THE COSTS OF PRODUCTION

UNIT 10
 What may be the objective of a firm?

Harcourt
 The Costs of Production

 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.
 The Firm’s Objective

 The economic goal of the firm is to maximise

profits.
 Total Revenue
 The amount that the firm receives for the sale of its
product.
 Total Cost
 The amount that the firm pays to buy inputs.
 Profit is often referred to as producer surplus.
 It is the amount a seller is paid minus costs.
Profit = Total revenue - Total cost
 Costs as Opportunity Costs

 A firm’s costs of production include all the

opportunity costs of making its output of
goods and services.
 Explicit and Implicit Costs

 A firm’s cost of production include explicit

costs and implicit costs.
 Explicit costs involve a direct money
outlay for factors of production.
 Implicit costs do not involve a direct money
outlay.
 Economic Profit versus
Accounting Profit

 Economists include all explicit & implicit/

opportunity costs when measuring costs.
 Accountants measure the explicit costs
but often ignore the implicit costs.
 When total revenue exceeds both explicit
and implicit costs, the firm earns
economic profit.
 Economic profit is smaller than accounting
profit.
 Economic Profit versus
Accounting Profit
How an Economist
Views a Firm

Economic
profit

Implicit
Revenue costs
Total
opportunity
costs
Explicit
costs
 Economic Profit versus
Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
 Production and Costs

 A firm’s costs reflect its production

process.
 The production function shows the
relationship between quantity of inputs
used to make a good and the quantity of
output of that good.
 Marginal Product

 The marginal product of any input into

production is the increase in the quantity
of output obtained from an additional unit
of that input.

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 Diminishing Marginal Product

 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.
 Diminishing Marginal Product

 The slope of the production function

measures the marginal product of an
input, such as a worker.
 When the marginal product declines, the
production function becomes flatter.
 A Production Function

Quantity of
Output
(cakes
per hour)
150 Production function
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0 1 2 3 4 5 Number of Workers Hired
 Production Function and Total
Costs

 The relationship between the quantity a

firm can produce and its costs determines
its pricing decisions.
 The total-cost curve shows this
relationship graphically.
A Production Function and Total
Cost

Total Marginal
Number of Output Cost of Cost of Total Cost
Workers (Quantity) Product of Factory Workers of Inputs
Labour FC VC TC
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
 Total-Cost Curve

Total
Cost
$80 Total-cost
curve
70

60

50

40

30

20

10

0 20 40 60 80 100 120 140 Quantity of Output

(cakes per hour)
 The Various Measures of Cost

 Costs of production may be divided into

fixed costs and variable costs.
 Fixed costs are those costs that do not
vary with the quantity of output produced.
 Variable costs are those costs that do vary
with the quantity of output produced.
 Family of Total Costs

 Total Fixed Costs (TFC)

 Total Variable Costs (TVC)
 Total Costs (TC)

TC = TFC + TVC
 Family of Total Costs

Quantity Total Cost Fixed Cost Variable Cost

0 $ 3.00 $3.00 $ 0.00
1 3.30 3.00 0.30
2 3.80 3.00 0.80
3 4.50 3.00 1.50
4 5.40 3.00 2.40
5 6.50 3.00 3.50
6 7.80 3.00 4.80
7 9.30 3.00 6.30
8 11.00 3.00 8.00
9 12.90 3.00 9.90
10 15.00 3.00 12.00
 Average Costs

 Average costs can be determined by

dividing the firm’s costs by the quantity of
output produced.
 The average cost is the typical cost of
each unit of product.
 Family of Average Costs

 Average Fixed Costs (AFC)

 Average Variable Costs (AVC)
 Average Total Costs (ATC)
Family of Average Costs

Fixed cost FC
AFC = =
Quantity Q
Variable cost VC
AVC = =
Quantity Q
Total cost TC
ATC = =
Quantity Q
 Family of Average Costs

Quantity AFC AVC ATC

0 — — —
1 $3.00 $0.30 $3.30
2 1.50 0.40 1.90
3 1.00 0.50 1.50
4 0.75 0.60 1.35
5 0.60 0.70 1.30
6 0.50 0.80 1.30
7 0.43 0.90 1.33
8 0.38 1.00 1.38
9 0.33 1.10 1.43
10 0.30 1.20 1.50
 Marginal Cost

 Marginal cost (MC) measures the increase

in total cost that arises from an extra unit
of production.
 Marginal cost helps answer the following
question:
 How much does it cost to produce an
additional unit of output?
 Marginal Cost

Change in total cost

MC=
Change in quantity

= TC
Q
 Marginal Cost

Quantity Total Cost Marginal Cost Quantity Total Cost Marginal Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10
 Cost Curves and Their Shapes

 Marginal cost rises with the amount of

output produced.
 At low levels of output, an increase in
production will occur at a relatively small cost.
 Increasing output is more costly when the
amount being produced is already high.
Cost Curves and Their Shapes

Costs
$3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity of Output
(bagels per hour)
 Cost Curves and Their Shapes

 The average total-cost curve is U-shaped.

 At very low levels of output average total cost
is high because fixed cost is spread over only a
few units.
 Average total cost declines as output
increases.
 Average total cost starts rising because
average variable cost rises substantially.
Cost Curves and Their Shapes

Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
ATC
1.25
1.00 AVC
0.75
0.50
0.25
AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity of Output
(bagels per hour)
Relationship Between Marginal Cost
and Average Total Cost

 Whenever marginal cost is less than average

total cost, average total cost is falling.
 Whenever marginal cost is greater than average
total cost, average total cost is rising.
Relationship Between Marginal Cost
and Average Total Cost

 The marginal-cost curve crosses the

average-total-cost curve at the efficient
scale.
 Efficient scale is the quantity that minimises
average total cost.
Relationship Between Marginal Cost
and Average Total Cost

Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
ATC
1.25
1.00
0.75
0.50
0.25
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity of Output
(bagels per hour)
Relationship Between Marginal Cost
and Average Total Cost

Costs
$3.00
2.75
2.50
2.25 MC
2.00
1.75
1.50
ATC
1.25
1.00
0.75
0.50
0.25
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Quantity of Output
(bagels per hour)
 Costs in the Long Run

 For many firms, the division of total costs

between fixed and variable costs depends
on the time horizon being considered.
 In the short run some costs are fixed.
 In the long run fixed costs become variable
costs.
 Because many costs are fixed in the short
run but variable in the long run, a firm’s
long-run cost curves differ from its short-
run cost curves.
 U-Shaped Long-Run Average
Total Cost

 Economies of scale occur when long-run

average total cost falls as the quantity of
output increases.
 Diseconomies of scale occur when long-
run average total cost rises as the
quantity of output increases.
 Constant returns to scale occur when
long-run average total cost stays the
same as the quantity of output increases.
U-Shaped Long-Run Average
Total Cost

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

0 Quantity of
Cars per Day
U-Shaped Long-Run Average
Total Cost

Average
Total
Cost
ATC in long run

Economies Constant
of scale returns to
scale
Diseconomies
of scale

0 Quantity of
Cars per Day
 Conclusion

 The goal of firms is to maximise profit,

which equals total revenue minus total
cost.
 Some costs are explicit. Other costs, such
as opportunity costs, are implicit.
 A firm has fixed and variable costs. Fixed
costs don’t vary with quantities produced;
variable costs do.
 Conclusion

 Average total cost is total cost divided by

the quantity of output.
 Marginal cost is the amount total cost
rises if output is increased by one unit.
 Marginal cost generally rises with the
quantity of output; average total cost first
falls as output increases and then
eventually rises with further output.
 Conclusion

 A firm’s costs often depend on the time

horizon being considered.
 Many costs are fixed in the short run but
variable in the long run.
 When the level of production changes,
average total cost may rise more in the
short run than in the long run.
Calculate AVC for each of the
following units of output.

Quantity AFC AVC ATC

0 — — —
1 $3.00 $3.30
2 1.50 1.90
3 1.00 1.50
4 0.75 1.35
5 0.60 1.30
6 0.50 1.30
7 0.43 1.33
8 0.38 1.38
9 0.33 1.43
10 0.30Harcourt 1.50
 Calculate MC for the each of the
following units.

Quantity Total Cost Marginal Cost Quantity Total Cost Marginal Cost
0 $4.00 — - - -
1 4.30 6 $8.80
2 4.80 7 10.30
3 5.50 8 12.00
4 6.40 9 13.90
5 7.50 10 16.00

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What would be the possible Variable
Cost for the following units?
Quantity Total Cost Fixed Cost Variable Cost
0 $ 2.00 $2.00 $
1 2.30 2.00
2 2.80 2.00
3 3.50 2.00
4 4.40 2.00
5 5.50 2.00
6 6.80 2.00
7 8.30 2.00
8 10.00 2.00
9 11.90 2.00
10 14.00 Harcourt 2.00
 Shapes of curves

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Why does variable cost decrease
at first?

 Initially, the variable cost per unit of

output decreases as output increases.
At one point, it reaches a low. After the
low, the variable cost per unit of output
starts toincrease. The increase in AVC
after a certain point is indirectly related to
the law of diminishing marginal returns.

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