1

Why we study cost Costs?

• Total revenue rofits
P

ximum
a
M

– Amount a firm receives for the sale of its

output
• Total cost
– Market value of the inputs a firm uses in
production
• Accountant Profit = Total Revenue – Total
cost ( explicit cost ) 2
 Lecture objectives
1- Difference between accounting & economic profit

2- Efficient scale : The minimum efficient scale (MES)

is the lowest point on a cost curve at which a company
can produce its product at a competitive price( short
term )
criteria: compare between MC & ATC

3- Economies of scale ( long term )

Note : profit = revenue – cost

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 The Costs of Production
• According to the Law of Supply:
– Firms are willing to produce and sell a greater
quantity of a good when the price of the good is high.
– This results in a supply curve that slopes upward.
 WHAT ARE COSTS?
• According to the Law of Supply:
– Firms are willing to produce and sell a
greater quantity of a good when the price of
the good is high.
– This results in a supply curve that slopes
upward.
 What are Costs?
• Total revenue
– Amount a firm receives for
the sale of its output
• Total cost
– Market value of the inputs a
firm uses in production
• Accountant Profit = Total
Revenue – Total cost ( "Elasticity and Production:
Applying Economic
explicit cost ) Concepts to Real-World
Scenarios" - YouTube
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How to calculate cost ?
 What are Costs?
• Explicit costs
– Input costs that require an outlay of money by
the firm – invoices – actual spend
• Implicit costs
– Input costs that do not require an outlay of
money by the firm – interest didn’t receive
– Ignored by accountants
• Total costs- opportunity cost =
Explicit costs + Implicit costs
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 What are Costs?
• The cost of capital as an opportunity cost
– Implicit cost
– Interest income not earned on financial capital
• Owned as saving
• Invested in business
– Not shown as cost by an accountant

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 What are Costs?
• Economic profit
– Total revenue minus total cost
• Total costs includes both explicit and implicit
costs
• Accounting profit
– Total revenue minus total explicit cost

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Economists versus Accountants

Economists include all opportunity costs when analyzing a firm, whereas accountants
measure only explicit costs. Therefore, economic profit is smaller than accounting profit.11
 Example
– Ali quit his $65,000 a year corporate lawyer
job to open up his own law practice. In Ali's
first year in business his total revenue equaled
$150,000. Ali's explicit cost during the year
totaled $85,000. What is Ali’s economic profit
for his first year in business?

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 Example
– Profit = $150,000 - $65,000 -$85,000.

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Example

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Figure 2
Caroline’s Production Function and Total-Cost Curve
Quantity Total
(a) Production function (b) Total-cost curve
of Output Cost
(cookies Production $90
per hour) Total-cost curve
160 function 80
140 70
120 60
100 50
80 40
60 30
40 20
20 10

0 1 2 3 4 5 6 Number of 0 20 40 60 80 100 120 140 160 Quantity

Workers Hired of Output
The production function in panel (a) shows the relationship between the number of workers hired and the quantity
of output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1,
and the quantity of output produced (on the vertical axis) is from the second column. The production function gets
flatter as the number of workers increases, which reflects diminishing marginal product. The total-cost curve in
panel (b) shows the relationship between the quantity of output produced and total cost of production. Here the
quantity of output produced (on the horizontal axis) is from the second column in Table 1, and the total cost (on
the vertical axis) is from the sixth column. The total-cost curve gets steeper as the quantity of output increases
because of diminishing marginal product.
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 Production and Costs
• Production function
– Relationship between
• Quantity of inputs used to make a good / output
• And the quantity of output of that good
– Gets flatter ( full capacity)as production rises
• Marginal product = contribution of labor on
output
– Increase in output that arises from an
additional unit of input ( labor ) simplicity
– Slope of the production function 17
 PRODUCTION AND COSTS
• The Production Function
– The production function shows the relationship
between quantity of inputs used to make a good and
the quantity of output of that good.
– The marginal product of any input in the production
process is the increase in output that arises from an
additional unit of that input.
 Production and Costs
• Diminishing ( decreasing) marginal product
– Marginal product of an input declines as the
quantity of the input increases
• Total-cost curve
– Relationship between quantity produced and
total costs
– Gets steeper ( slope is small) as the amount
produced rises

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Diminishing marginal
product is the property
whereby the marginal
product of an input
declines as the quantity
of the input increases.

Example: As more and

more workers are hired
at a firm, each additional
worker contributes less
and less to production
because the firm has a
limited amount of
equipment.
A Production Function and Total Cost: Caroline’s Cookie Factory
Production
Total cost = FC + VC
P =$1

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 Various Measures of Cost
EFFICIENT SCALE; ATC ( AFC+ AVC) = MC
• Average fixed cost (AFC) = FC / Units = share
– Fixed cost divided by the quantity of output
• Average variable cost (AVC) = TVC/ Units = share
– Variable cost divided by the quantity of output
• Marginal cost (MC) =MC = ΔTC / ΔQ
– Increase in total cost arising from an extra unit of
production
– Marginal cost = Change in total cost / Change in
quantity
– Increase in total cost : From producing an additional
unit of output
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Cost Curves and Their Shapes

Marginal cost rises

with the amount of
output produced.
This reflects the
property of
diminishing marginal
product.
The Various Measures of Cost: Conrad’s Coffee Shop

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 Various Measures of Cost
• Average total cost (ATC)
– Total cost divided by the quantity of output
– Average total cost = Total cost / Quantity
– ATC = TC / Q
– Cost of a typical unit of output
• If total cost is divided evenly over all the units
produced

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 Various Measures of Cost
• Marginal cost (MC)
– Increase in total cost arising from an extra
unit of production
– Marginal cost = Change in total cost /
Change in quantity
– MC = ΔTC / ΔQ
– Increase in total cost
• From producing an additional unit of output

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 Various Measures of Cost
• Rising marginal cost curve
– Because of diminishing marginal product
• U-shaped average total cost curve
– ATC = AVC + AFC
– AFC – always declines as output rises
– AVC – typically rises as output increases
• Because of diminishing marginal product
– The ATC is a U-shape
• At quantity that minimizes average total cost
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 Various Measures of Cost
• Efficient scale
– Quantity of output that minimizes ATC
• Relationship between MC and ATC
– When MC < ATC: average total cost is
falling
– When MC > ATC: average total cost is
rising
– The marginal-cost curve crosses the
average-total-cost curve at its minimum
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Conrad’s Average-Cost and Marginal-Cost Curves
This figure shows the
Costs
average total cost (ATC),
average fixed cost (AFC),
$3.50 average variable cost
3.25
3.00
(AVC), and marginal cost
2.75 (MC) for Conrad’s Coffee
2.50 Shop. All of these curves
2.25
MC
are obtained by graphing
2.00 the data in Table 2. These
1.75 ATC
1.50
cost curves show three
1.25 features that are typical of
1.00 AVC many firms: (1) Marginal
0.75 cost rises with the quantity
0.50 of output. (2) The average-
0.25 AFC
total-cost curve is U-
0 1 2 3 4 5 6 7 8 9 10 shaped. (3) The marginal-
cost curve crosses the
Quantity of Output (cups of coffee per hour) average-total-cost curve at
the minimum of average
total cost.
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 Various Measures of Cost
• Typical cost curves
– Marginal cost eventually rises with the
quantity of output
– Average-total-cost curve is U-shaped
– Marginal-cost curve crosses the average-
total-cost curve at the minimum of
average total cost

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Cost Curves for a Typical Firm
Costs Many firms
$3.00 experience
increasing
2.50 marginal product
MC before diminishing
marginal product.
2.00
As a result, they
have cost curves
1.50 ATC shaped like those
in this figure.
1.00 AVC Notice that
marginal cost and
0.50 average variable
AFC cost fall for a while
before starting to
0 2 4 6 8 10 12 14 rise.
Quantity of Output

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Economies and Diseconomies of Scale
 Costs in Short and Long Run
• Many decisions
– Fixed in the short run
– Variable in the long run
• Firms – greater flexibility in the long-run
– Long-run cost curves
• Differ from short-run cost curves
• Much flatter than short-run cost curves
– Short-run cost curves
• Lie on or above the long-run cost curves

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Figure 6
Average Total Cost in the Short and Long Runs
Average ATC in short run
ATC in short run ATC in short run
Total with medium factory
with small factory with large factory
Cost
ATC in long run

$12,000

10,000
Diseconomies
Economies
Constant returns to scale of scale
of scale

0 1,000 1,200 Quantity of Cars per Day

Because fixed costs are variable in the long run, the average-total-cost curve in the
short run differs from the average-total-cost curve in the long run.
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 Costs in Short and Long Run
• Economies of scale
– Long-run average total cost falls as the quantity of
output increases
– Increasing specialization among workers
• Constant returns to scale
– Long-run average total cost stays the same as the
quantity of output changes
• Diseconomies of scale
– Long-run average total cost rises as the
quantity of output increases
– Increasing coordination problems
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Table 3
The Many Types of Cost: A Summary

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Assess your self
If Saeed's Pizza Parlor knows that the marginal cost of the 500th pizza is $3.50 and
that the average total cost of making 499 pizzas is $3.30, then
a.
average total costs are rising at Q = 500.
b.
average total costs are falling at Q = 500.
c.
total costs are falling at Q = 500.
d.
average variable costs must be falling.

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7
Assess your self
Suppose that a firm has only one variable input, labor, and firm output is zero when
labor is zero. When the firm hires 6 workers the firm produces 90 units of output.
Fixed costs of production are $6 and the variable cost per unit of labor is $10. The
marginal product of the seventh unit of labor is 4. Given this information, what is the
marginal cost of production when the firm hires the 7th worker?
a. $1.50

b. $2.50

c. $5

d. $10

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Assess your self
-Which of the following statements about costs is correct?

a. When marginal cost is less than average total cost, average total cost
is rising.
b. The total cost curve is U-shaped.
c. As the quantity of output increases, marginal cost eventually rises.
d. All of the above are correct.

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Assess your self
Suppose that Haidy firm has only one variable input, labor, and firm output is zero
when labor is zero. When the firm hires 6 workers the firm produces 90 units of output.
Fixed costs of production are $6 and the variable cost per unit of labor is $10. The
marginal product of the seventh unit of labor is 4. Given this information, what is the
average variable cost of production when the firm hires 7 workers?

a. $12.67
b. $11
c. 81 cents
d. 75 cents