1. The Costs of Production13
The Costs of Production

2. What Does a Firm Do? Firm’s Objective Total revenue = P*Q
Firms seek to maximize profits
Profits = Total Revenues - Total Costs
Choose output (Q*) such that
Max {TR(Q*) –TC{Q*}
Total revenue = P*Q
Revenue received from sale of its output
Total cost C(Q) = sum of price of inputs * quantity of inputs used

3. Total cost Market value of the inputs a firm uses in production
Cost = price(input 1)*Q(input 1) + … + price(input n)* Q(input n)
C(Q) = 𝑖=1 𝑛 𝑃𝑖 Qi

4. Why Are Costs Important to a Firm?
Primary economic objective of a firm
Maximize profits
Total revenues depend on customer demand
Tot Rev(Q) = Price x Qty Demanded
Price-taker (competitive world)
Initially assume: firm is a Price-taker (competitive world)
Market Price can not be affected/chosen by 1 firm
Costs {can controlled by p-taking firm}
Depend on amount supplied (Q*) by the firm
prices of and amounts used of inputs

5. Choose Q* such that profits are maximized
Max {TR(Q*) –TC{Q*}
𝑀𝑎𝑥 Π(𝑄∗) = 𝑃∗𝑄 −𝑇𝐶{𝑄}
First order condition δΠ/δQ = 0
P = δTC{Q}/δQ = 0 or price = marginal cost
Choose Q* where market price is just equal to the increase in total costs (marginal/incremental/additional) costs of producing 1 more unit of output

6. PC Market: Profits Max’ed at Q* where P = MC
In long-run, no economic profit -> produce at Min ATC(Q*)
Marginal Costs
Profits Max’ed
Price does not change

7. What are Costs? Costs as opportunity costs Explicit costs
Input costs that require an outlay of money by the firm
Reflect value of input used by other producers/markets – price willing to pay
Implicit costs
Input costs that do not require an outlay of money by the firm
Opportunity costs of time; alternative investment; rental/resale value of property (K)

8. What are Implicit Costs?
The cost of capital as an opportunity cost
Implicit cost of investment in firm
Interest income not earned
Invested in business
Not shown as cost by an accountant
But is an opportunity cost to an economist; the foregone investment/return
Key difference between economists/accountants and treatment of what costs are and how they affect economic versus accounting profits

9. What are Implicit Costs?
The cost of your labor as an opportunity cost
Implicit cost of your labor (owner)
Wages not earned/paid by someone else
Do you pay yourself a wage if you own the business?
If not, then not shown as cost by an accountant
But is an opportunity cost to an economist; the foregone salary
Another example of key differenced between how costs are recognized by economists/accountants

10. What are Implicit Costs?
The opportunity costs of your capital
Implicit cost of your labor (owner)
What someone else is willing to pay for it, i.e., current market value
opportunity cost to an economist; foregone rent/resale
Accountants tend to rely on original (historical) purchase price of property, equipment
Depreciate it over time
moving to “mark it to market value”
Another example key difference between how costs are recognized by economists/accountants

11. What are Costs? Economic profit Accounting profit
Total revenue minus total cost
Including both explicit and implicit costs
Accounting profit
Total revenue minus total explicit cost

12. Economists versus accountants1
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

13. Production and Costs Production function Marginal product
Relationship between
Quantity of inputs used to make a good
And the quantity of output of that good
Gets flatter as production rises
Diminishing marginal returns to inputs (e.g., K, L)
Marginal product
Increase (change) in output arising from an additional unit of input (ΔQ/ΔL)

14. A production function and total cost: Caroline’s cookie factory1
A production function and total cost: Caroline’s cookie factory
Number
of workers
Output
(quantity of cookies
produced per hour)
Marginal
product
of labor
Cost of
factory
workers
Total cost of inputs
(cost of factory +
cost of workers) 1 2 3 4 5 6 50 90
120
140
150
155
$30 30 $0 10 20 40 60 70 80 50 40 30 20 10 5

15. Caroline’s production function and total-cost curve2
Caroline’s production function and total-cost curve
Quantity
of Output
(cookies
per hour)
100 80 60 40 20
160
140
120
(a) Production function
(b) Total-cost curve
Total
Cost 50 40 30 20 10 80 70 60
$90
Production
function
Total-cost curve
Number of
Workers Hired 1 2 3 4 5 6
Quantity
of Output
(cookies per hour) 20 40 60 80
100
120
140
160
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, which reflects 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.

16. The Various Measures of Cost
Fixed costs (short-run)
Do not vary with the quantity of output produced
Variable costs (short and long-run)
Vary with the quantity of output produced
Average fixed cost (AFC)
Fixed cost divided by the quantity of output
Average variable cost (AVC)
Variable cost divided by the quantity of output

17. The various measures of cost: Conrad’s coffee shop2
The various measures of cost: Conrad’s coffee shop
Quantity
of coffee
(cups per hour)
Total
Cost
Fixed
Variable
Average
Marginal 1 2 3 4 5 6 7 8 9 10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
3.00
$0.00
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00 -
1.00
0.75
0.60
0.50
0.43
0.38
0.33
$0.30
0.40
0.70
0.90
1.10
1.20
$3.30
1.90
1.35
1.30
1.33
1.38
1.43
$0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10

18. Conrad’s total-cost curve3
Conrad’s total-cost curve
Total Cost
5.00
4.00
3.00
2.00
1.00
8.00
7.00
6.00
9.00
10.00
11.00
12.00
13.00
14.00
$15.00
Total-cost curve
Quantity of Output
(cups of coffee per hour) 1 2 3 4 5 6 7 8 9 10
Here the quantity of output produced (on the horizontal axis) is from the first column in Table 2, and the total cost (on the vertical axis) is from the second column. As in Figure 2, the total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product.

19. The Various Measures of Cost
Average total cost (ATC)
Total cost divided by the quantity of output
Average total cost = Total cost / Quantity
ATC = TC / Q
Marginal cost (MC)
Increase in total cost
Arising from an extra unit of production
Marginal cost = Change in total cost / Change in quantity
MC = ΔTC / ΔQ

20. The Various Measures of Cost
Average total cost = Total Costs(Q) ÷Q
Cost of a typical unit of output
Average Fixed Costs = Total Fixed Costs ÷ Q
Average Variable Costs = Total Var Costs ÷ Q
Marginal cost = ΔTC(Q+1 – Q)/ΔQ
Increase in total cost from producing an additional unit of output

21. EXHIBIT 5.1 Daily Costs of Manufacturing Pine Lumber
5-21

22. EXHIBIT 5.2 The Marginal Cost of Manufacturing Pine Lumber
5-22

23. EXHIBIT 5.1 Daily Costs of Manufacturing Pine Lumber
5-23

24. EXHIBIT 5.3 The Cost Curves
5-24

25. The Various Measures of Cost
Cost curves and their shapes
U-shaped average total cost: ATC = AVC + AFC
AFC – always declines as output rises
AVC – typically rises as output increases
Diminishing marginal product
At the minimum of ATC or AVC
The bottom (lowest point) of the U-shaped curve
MC = min(ATC) and MC = min(AVC)

26. The Various Measures of Cost
Cost curves and their shapes
Efficient scale
Quantity of output that minimizes average total cost
Relationship between MC and ATC
When MC < ATC: average total cost is falling
When MC > ATC: average total cost is rising
The marginal-cost curve crosses the average-total-cost curve at its minimum

27. Cost curves for a typical firm5
Cost curves for a typical firm
Costs
1.00
0.50
2.00
1.50
2.50
$3.00
ATC MC
AFC
AVC
Quantity of Output 2 4 6 8 10 12 14
Many firms experience increasing marginal product before diminishing marginal product. As a result, they have cost curves shaped like those in this figure. Notice that marginal cost and average variable cost fall for a while before starting to rise.

28.  FIGURE 9.2 Short-Run Supply Curve of a Perfectly Competitive Firm
At prices below average variable cost, it pays a firm to shut down rather than continue operating.
Thus, the short-run supply curve of a competitive firm is the part of its marginal cost curve that lies above its average variable cost curve.

29. Costs in Short Run and in Long Run
Many decisions
Some inputs are fixed (unalterable)in the short run
All inputs are 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

30. Average total cost in the short and long runs6
Average total cost in the short and long runs
Average
Total
Cost
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
Economies
of scale
Diseconomies
of scale
$12,000
1,200
10,000
Constant returns to scale
1,000
Quantity of Cars per Day
Because fixed costs are variable in the long run, the average-total-cost curve in the short run differs from the average-total-cost curve in the long run.

32. Costs in Short Run and in Long Run
Economies of scale
Long-run average total cost falls as the quantity of output increases
Increasing specialization
Constant returns to scale
Long-run average total cost stays the same as the quantity of output changes

33. Costs in Short Run and in Long Run
Diseconomies of scale
Long-run average total cost rises as the quantity of output increases
Increasing coordination problems

34. The many types of cost: A summary3
The many types of cost: A summary
Term
Definition
Mathematical
Description
Explicit costs
Implicit costs
Fixed costs
Variable costs
Total cost
Average fixed cost
Average variable cost
Average total cost
Marginal cost
Costs that require an outlay of money by the firm
Costs that do not require an outlay of money by the firm
Costs that do not vary with the quantity of output produced
Costs that vary with the quantity of output produced
The market value of all the inputs that a firm uses in production
Fixed cost divided by the quantity of output
Variable cost divided by the quantity of output
Total cost divided by the quantity of output
The increase in total cost that arises from an extra unit of production FC VC
TC = FC + VC
AFC = FC / Q
AVC = VC / Q
ATC = TC / Q
MC = ΔTC / ΔQ