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The Costs of ProductionThe 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 ProductionThe 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 ProductionThe 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 Economic Costs Versus Accounting CostsCosts
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 Economic Profit Versus Accounting ProfitProfit
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 Economic Profit Versus Accounting ProfitProfit
Economic profit
Implicit Costs
Explicit costs
Accounting profit
Explicit costs
TROC
TR
Economist’s view
Accountant's view
Production and Costs 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 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 Production and Costs
# workers
Output/hour
MP of L Cost of factory
Cost of workers
TC of inputs
0 0 30 0 30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
Wage=$10/ worker
Production function
0
20
40
60
80
100
120
140
160
0 1 2 3 4 5
# Workers hired
Ou
tpu
t/ h
ou
r
Output/hour
Production Function and Total Cost 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 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 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 MC0 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
0
2
4
6
8
10
12
14
16
18
20
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Output/hour
Cos
t
Total cost Fixed Cost Variable cost
Average Costs
0
0.5
1
1.5
2
2.5
3
3.5
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output/ hour
Co
sts
AFC
AVC
ATC
MC
MC cuts ATC at its minimum point ATC is U-shaped
MC is less than ATC, ATC is falling
MC is greater than ATC, ATC is rising
Efficient scale of the firm
Typical Cost Curves 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 increases- diminishing marginal product
Typical Cost Curves 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 Typical Cost Curves
The combination of increasing and then decreasing MP also make the AVC U- shaped
Both MC and AVC fall initially before rising with increase in output
LR and SR costs 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 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
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