THE COSTS OF

PRODUCTION
The Market Forces of
Supply and Demand
• Supply
and demand are the two words that
economists use most often.
• Supply
and demand are the forces that make market
economies work.
• Modernmicroeconomics is about supply, demand, and
market equilibrium.
WHAT ARE COSTS?
• According to the Law of Supply:
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?
• The Firm’s Objective
• The economic goal of the firm is to maximize profits.
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.
Total Revenue, Total Cost, and
Profit
• Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue -

Total cost
 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.
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.
Economic Profit versus Accounting
Profit
• When total revenue exceeds both explicit and implicit
costs, the firm earns economic profit.
• Economic profit is smaller than accounting profit.
 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

Copyright © 2004 South-Western

Table 1 A Production Function and Total Cost:
ABC Cookie Factory
PRODUCTION AND COSTS
• The Production Function
• Theproduction function shows the relationship between
quantity of inputs used to make a good and the quantity of
output of that good.
The Production Function

• Marginal Product
• Themarginal product of any input in the production
process is the increase in output that arises from an
additional unit of that input.
The Production Function
• Diminishing Marginal Product
• Diminishingmarginal 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.
Figure 2 Hungry Helen’s Production Function

Quantity of
Output
(cookies
per hour)
150 Production function
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

The Production Function

•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.
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.
Table 1 A Production Function and Total Cost:
ABC Cookie Factory

Copyright©2004 South-Western
Figure 3 ABC’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
(cookies per hour)
Copyright © 2004 South-Western
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.
Fixed and Variable Costs

•Total Costs
•Total FixedCosts (TFC)
•Total Variable Costs (TVC)
•Total Costs (TC)
•TC = TFC + TVC
Table 2 The Various Measures of Cost: Thirsty
Thelma’s Lemonade Stand
Fixed and Variable Costs
•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 Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC
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
Table 2 The Various Measures of Cost: Thirsty
Thelma’s Lemonade Stand
Fixed and Variable Costs
•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
 Marginal Cost
Thirsty Thelma’s Lemonade
Stand
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
Figure 4 Thirsty Thelma’s Total-Cost Curves

Total Cost
$15.00 Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Figure 5 Thirsty Thelma’s Average-Cost and
Marginal-Cost Curves

Costs
$3.50 Marginal cost rises with
3.25
3.00
the amount of output
2.75 produced. This reflects
2.50 the property of
2.25
2.00
diminishing marginal
MC

1.75 product.
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
(glasses of lemonade per hour)
Copyright © 2004 South-Western
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
1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(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.
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.
Figure 5 Thirsty Thelma’s Average-Cost and
Marginal-Cost Curves

Costs
$3.50
3.25
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 Quantity
of Output
(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.
Cost Curves and Their Shapes

Relationship Between Marginal Cost

and Average Total Cost
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.
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
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Relationship between Cost
Curves
Figure 6 Total Cost Curves

(a) Total-Cost Curve

Total
Cost
$18.00 TC
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00

0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)

Copyright © 2004 South-Western

Figure Cost Curves

(b) Marginal- and Average-Cost Curves

Costs

$3.00

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)

Copyright © 2004 South-Western

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.
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.
COSTS IN THE SHORT RUN
AND IN THE LONG RUN
•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.
 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

ATC in long run

0 1,200 Quantity of
Cars per Day
Copyright © 2004 South-Western
Economies and Diseconomies of
Scale
•Economies of scale refer to the property
whereby long-run average total cost falls
as the quantity of output increases.
•Diseconomies of scale refer to the property
whereby long-run average total cost rises
as the quantity of output increases.
•Constant returns to scale refers to the
property whereby long-run average total
cost stays the same as the quantity of
output increases
 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 ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
Copyright © 2004 South-Western
Recurrent and Capital Cost

Recurrent Cost: The cost which

incurred in regular interval (Salaries
of the employee)

Capital costs: Expenses that are

incurred for one-time but that serve
for several period (for examples
purchase of land, buildings,
construction, and equipment used in
the production of goods or in the
rendering of services)
 SUMMARY

• THE GOAL OF FIRMS IS TO MAXIMIZE PROFIT, WHICH

EQUALS TOTAL REVENUE MINUS TOTAL COST.
• WHEN ANALYZING A FIRM’S BEHAVIOR, IT IS IMPORTANT
TO INCLUDE ALL THE OPPORTUNITY COSTS OF
PRODUCTION.
• SOME OPPORTUNITY COSTS ARE EXPLICIT WHILE OTHER
OPPORTUNITY COSTS ARE IMPLICIT.
 SUMMARY

• A FIRM’S COSTS REFLECT ITS PRODUCTION PROCESS.

• A TYPICAL FIRM’S PRODUCTION FUNCTION GETS FLATTER
AS THE QUANTITY OF INPUT INCREASES, DISPLAYING THE
PROPERTY OF DIMINISHING MARGINAL PRODUCT.
• A FIRM’S TOTAL COSTS ARE DIVIDED BETWEEN FIXED AND
VARIABLE COSTS. FIXED COSTS DO NOT CHANGE WHEN
THE FIRM ALTERS THE QUANTITY OF OUTPUT PRODUCED;
VARIABLE COSTS DO CHANGE AS THE FIRM ALTERS
QUANTITY OF OUTPUT PRODUCED.
 SUMMARY

• AVERAGE TOTAL COST IS TOTAL COST DIVIDED BY THE

QUANTITY OF OUTPUT.
• MARGINAL COST IS THE AMOUNT BY WHICH TOTAL COST
WOULD RISE IF OUTPUT WERE INCREASED BY ONE UNIT.
• THE MARGINAL COST ALWAYS RISES WITH THE QUANTITY
OF OUTPUT.
• AVERAGE COST FIRST FALLS AS OUTPUT INCREASES AND
THEN RISES.
 SUMMARY
• THE AVERAGE-TOTAL-COST CURVE IS U-SHAPED.
• THE MARGINAL-COST CURVE ALWAYS CROSSES THE
AVERAGE-TOTAL-COST CURVE AT THE MINIMUM OF ATC.
• A FIRM’S COSTS OFTEN DEPEND ON THE TIME HORIZON
BEING CONSIDERED.
• IN PARTICULAR, MANY COSTS ARE FIXED IN THE SHORT
RUN BUT VARIABLE IN THE LONG RUN.
• BOTH VARIABLE OR FIXED COST CAN BE FALL UNDER THE
CLASSIFICATION OF RECURRENT COST. SAME CAN BE
SAID FOR CAPITAL COST