1. THEORY OF FIRM BEHAVIOR
Chapter 6: COSTS OF THE FIRM

2. Firm’s Choice: Firm’s Costs and Production Decision
A firm chooses:
What quantity of the good to produce,
The price of the good (sometimes...).
Firm’s decision depends on:
Costs of production.
The degree of competition in the market (if there are more sellers, more competitive).

3. Firm’s Choice: Firm’s Costs and Production Decision
Firm’s Objective
The goal of a firm is to maximize profits.

4. Total Revenue, Total Cost, and Profit
Profit is the firm’s total revenue minus its total cost.
Profit = Total Revenue - Total Cost

5. Total Revenue, Total Cost, and Profit
The amount a firm receives for the sale of its output. For a competitive firm, TR = P x Q
Total Cost
The market value of the inputs a firm uses in production.

6. Economic Profit versus Accounting Profit
Economic profit is not the same as accounting profit. When calculating economic profit, we include all opportunity costs including hidden (implicit) costs.
Accounting profit (as it appears on balance sheets) refers to the firm’s total revenue minus only the firm’s open (explicit) costs.

7. Costs as Opportunity Costs
Example: Costs of Your Textile Factory
Worker’s wages, electricity, cost of machines, rent are open (explicit) costs.
Instead of starting the textile factory, you could work as an engineer for 2,500 liras per month. Then the hidden (implicit) cost of running the textile factory is 2,500 liras per month.

8. Economic Profit versus Accounting Profit
A firm earns positive economic profit only if total revenue exceeds both open and hidden opportunity costs.
Economic profit is always less than or equal to accounting profit: A firm could be making positive accounting profit but at the same time zero or negative economic profit.

9. PRODUCTION AND COSTS The Production Function
The production function shows the relationship between quantity of inputs (Ex: number of workers) used to make a good and the quantity of output of that good.

10. Table 1: A Production Function and Total Cost: Emine’s Cookie Factory
Fixed
Variable 1
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11. Figure 2 Emine’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 1 2 3 4 5
Number of Workers Hired
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12. The Production Function
Marginal Product
The marginal product of labor (any input) is the change in output produced by an additional worker (additional input).

13. The Production Function
Diminishing Marginal Product
Diminishing marginal product: Keeping all other inputs fixed, marginal product of one of the inputs declines as the quantity of that input increases.
Ex: As more and more workers are hired at a firm, each additional worker contributes less and less to output because the firm has a fixed amount of machines & equipment & capacity.
Another example: a farm with fixed area, machines, technology, labor. Try planting 100 gr. seeds or 200 gr. or 300 gr. seeds.

14. The Production Function
Diminishing Marginal Product
The slope of the production function measures the marginal product of labor.
When the marginal product of labor declines, the production function becomes flatter.

15. Figure 2 Emine’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 1 2 3 4 5
Number of Workers Hired
Copyright © South-Western

16. Table 1 A Production Function and Total Cost: Emine’s Cookie Factory
Fixed
Variable
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17. The Various Measures Of Cost
Costs of production may be separated into fixed costs and variable costs.
Fixed costs are those costs that do not change with the quantity of output produced. Ex: Rent, accountant’s wage, some taxes..
Variable costs are those costs that do change with the quantity of output produced. Ex: Labor, Electricity, Transportation,...

18. Fixed and Variable Costs
Total Costs
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC

19. Table 2 The Various Measures of Cost: Osman’s Lemonade Stand
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20. Fixed and Variable Costs
Average Costs
Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.
Average cost answers the following question: How much does it cost to produce one unit of a good on average?

21. Fixed and Variable Costs
Average Costs
Average Fixed Cost (AFC) =
Total Fixed Cost / Qty
Average Variable Cost (AVC) =
Total Variable Cost / Qty
Average Total Costs (ATC) =
Total Cost / Qty
ATC = AFC + AVC

22. Table 2 The Various Measures of Cost: Osman’s Lemonade Stand
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23. Marginal Cost Marginal Cost
Marginal cost (MC) is the additional cost of producing the last unit.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

24. Marginal Cost Osman’s Lemonade Stand

25. Marginal Cost

26. Figure 4 Osman’s Total-Cost Curves
$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 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
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27. Figure 5 Osman’s Marginal-Cost Curve
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 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

28. Cost Curves and Their Shapes
Marginal cost increases as we produce more and more
This is due to the property of diminishing marginal product. See example.

29. Figure 6 Osman’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
AFC
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

30. Table 2 The Various Measures of Cost: Osman’s Lemonade Stand
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31. Cost Curves and Their Shapes
The average total-cost (ATC) curve is U-shaped.
At very low levels of output, ATC is high because fixed cost is spread over only a few units.
ATC declines as output increases because fixed cost is spread over more units.
As output increases further, ATC starts rising because average variable cost rises faster than the decline in AFC.

32. Cost Curves and Their Shapes
The quantity where the firm achieves the lowest average cost is at the minimum point of the U-shaped ATC curve. This quantity is called the efficient scale of the firm.

33. Figure 7 Osman’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 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

34. Cost Curves and Their Shapes
Relationship between Marginal Cost and Average Total Cost
Whenever MC is smaller than ATC, ATC is falling.
Whenever MC is greater than ATC, ATC is rising.
ATC is like your cumulative GPA and MC is like your last semester’s grade average.
As a result, MC crosses ATC at the minimum of ATC.

35. Figure 5 Osman’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 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(glasses of lemonade per hour)
Copyright © South-Western

36. Cost Curves and Their Shapes
Summarize Three Important Properties of Cost Curves
Marginal cost eventually rises as the quantity of output increases.
The ATC curve is U-shaped.
The MC curve crosses the ATC curve at the minimum point of ATC.

37. 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 (Ex: rent of building and machines), some are variable (labor, energy, raw materials).
In the long-run, fixed costs become variable costs (Ex: renting decisions can change, can buy/rent new machines and equipment). All costs are variable in the long-run.

38. 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 are different from its short-run cost curves.

39. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
$12,000
ATC
in long run
1,200
Quantity of
Cars per Day
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40. Figure 7 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
ATC
in long run
Economies of
scale
Diseconomies of
scale
1,200
$12,000
1,000
10,000
Constant
returns to
scale
Quantity of
Cars per Day
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41. Costs versus Size of the Firm
If long-run ATC falls as the quantity of output increases, the firm has Increasing Returns to Scale (=Economies of Scale).
If long-run ATC rises as the quantity of output increases, the firm has Decreasing Returns to Scale (=Diseconomies of Scale).
If long-run ATC stays constant as the quantity of output increases, the firm has Constant Returns to Scale.

42. Economies and Diseconomies of Scale
The shape of LRATC depends on the type of industry.
Some industries exhibit economies of scale (also called increasing returns to scale) like cable TV, GSM providers, electricity, oil extraction, high-tech goods, etc. Such industries are characterized by high fixed costs.
Some industries show decreasing returns to scale because firms are too big. Coordination problems & bureaucracy. IBM and General Motors are examples.