1. The Costs of Production13

2. 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

3. 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

4. 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)

5. 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

6. 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

7. 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

8. 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

9. EXHIBIT 5.1 Daily Costs of Manufacturing Pine Lumber
5-9

10. EXHIBIT 5.2 The Marginal Cost of Manufacturing Pine Lumber
5-10

11. EXHIBIT 5.1 Daily Costs of Manufacturing Pine Lumber
5-11

12. EXHIBIT 5.3 The Cost Curves
5-12

13. 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)

14. When to Operate or Shut Down
Image: Animated Figure 9.2
Lecture notes:
Green = go. Yellow = caution. Red = stop.
If the MR curve is above the minimum point on the ATC curve, the firm will make a profit (shown in green).
If the MR curve is below the minimum point on the ATC curve but above the minimum point on the AVC curve, the firm will operate at a loss (shown in yellow).
If the MR curve is below the minimum point on the AVC curve, the firm will temporarily shut down (shown in red).

15. Profit and Loss in the Short Run
Condition
Outcome
P > ATC
The firm makes a profit
ATC > P > AVC
The firm will operate to minimize loss
AVC > P
The firm will temporarily shut down
Lecture notes:
Yellow area detail:
In this area, you are covering all of your VC (variable costs) and at least SOME of your FC (fixed costs). You are operating at a loss because you can’t cover ALL of your expenses. So why are we still producing?
Think about this: Suppose I have FC = $1,000. If I produce Q = 0, I have no revenues, but I also have no VC. Thus, I will lose $1,000 if I shut down and produce Q = 0. However, what if I can cover all of my VC and SOME of my FC? What if I am able to pay $400 of my $1,000 FC? Then, I will ONLY lose $600 for the time period. It’s better to lose $600 than to lose $1,000.
I’m still maximizing my profit, it’s just that my profit is negative!

16. Short Run Supply Curve Image: Animated Figure 9.3 From the text:
In the short run diminishing marginal product causes the firm’s costs to rise as the quantity produced increases. This is reflected in the shape of the firm’s supply curve, shown in yellow. The supply curve is upward-sloping above the minimum point on the AVC curve. Below the minimum point on the AVC curve—denoted by V on the y axis—the supply curve becomes vertical at a quantity of 0, indicating that a willingness to supply the good does not exist below a price of V. At prices above V, the firm will offer more for sale as the price increases.

17. Long Run Supply Curve Image: Animated Figure 9.4 From the text:
Any point below the minimum point on the ATC curve, denoted by C on the y axis, the firm will experience a loss. Since, in the long run, firms are free to enter or exit the market, no firm will willingly produce in the market if the price is less than cost (P < C). As a result, no supply exists below C. However, if price is greater than cost (P > C), the Float expects to make a profit and so it will continue to produce. Therefore, profits and losses act as signals for resources to enter or leave an industry.
The firm’s long-run supply curve, shown in yellow, is upward-sloping above the minimum point on the ATC curve, which is denoted by denoted by C on the y-axis. The supply curve becomes vertical at a quantity of 0, indicating that a willingness to supply the good does not exist below a price of C. In the long run, a firm that expects price to exceed ATC will continue to operate, since the conditions for making a profit seem favorable. On the other hand, a firm that does not expect price to exceed ATC should cut its losses and exit the industry.