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Chapter 3:
The Costs of Production

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 Producer’s Theory: Profit maximization
◼ Firms decide how many units of goods or services to produce -- Q.
❑ Benefit: Total revenue

𝑇𝑅 = 𝑃(𝑄)𝑄
❑ P is a function of Q, depending on the property of the market structure.

❑ Cost (inputs): Total cost

◼ Production function: the relationship that describes how inputs like

capital and labor are transformed into output.
❑ For example, Capital (K) and Labor (L): 𝑄 = 𝐹(𝐾, 𝐿)

◼ Given the rental rate r and the wage rate w

𝑇𝐶 = 𝑟𝐾 + 𝑤𝐿
◼ which implies
𝑇𝐶 = 𝐶(𝑄)
❑ Goal: Maximize profits
𝑀𝑎𝑥 𝜋 = 𝑇𝑅 − 𝑇𝐶 = 𝑃(𝑄)𝑄 − 𝐶(𝑄)
𝑄
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 What are Costs?
• Costs as opportunity costs (OC)
– The cost of something is what you give up to get it
• Firm’s cost of production
– Include all the opportunity costs of making its output of
goods and services
Explicit Costs Implicit Costs
– Explicit costs ($) Building rent Employee training time
Time equipment is offline for
– Implicit costs Equipment
maintenance
Time equipment is offline for
Advertising/marketing
repair
Cost to maintain or repair Decision not to make other
equipment products
Supplies and raw materials
Utilities
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Employee wages
 What are Costs?

• Explicit costs
– Input costs that require an outlay of money by the firm
• Implicit costs
– Input costs that do not require an outlay of money by the firm
(resources owned by the firm)
– Ignored by accountants (NOT reflected in financial statements)
• Total costs = Explicit costs + Implicit costs

• Example: the cost of financial capital

– 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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 Figure 1
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.
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 Production and Costs

• Production function: relationship between

– Quantity of inputs used to make a good and the quantity of
output of that good: 𝑄 = 𝐹(𝐾, 𝐿)
– Short-run: ഥ ⇒ 𝑄 = 𝐹(𝐾,
𝐾=𝐾 ഥ 𝐿)

• Marginal product (of Labor)

– Increase in output that arises from an additional unit of input (L)
– Slope of the production function
• Diminishing marginal product
– Marginal product (MP)of an input declines as the quantity of the
input increases
– Production function gets flatter as more inputs are being used
– The slope of the production function decreases
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 Table 1
A Production Function and Total Cost: Caroline’s Cookie Factory

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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, reflecting 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

• Total-cost curve
– Relationship between quantity produced and total costs
𝑄 = 𝐹 𝐾,ഥ 𝐿 ⇒ 𝑇𝐶 = 𝑟𝐾 ഥ + 𝑤𝐿 ⇒ 𝑇𝐶 = 𝐶(𝑄)

– Gets steeper as the amount produced rises

• Diminishing marginal product
• Producing one additional unit of output requires a lot of
additional units of inputs
• Fixed cost: costs that do not vary with the quantity of output
produced -- 𝐹𝐶 = 𝑟𝐾 ഥ
• Variable cost: costs that vary with the quantity of output
produced -- 𝑉𝐶 = 𝑤𝐿
• Total cost: 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶 = 𝑟𝐾 ഥ + 𝑤𝐿
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 The Various Measures of Cost

• Average total cost, ATC

– ATC = TC / Q
• Average fixed cost, AFC
– AFC = FC / Q
• Average variable cost, AVC
– AVC = VC / Q

• Marginal cost, MC: increase in total cost arising from an

extra unit of production
– MC cost = Change in total cost / Change in quantity
– MC = ΔTC / ΔQ
• marginal cost curve rising (eventually)
– diminishing marginal product 10
 Table 2
The Various Measures of Cost: Conrad’s Coffee Shop

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 Figure 3
Conrad’s Total-Cost Curve
Total Cost
Here the quantity of output
$15.00 produced (on the
14.00 Total-cost curve horizontal axis) is from the
13.00
first column in Table 2, and
12.00
11.00 the total cost (on the
10.00 vertical axis) is from the
9.00 second column. As in
8.00 Figure 2, the total-cost
7.00
curve gets steeper as the
6.00
5.00 quantity of output
4.00 increases because of
3.00 diminishing marginal
2.00 product.
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity of Output
(cups of coffee per hour)

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 Figure 4
Conrad’s Average-Cost and Marginal-Cost Curves
Costs
This figure shows the average
$3.50 total cost (ATC), average fixed
3.25 cost (AFC), average variable
3.00 cost (AVC), and marginal cost
2.75
(MC) for Conrad’s Coffee
2.50
2.25
MC Shop. All of these curves are
2.00 obtained by graphing the data
1.75 ATC in Table 2. These cost curves
1.50 show three features that are
1.25
AVC typical of many firms: (1)
1.00
0.75 Marginal cost rises with the
0.50 quantity of output. (2) The
0.25 AFC average-total-cost curve is U-
0 1 2 3 4 5 6 7 8 9 10
shaped. (3) The marginal-cost
curve crosses the average-
Quantity of Output (cups of coffee per hour) total-cost curve at the
minimum of average total cost.

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 The Various Measures of Cost

• U-shaped average total cost curve

– ATC = AVC + AFC
– AFC – always declines as output rises
– AVC – rises as output increases (eventually) – diminishing MP
• Efficient scale (Qty at MIN ATC)
• Relationship between MC and ATC
– When MC < ATC: average total cost is falling
– When MC > ATC: average total cost is rising
– MC = ATC: ATC at its minimum

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 Figure 5
Cost Curves for a Typical Firm

Costs Many firms

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

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 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 ATC curve in the short run differs
from the ATC curve in the long run.
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 Costs in Short and Long Run

• Economies of scale
– Long-run ATC falls as the quantity of output increases
– Increasing specialization among workers
• Constant returns to scale
– Long-run ATC stays the same as the quantity of output
changes
• Diseconomies of scale
– Long-run ATC 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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