1. Copyright © 2004 South-Western/ WHAT ARE COSTS? A Firm’s Objective The economic goal of a firm is to maximize profits.

2. Copyright © 2004 South-Western/ Total Revenue, Total Cost, and Profit Total Revenue The amount a firm receives for the sale of its output. Price times Quantity (TR) Total Cost The market value of the inputs a firm uses in production. Opportunity cost, implicit and explicit (TC) Profit = TR- TC

3. Copyright © 2004 South-Western/ Costs as Opportunity Costs A firm’s cost of production includes all of 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.

4. Copyright © 2004 South-Western/ Economic Profit versus Accounting Profit Economic profit is total revenue minus total cost, including both explicit and implicit costs. Accounting profit is 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. Joe’s Boat Factory Example.

5. Copyright © 2004 South-Western/ SHORT RUN AND LONG RUN In the short run, at least one factor of production (input) is fixed (cannot be changed). -fixed costs and variable costs -kapital constrained (add workers to fixed kapital stock) In the long run, all factors of production (inputs) are variable (can be changed). -all costs are variable (increase entire scale of operation)

6. Copyright © 2004 South-Western/ SHORT RUN AND LONG RUN Firm is nearly always in the Short Run -Long Run envelopes series of Short Runs Short Run/Long Run time periods vary across industry -Kapital intensive industry is likely to be longer period -Hot Dog Vendor vs. General Motors

7. Copyright © 2004 South-Western/ Fixed and Variable Costs (Short Run) Fixed costsFixed costs are those costs that do not vary with the quantity of output produced. Variable costsVariable costs are those costs that do vary with the quantity of output produced. Costs Fixed Costs (FC) Variable Costs (VC) Total Costs (TC) TC = FC + VC

8. Copyright © 2004 South-Western/ PRODUCTION AND COSTS The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input. MPL = change in output / change labor

9. Copyright © 2004 South-Western/ Production Function Characteristics 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, each additional worker contributes less to production because the firm has a limited amount of equipment. -Kapital constrained

10. Copyright © 2004 South-Western/ Production Function and Total Cost: Hungry Helen’s Cookie Factory

11. Copyright © 2004 South-Western/ Figure 2 Hungry Helen’s Production Function Copyright © 2004 South-Western Quantity of Output (cookies per hour) 150 140 130 120 110 100 90 80 70 60 50 40 30 20 10 Number of Workers Hired 012345 Production function

12. Copyright © 2004 South-Western/ From the Production Function to the Total-Cost Curve The firm uses inputs to produce output -the production function The total-cost curve graphically shows the relationship between the amount of output produced by the firm and the cost associated with this production.

13. Copyright © 2004 South-Western/ Marginal Cost Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production. How much does it cost to produce one additional unit?

14. Copyright © 2004 South-Western/Copyright©2004 South-Western Production Function and Total Cost: Hungry Helen’s Cookie Factory

15. Copyright © 2004 South-Western/ Figure 3 Hungry Helen’s Total-Cost Curve Copyright © 2004 South-Western Total Cost $80 70 60 50 40 30 20 10 Quantity of Output (cookies per hour) 0102030150130110907050401401201008060 Total-cost curve

16. Copyright © 2004 South-Western/ Marginal Cost Characteristics Marginal cost eventually rises as output increases. This reflects diminishing marginal product.

17. Copyright © 2004 South-Western/ Marginal Product and Marginal Cost A more likely story as a firm adds labor to a fixed kapital stock…. A firm will initially experience increasing marginal product. -teamwork and specialization, grow into factory But eventually a firm will experience decreasing marginal product and rising marginal cost. -grow out of factory

18. Copyright © 2004 South-Western/ Big Bob’s Production & Costs

19. Copyright © 2004 South-Western/ Figure 6 Big Bob’s Cost Curves Copyright © 2004 South-Western (a) Total-Cost Curve $18.00 16.00 14.00 12.00 10.00 8.00 6.00 4.00 Quantity of Output (bagels per hour) TC 4268141210 2.00 Total Cost 0

20. Big Bob’s Production Function?

21. Copyright © 2004 South-Western/ Economies and Diseconomies of Scale (Long Run) 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

22. Figure 7 Average Total Cost in the Short and Long Run Copyright © 2004 South-Western Quantity of Cars per Day 0 Average Total Cost 1,200 $12,000 1,000 10,000 Economies of scale ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run Diseconomies of scale Constant returns to scale

23. Copyright © 2004 South-Western/ Economies and Diseconomies of Scale If an industry exhibits economies of scale over a large range then we would expect that market to be served by one or at most a few large firms. If an industry exhibits diseconomies of scale early on then we would expect that market to be served by many small competing firms.

24. Copyright © 2004 South-Western/ 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 costs are explicit while other costs are implicit; total opportunity cost includes both.

25. Copyright © 2004 South-Western/ Summary A firm’s costs reflect its production process. A typical firm’s production function exhibits the property of diminishing marginal product.

26. Copyright © 2004 South-Western/ Summary A firm’s total costs are divided between fixed costs 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.

27. Copyright © 2004 South-Western/ Summary Marginal cost is the amount by which total cost would rise if output were increased by one unit. The marginal cost eventually rises with the quantity of output in the short run. Grow into factory, grow out of factory.