TOPIC 4

Chapter:13

The Production & Costs

1
The Firm’s Objective

 The Firm’s Objective

 The economic goal of the firm is to
maximize profits.

2
Total Revenue, Total Cost, and Profit
 Total Revenue
 The amount a firm receives for the sale
of its output.
 Total Cost
 The market value of the inputs a firm
uses in production.

3
Total Revenue, Total Cost, and Profit
 Profit is the firm’s total revenue minus
its total cost.

Profit = Total revenue - Total

cost

4
Costs as Opportunity Costs
 A firm’s cost of production includes 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 are input costs that require a
direct outlay of money by the firm.
 Implicit costs are input costs that do not
require an outlay of money by the firm.
5
Economic Profit versus Accounting
Profit
 Economists measure a firm’s economic
profit as total revenue minus total cost,
including both explicit and implicit costs.
 Accountants measure the accounting
profit as the firm’s total revenue minus
only the firm’s explicit costs.
When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting
profit.
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 Figure 1 Economic versus Accountants

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

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The Production Function
 The production function specifies the
maximum amount of output that can
be produced with a given quantity of
inputs. It is defined for a given state
of technical knowledge.
 The concept of a production function
is a useful way of describing the
productive capabilities of a firm.

8
The Production Function Contd.
 Mathematically, Y = F (x);
where x = level of input
Y = The maximum level of output
 Or more generally, Y = F (K, L)
 This equation states that output is a function of
the amount of capital and the amount of labor
 The production function reflects the available
technology for turning capital and labor into
output
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 Production Function
With the
Y available
Y = F(x)
technology
2. As more input This curve
added, MP
declines shows how
output
depends on
input,

1. The slope of
production function
equals marginal product

10
Total, Average and Marginal
Product
Total Product is the total amount of output produced in physical
units such as bushels of wheat or number of sneakers.

Marginal Product of an input is the extra product or output

produced by 1 additional unit of that input while other inputs
are held constant.
For example, assume that we are holding land, machinery and
all other inputs constant. Then labor’s marginal product is the
extra output obtained by adding 1 unit of labor.

Average Product is the total output divided by total units of

input.
Average product of labor or APL = Q/L
This is the accounting measure of productivity.

11
A numerical example
Units of Total Marginal Average
labor (a) product (b) product (c) product(d=b/a)
0 0
1 2000 2000 2000
2 3000 1000 1500
3 3500 500 1167
4 3800 300 950
5 3900 100 780
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 Production Function
This curve
Output, shows
Y MPL 2. As more labor
how
1 is added, MPL
MPL declines output
1
depends
on labor
input,
holding
MPL the
1. The slope of amount of
production function
1 equals marginal product capital
constant
Labor, L

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 Marginal Product of Labor
 Marginal product curve is downward slopping.

Marginal
MPL = DQ/DL
product
Measures the output produced by the
last worker.
Slope of the production function

Labor

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Production Function
 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.

15
From the Production Function to the
Total-Cost Curve
 The relationship between the quantity
a firm can produce and its costs
determines pricing decisions.
 The total-cost curve shows this
relationship graphically.

16
Table 1 A Production Function and Total Cost:
Hungry Helen’s Cookie Factory

17

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The Total-Cost Curve
 The relationship between the quantity
a firm can produce and its costs
determines pricing decisions.
 The total-cost curve shows this
relationship graphically.

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 THE VARIOUS MEASURES OF COST

 Everywhere that production goes, costs follow

close behind like a shadow.
 Total 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

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 Fixed Cost & Variable Cost
$ Cost
TC
C(Q) = FC + VC
VC(Q)

Total Cost
=Fixed Cost + Variable Cost

FC

20
Q
Figure : Hungry Helen’s Total-Cost Curve
Total
Cost

$80 Total-cost
curve

70

60

50

40

30

20

10

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity

of Output 21
(cookies per hour)
Copyright © 2004 South-Western
Average Costs
Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces.
The average cost is the cost of each typical unit
of product.
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

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Average Costs
F ix ed co st F C
AFC  
Q u an tity Q

V ariab le co st V C
AVC  
Q u an tity Q

T o tal co st T C
ATC  
Q u an tity Q
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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?

(ch an g e in to tal co st) T C

MC  
(ch an g e in q u an tity ) Q
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Marginal Cost

Quantity Total Marginal Quantity Total Marginal

Cost Cost Cost 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

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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost
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
0.25 AFC

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
26
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Cost Curves and Their Shapes
 Marginal cost rises with the amount of
output produced.
 This reflects the property of diminishing
marginal product.

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Figure 5 : Marginal-Cost Curves

Costs
$3.50
3.25
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 Quantity
of Output
28
(glasses of lemonade per hour)
Copyright © 2004 South-Western
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.
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Cost Curves and Their Shapes
 The bottom of the U-shaped ATC
curve occurs at the quantity that
minimizes average total cost. This
quantity is sometimes called the
efficient scale of the firm.

30
Figure :Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
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 Quantity
of Output
31
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Cost Curves and Their Shapes
 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.
•The marginal-cost curve crosses the average-
total-cost curve at the efficient scale.
scale
•Efficient scale is the quantity that minimizes
average total cost.
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Typical Cost Curves
 Three Important Properties of Cost Curves
 Marginal cost eventually rises with the
quantity of output.
 The average-total-cost curve is U-shaped.
 The marginal-cost curve crosses the
average-total-cost curve at the minimum of
average total cost.

33
COSTS IN THE SHORT RUN AND 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.

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 Figure 7 Average Total Cost in the Short and Long Run

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

$12,000

$10,000

ATC in long run

0 1,000 1,200 Quantity of

Cars per Day35
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Economies and diseconomies of
scale
 Economies of scale – factors that lower
average cost as the size of the firm rises in
the long run
 Sources: specialization and division of labor,
indivisibilities of capital, etc.
 Diseconomies of scale – factors that raise
average cost as the size of the firm rises in
the long run
 Sources: increased cost of managing and
coordination as firm size rises
 Constant returns to scale – average costs do
not change as firm size changes
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Long-run average total cost
(LRATC)

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