximum satisfaction from scarce
resources: The two conditions are:
– Produce the combination of goods and services that consumers
most highly value
– Produce the combination of goods and services at least possible
cost.
Economic versus Accounting
Costs
• Understanding costs will help to understand
efficiency as well as behavior.
• Economic costs are theoretical constructs
which are intended to aid in rational
decision-making.
• Accounting costs are legal constructs
intended to provide uniformity in
measurement.
• Profit = Total Revenue – Total Costs
• Total Net Benefits = Total Benefits minus Total
Costs
• Costs as Opportunity Costs
– Explicit Costs
– Implicit Costs
• Opportunity cost of entrepreneur’s invested capital
• Opportunity cost of entrepreneur’s time
• Economic versus Accounting Profit
• Normal Profits: the accounting profits that just
covers implicit or opportunity costs
Figure 1 Economic versus Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © 2004 South-Western
Production and Costs
• Intuitively, costs of production depend on two
things:
– Production technology
– Input Price
• Technology is the state of knowledge about how to
combine inputs to produce output.
• Production Function describes the relationship
between inputs and outputs
– Q = F ( K, L , NR, E)
• Short-run versus Long-run
– SR - at least one input is fixed – limits to adjustment –
diminishing returns
– LR – all inputs are variable – complete flexibility –
returns to scale
• Remember the widget example!
• Applying more labor resulting in a diminishing
marginal product of labor and increasing marginal
costs.
• Let’s see this at work again in a more detailed
way.
A Short-Run Production Function
and Costs
• Assume two inputs, capital (say a factory) and
labor, and that capital is fixed in the short-run.
• Marginal Product of Labor – change in total
output from added one more laborer.
• MPL = change in Q / change in L
• Preview of Costs: Production + input prices
– With only one variable input, say labor,
– MC= wage/MPL=(wage x change L)/change Q
– Table and exercise
Figure 2 Hungry Helen’s Production Function
Quantity of
Output
(cookies
per hour)
Production function
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
1
2
3
4
5Number of Workers Hired
Copyright © 2004 South-Western
Table 1 A Production Function and Total Cost:
Hungry Helen’s Cookie Factory
Copyright©2004 South-Western
Different Measures of Cost
• Total Cost (TC) = FC+VC
– Fixed Cost (FC) – are costs that do not vary with
output. FC only are present in the short-run are the
result of fixed factors.
– Variable Cost (VC) – are costs that vary with output.
VC result from different levels of fixed factors. All
costs are VC in the long-run.
• Marginal Cost (MC) = change in TC/ change in Q
and measures the cost of producing another unit.
(general formula)
• Average Cost (AC) = TC/Q and measures the cost
of a typical unit of output.
Cost Formulas
• TC = FC +VC
• Dividing both sides of the total cost formula
by Q, we get the average cost formula:
– TC/Q = FC/Q + VC/Q
– ATC = AFC +AVC
– Average Total Cost = Average Fixed Cost +
Average Variable Cost
Marginal and Average Costs
Revisited
• As Q increases if
– MC<AC AC is falling
– MC>AC AC is rising
– So, when MC=AC AC is at its minimum
• The above also applies to MC and AVC
• The height example
The Cost Curves
• Short-run Cost Curves – at least one fixed factor,
so fixed costs exist. Economist like to use the
example of the factory or plant size being fixed
and labor being the variable input.
– Law of Diminishing Marginal Returns implies that the
MC will eventually increase.
– Increasing MC results in U-shaped ATC curves.
– If MC initially falls and then begins to rise, both the
ATC and AVC curves will be U-shaped.
– Since capital is often assumed to be fixed, the short-run
cost curves describe costs associated with the utilization
of existing plant capacity.
Fixed
Quantity Cost
0
1
2
3
4
5
6
7
8
9
10
$
$
$
$
$
$
$
$
$
$
$
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
3.00
Variable Total
Costs
Costs
$
$
$
$
$
$
$
$
$
$
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.0
$ 3.30
$ 3.80
$ 4.50
$ 5.40
$ 6.50
$ 7.80
$ 9.30
$ 11.00
$ 12.90
$ 15.00
Marginal
Costs
$
$
$
$
$
$
$
$
$
$
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
Quantity AFC
0
1
2
3
4
5
6
7
8
9
10
$
$
$
$
$
$
$
$
$
$
3.00
1.50
1.00
0.75
0.60
0.50
0.43
0.38
0.33
0.30
AVC
$
$
$
$
$
$
$
$
$
$
0.30
0.40
0.50
0.60
0.70
0.80
0.90
1.00
1.10
1.20
ATC
$
$
$
$
$
$
$
$
$
$
MC
3.30
1.90
1.50
1.35
1.30
1.30
1.33
1.38
1.43
1.50
$
$
$
$
$
$
$
$
$
$
0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
Figure 5 Thirsty Thelma’s Average-Cost and MarginalCost Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
Quantity
of Output
(glasses of lemonade per hour)
9
10
Copyright © 2004 South-Western
Excel Cost Curves
• Changes in input prices or productivity
change the cost curves
– Change in fixed costs do not affect MC
– Increases in prices or or decreases in
productivity of variable inputs cause VC, TC,
AVC, ATC, and MC to increase
– Decreases in prices or increases in productivity
of variable inputs causes VC, TC, AVC, ATC,
and MC to decrease
Long-run Cost Curves
• Long-run cost curves – all factors are variable, so
there are no fixed costs and all costs are variable.
– Economies and diseconomies of scale
• benefits to a larger scale of operations – specialization,
purchasing volume, efficient use of capital, design and
development costs
• costs of a larger scale of operation – coordination problems
– LR cost curves are U-shaped if a production process is
characterized by first by economies of scale, and then
diseconomies of scale.
– Since capital can be varied, the long-run cost curves
describe the costs with changing the scale of operations
(reducing or increasing plant size).
• The long-run cost curve is constructed from
various short-run cost curves.
– Remember increasing capital makes labor more
productive, so increase plant size makes labor
more productive and decreases marginal costs
– Even though marginal costs decline, average
costs may go up or down because of the cost of
capital and labor are added together to calculate
average costs.
Figure 7 Average Total Cost in the Short and Long Run
Average
Total
Cost
ATC in short
run with
small factory
ATC in short ATC in short
run with
run with
medium factory large factory
$12,000
ATC in long run
0
1,200
Quantity of
Cars per Day
Copyright © 2004 South-Western
Figure 7 Average Total Cost in the Short and Long Run
Average
Total
Cost
ATC in short
run with
small factory
ATC in short ATC in short
run with
run with
medium factory large factory
ATC in long run
$12,000
10,000
Economies
of
scale
0
Constant
returns to
scale
1,000 1,200
Diseconomies
of
scale
Quantity of
Cars per Day
Copyright © 2004 South-Western
Summary
• Short-run – at least one input is fixed so the
primary decision is how best to use existing
plant capacity
• Long-run – all inputs are variable so the
primary decision is what overall scale of
operations or plant size should be chosen.