Principles of Microeconomics : Ch.13 First Canadian Edition Supply The Costs of Production The Law of Supply: Firms are willing to produce and sell a greater quantity of a good when the price of a good is high, due to typical productivity and cost behaviour.

Principles of Microeconomics : Ch.13 First Canadian Edition Total Revenue, Total Cost, Profit u We assume that the firm’s goal is to maximize profit. Profit = Total revenue – Total cost TR-the amount a firm receives from the sale of its output TC-the market value of the inputs a firm uses in production

Principles of Microeconomics : Ch.13 First Canadian Edition Costs as Opportunity Costs u The firm’s costs include Explicit Costs and Implicit Costs: –Explicit Costs: costs that involve a direct money outlay for factors of production. –Implicit Costs: costs that do not involve a direct money outlay (e.g. opportunity costs of the owner’s own inputs used - implicit wages, implicit rent, cost of capital).

Principles of Microeconomics : Ch.13 First Canadian Edition Costs as Opportunity Costs u Accountants measure the explicit costs but often ignore the implicit costs. u Economists include all opportunity costs when measuring costs. u Accounting Profit = TR - Explicit Costs u Economic Profit = TR - Explicit Costs - Implicit Costs

Principles of Microeconomics : Ch.13 First Canadian Edition Explicit vs. Implicit Costs: An Example You need $100,000 to start your business. The interest rate is 5%. u Case 1: borrow $100,000 –explicit cost = $5000 interest on loan u Case 2: use $40,000 of your savings, borrow the other $60,000 –explicit cost = $3000 (5%) interest on the loan –implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000. In both cases, total (exp + imp) costs are $5000.

Principles of Microeconomics : Ch.13 First Canadian Edition Marginal Product u The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant. u E.g., if Farmer Jack hires one more worker, his output rises by the marginal product of labour. u Notation: ∆ (delta) = “change in…” Examples: ∆Q = change in output, ∆L = change in labour u Marginal product of labour (MPL) = delta Q/delta L

Principles of Microeconomics : Ch.13 First Canadian Edition Why MPL Diminishes u Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal) E.g., Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why? u If Jack increases workers but not land, the average worker has less land to work with, so will be less productive. u In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines, etc.).

Principles of Microeconomics : Ch.13 First Canadian Edition Short-Run vs. Long-Run Two different time horizons are important when analyzing costs. u Short-Run: Time period over which some inputs are variable (labour, materials) and some inputs are fixed (plant size). u Long-Run: Time period over which all inputs are variable, including plant size.

Principles of Microeconomics : Ch.13 First Canadian Edition Short-Run Costs Costs of production may be divided into two categories in the short-run: u Fixed Costs: –Those costs that do not vary with the amount of output produced. u Variable Costs: –Those costs that do vary with the amount of output produced.

Principles of Microeconomics : Ch.13 First Canadian Edition Marginal Cost u Marginal Cost (MC) is the increase in Total Cost from producing one more unit: u MC = delta TC/delta Q

Principles of Microeconomics : Ch.13 First Canadian Edition The Shape of Short-Run Cost Curves u Short-run cost behaviour is based on the productivity of the inputs (resources). u As the firm continues to expand output, in a fixed plant-size situation, eventually the marginal product of each successive worker hired will decrease. u The diminishing marginal product causes the marginal cost to increase in the short- run. This in turn affects the behaviour of average total cost.

Principles of Microeconomics : Ch.13 First Canadian Edition The Shape of Typical Cost Curves U-Shaped Average Total Cost (ATC): –At low levels of output, as the firm expands production, ATC declines. –At higher production levels, as output is increased, ATC increases. –The bottom of the U-Shape occurs at the quantity that minimizes average total cost. –This is called the Efficient Size of the firm.

Principles of Microeconomics : Ch.13 First Canadian Edition The Relationship Between Marginal Cost and Average Total Cost u Why is ATC U - shaped? u When marginal cost is less than average total cost, average total cost is falling. MC < ATC ATC u When marginal cost is greater than average total cost, average total cost is rising. MC > ATC ATC

Principles of Microeconomics : Ch.13 First Canadian Edition The Relationship Between Marginal Cost and Average Total Cost Cost ($’s) Quantity MC ATC The marginal cost curve always crosses the average total cost curve at the minimum average total cost!

Principles of Microeconomics : Ch.13 First Canadian Edition Costs in the Short Run & Long Run u Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC. u Long run: All inputs are variable (e.g., firms can build more factories, or sell existing ones) u In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).

Principles of Microeconomics : Ch.13 First Canadian Edition Long-Run Costs Econ. of Scale Disecon. of Scale Constant Returns to Scale LRATC Curve $ Per Unit Scale of Operation (Q)

Principles of Microeconomics : Ch.13 First Canadian Edition How ATC Changes as the Scale of Production Changes u Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task. –More common when Q is low. u Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs. –More common when Q is high. –Constant returns to scale if more output neither increases or decreases cost. (flat portion of LRATC)