The Costs of Production

ECO 1301:
Microeconomics
13. The Costs of Production
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.
The Firms 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.
Profit is the firms total revenue minus

its total cost.
Profit = Total revenue - Total cost

3
Costs as Opportunity Costs

A firms cost of production includes all
the opportunity costs of making its
output of goods and services.
Explicit and Implicit Costs
A firms 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.
4
Economic Profit versus Accounting

Profit
Economists measure a firms economic
profit as total revenue minus total cost,
including both explicit and implicit costs.
Accountants measure the accounting profit
as the firms total revenue minus only the
firms explicit costs.
When total revenue exceeds both explicit
and implicit costs, the firm earns economic
profit.
Economic profit is smaller than accounting profit.
5
Economists versus Accountants
A Production Function and Total Cost: Hungry Helens

Cookie Factory
The Production Function

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.
Marginal Product
The marginal product of any input in the production process is the
increase in output that arises from an additional unit of that input.
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.
8
Hungry Helens Production Function
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.
10
Hungry Helens Total-Cost Curve
11
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.
Total Costs
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
12
The Various Measures of Cost: Thirsty

Thelmas Lemonade Stand
13
Average Costs
Average Costs
Average costs can be determined by dividing the
firms 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
14
F ix e d c o s t F C
AFC
Q u a n tity
Q
V a ria b le c o s t V C
AVC
Q u a n tity
Q
T o ta l c o s t T C
ATC
Q u a n tity
Q
15
Marginal Cost
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?
( c h a n g e in to ta l c o s t) T C
M C
(c h a n g e in q u a n tity )
Q
16
Marginal Cost
Thirsty Thelmas Lemonade Stand
Quantity
0
1
2
3
4
5
Total
Cost
Marginal
Cost
$3.00
3.30 $0.30
3.80
0.50
4.50
0.70
5.40
0.90
6.50
1.10
Quantity
6
7
8
9
10
Total
Cost
$7.80
9.30
11.00
12.90
15.00
Marginal
Cost
$1.30
1.50
1.70
1.90
2.10
17
Thirsty Thelmas Total-Cost Curves
18
Thirsty Thelmas Average-Cost and MarginalCost Curves
19
20
Cost Curves and Their Shapes

Marginal cost rises with the amount of output
produced.
This reflects the property of diminishing marginal product.
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.
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.
21
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.
Relationship Between Marginal Cost and

Average Total Cost
The marginal-cost curve crosses the average-totalcost curve at the efficient scale.
Efficient scale is the quantity that minimizes average total
cost.
22
23
Big Bobs Cost Curves
24
Big Bobs Cost Curves
25
Typical Cost Curves
Three Important Properties of Cost

Curves
Marginal cost eventually rises with the
quantity of output.
The average-total-cost curve is Ushaped.
The marginal-cost curve crosses the
average-total-cost curve at the
minimum of average total cost.
26
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 firms
long-run cost curves differ from its shortrun cost curves.
27
Average Total Cost in the Short and

Long Run
28
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
29
Average Total Cost in the Short and Long

Run
30

The Costs of Production

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ECO 1301:

WHAT ARE COSTS?

The Firms Objective

Total Revenue, Total Cost, and Profit

Profit is the firms total revenue minus

Profit = Total revenue - Total cost

Costs as Opportunity Costs

Economic Profit versus Accounting

Economists versus Accountants

A Production Function and Total Cost: Hungry Helens

The Production Function

Diminishing Marginal Product

Diminishing Marginal Product

Hungry Helens Production Function

From the Production Function to the

Hungry Helens Total-Cost Curve

THE VARIOUS MEASURES OF

The Various Measures of Cost: Thirsty

Thirsty Thelmas Total-Cost Curves

Thirsty Thelmas Average-Cost and MarginalCost Curves

Thirsty Thelmas Average-Cost and MarginalCost Curves

Cost Curves and Their Shapes

The average total-cost curve is U-shaped.

Cost Curves and Their Shapes

Relationship Between Marginal Cost and

Thirsty Thelmas Average-Cost and MarginalCost Curves

Big Bobs Cost Curves

Big Bobs Cost Curves

Typical Cost Curves

Three Important Properties of Cost

COSTS IN THE SHORT RUN AND IN

Because many costs are fixed in the short

Average Total Cost in the Short and

Economies and Diseconomies of Scale

Average Total Cost in the Short and Long

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