1. Production and Costs

2. In this chapter, look for the answers to these questions:
What is a production function? What is marginal product? How are they related?
What are the various costs, and how are they related to each other and to output?
How are costs different in the short run vs. the long run?
What are “economies of scale”? 2

3. The Production Function
Relationship between
Quantity of inputs used to make a good
And the quantity of output of that good
Gets flatter as production rises
It can be represented by a table, equation, or graph.
Input sometimes called factors of production to produce output.

4. Example 1: Farmer Jack’s Production Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
Q (bushels of wheat)
L (no. of workers)
1000 1
1800 2
2400 3
2800 4
3000 5
THE COSTS OF PRODUCTION 4

5. Marginal Product
The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant.
Notation: ∆ (delta) = “change in…”
Examples: ∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) = ∆Q ∆L

6. EXAMPLE 1: Total & Marginal Product
3000 5
2800 4
2400 3
1800 2
1000 1
Q (bushels of wheat)
L (no. of workers)
MPL
∆Q = 1000
∆L = 1
1000
∆Q = 800
∆L = 1
800
∆Q = 600
∆L = 1
600
∆Q = 400
∆L = 1
400
∆Q = 200
∆L = 1
200
THE COSTS OF PRODUCTION 6

7. EXAMPLE 1: MPL = Slope of Prod Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
L (no. of workers)
Q (bushels of wheat)
MPL
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
1000 1
1000
800 2
1800
600 3
2400
400 4
2800
200 5
3000
THE COSTS OF PRODUCTION 7

8. Production and Costs Diminishing marginal product Total-cost curve
Marginal product of an input declines as the quantity of the input increases
Total-cost curve
Relationship between quantity produced and total costs
Gets steeper as the amount produced rises

9. Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production

10. Costs: Explicit vs. Implicit
Costs as opportunity costs
The cost of something is what you give up to get it
Firm’s cost of production
Include all the opportunity costs of making its output of goods and services
Explicit costs
Implicit costs

11. Costs: Explicit vs. Implicit
Explicit costs
Input costs that require an outlay of money by the firm
Implicit costs
Input costs that do not require an outlay of money by the firm
Ignored by accountants
Total costs
Explicit costs + Implicit costs

12. Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest rate is 5%.
Case 1: borrow $100,000
explicit cost = $5000 interest on loan
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 Case 2, the foregone interest is the interest you could have earned on your savings. It is an opportunity cost.
This example shows that an important implicit cost is the cost of capital, the foregone returns you could have earned had you used your savings to buy bonds or other assets instead of investing them in your business.
The hope is that students will see that what really matters to them is not just the explicit costs, but total (implicit + explicit) costs.
In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION 12

13. Economic Profit vs. Accounting Profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs, so it’s higher than economic profit.

14. Economists include all opportunity costs when analyzing a firm, whereas accountants measure only explicit costs. Therefore, economic profit is smaller than accounting profit.

15. EXAMPLE 1: Farmer Jack’s Costs
L (no. of workers)
Q (bushels of wheat)
Cost of land
Cost of labor
Total Cost
$1,000
$10,000
$8,000
$6,000
$4,000
$2,000 $0
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000 1
1000 2
1800 3
2400 4
2800 5
3000
THE COSTS OF PRODUCTION 15

16. EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q (bushels of wheat)
Total Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000
THE COSTS OF PRODUCTION 16

17. Various Measures of Cost
Fixed costs
Costs that do not vary with the quantity of output produced
Variable costs
Costs that vary with the quantity of output produced
Total cost
Fixed cost + Variable cost

18. Costs in Short and Long Run
Many decisions
Fixed in the short run
Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
Variable in the long run
All inputs are variable (e.g., firms can build more factories, or sell existing ones).

19. EXAMPLE 2: Costs Q FC VC TC 100 $100 520 380 280 210 160 120 70 $0 620
$800 FC Q FC VC TC VC
$700
100
$100
520
380
280
210
160
120 70 $0
620
480
380
310
260
220
170
$100 TC
$600 1
$500 2
Costs
$400 3
$300 4
$200 5
$100 6 $0 7 1 2 3 4 5 6 7 Q
THE COSTS OF PRODUCTION 19

20. Marginal cost
Marginal cost The change in a firm’s total cost from producing one more unit of a good or service.
MC= ∆TC/ ∆Q
Rising marginal cost curve
Because of diminishing marginal product

21. EXAMPLE 2: Marginal CostQ TC MC
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
$100
$70 1
170
∆TC ∆Q
MC = 50 2
220 40 3
260
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.) 50 4
310 70 5
380
100 6
480
140 7
620
THE COSTS OF PRODUCTION 21

22. Why Marginal Cost is U-shaped
When the marginal product of labor is raising the marginal cost of output is falling.
When the marginal product of labor is falling the marginal cost of production is raising.
Labour
Quantity
Marginal Product of Labour (MPL)
Total Cost
Marginal Cost (MC) $ -
800 1
200
1450
3.25 2
450
250
2100
2.60 3
550
100
2750
6.50 4
600 50
3400
13.00
THE COSTS OF PRODUCTION 22

23. Various Measures of Cost
Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q
Cost of a typical unit of output
ATC = AFC + AVC
Average fixed cost (AFC), Fixed cost divided by the quantity of output produced= FC/Q
Average variable cost (AVC), Variable cost divided by the quantity of output produced=VC/Q

24. Various Measures of Cost
U-shaped average total cost curve
ATC = AVC + AFC
AFC – always declines as output rises
AVC – typically rises as output increases
Because of diminishing marginal product
The bottom of the U-shape
At quantity that minimizes average total cost

25. © 2012 Cengage Learning. All Rights Reserved.
Cost Curves for a Typical Firm
Costs
1.00
0.50
2.00
1.50
2.50
$3.00
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.
ATC MC
AFC
AVC
Quantity of Output 2 4 6 8 10 12 14
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26. Various Measures of Cost
Efficient scale
Quantity of output that minimizes ATC
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. EXAMPLE 2: ATC and MC When MC < ATC, ATC ATC is falling.$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
When MC < ATC,
ATC is falling.
When MC > ATC,
ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum.
ATC MC
THE COSTS OF PRODUCTION 27

28. Costs in Long Run
Long-run average cost curve A curve showing the lowest cost at which a firm is able to produce a given quantity of output in the long run, when no inputs are fixed.
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).

29. © 2012 Cengage Learning. All Rights Reserved.
Average Total Cost in the Short and Long Runs
Average
Total
Cost
ATC in short run
with medium factory
ATC in short run
with large factory
ATC in short run
with small 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.
© 2012 Cengage Learning. All Rights Reserved.

30. How ATC Changes as the Scale of Production Changes
Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scale: ATC rises as Q increases. Q
ATC
LRATC
THE COSTS OF PRODUCTION 30

31. Costs in Long Run
Economies of scale The situation when a firm’s long-run average total costs fall as it increases output
Increasing specialization among workers .
Constant returns to scale
Long-run average total cost stays the same as the quantity of output changes
Diseconomies of scale
The situation when a firm’s long-run average costs rise as the firm increases output.
Increasing coordination problems

32. Conclusion Table 10-4 A Summary of Definitions of Cost TERM DEFINITION
SYMBOLS AND EQUATIONS
Total cost
The cost of all the inputs used by a firm, or fixed cost plus variable cost TC
Fixed costs
Costs that remain constant when a firm’s level of output changes FC
Variable costs
Costs that change when the firm’s level of output changes VC
Marginal cost
Increase in total cost resulting from producing another unit of output
Average total cost
Total cost divided by the quantity of output produced
Average fixed cost
Fixed cost divided by the quantity of output produced
Average variable cost
Variable cost divided by the quantity of output produced
Implicit cost
A nonmonetary opportunity cost ―
Explicit cost
A cost that involves spending money

33. EXERCISE
Table 13-1
Listed in the table are the long-run total costs for three different firms.
Refer to Table Firm A is experiencing economies of scale.
ANS: T/F
Quantity 1 2 3 4 5
Firm A
100
Firm B
200
300
400
500
Firm C
600
1,000
1,500