FIRM BEHAVIOR AND THE ORGANIZATION OF Industry

13
The Costs of Production

The Market Forces of Supply and Demand
Supply and demand are the two words that economists use most often.
Supply and demand are the forces that make market economies work.
Modern microeconomics is about supply, demand, and market equilibrium.

WHAT ARE COSTS?
According to the Law of Supply:
Firms are willing to produce and sell a greater quantity of a good when the price of the good is high.
This results in a supply curve that slopes upward.

WHAT ARE COSTS?
The Firm’s Objective
The economic goal of the firm is to maximize profits.
Maximum Profits

Total Revenue, Total Cost, and Profit
Total Revenue
The amount a firm receives for the sale of its output.
Total Cost
The market value of the inputs a firm uses in production.

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

Costs as Opportunity Costs
A firm’s cost of production includes all the opportunity costs of making its output of goods and services.
Explicit and Implicit Costs
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs are input costs that require a direct outlay of money by the firm.
Implicit costs are input costs that do not require an outlay of money by the firm.

Economic Profit versus Accounting Profit
Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.

Economic Profit versus Accounting Profit
When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.
Economic profit is smaller than accounting profit.

Figure 1 Economic versus Accountants
Copyright © 2004 South-Western
How an Economist
Views a Firm
How an Accountant
Views a Firm

Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory
Copyright©2004 South-Western

PRODUCTION AND COSTS
The Production Function
The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.

The Production Function
Marginal Product
The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.

The Production Function
Diminishing Marginal Product
Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.
Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

Figure 2 Hungry Helen’s Production Function
Copyright © 2004 South-Western
Quantity of
Output
(cookies
per hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired
0
1
2
3
4
5
Production function

The Production Function
Diminishing Marginal Product
The slope of the production function measures the marginal product of an input, such as a worker.
When the marginal product declines, the production function becomes flatter.

From the Production Function to the Total-Cost Curve
The relationship between the quantity a firm can produce and its costs determines pricing decisions.
The total-cost curve shows this relationship graphically.

Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory
Copyright©2004 South-Western

Figure 3 Hungry Helen’s Total-Cost Curve
Copyright © 2004 South-Western
Total
Cost
$80
70
60
50
40
30
20
10
Quantity
of Output
(cookies per hour)
0
10
20
30
150
130
110
90
70
50
40
140
120
100
80
60

THE VARIOUS MEASURES OF COST
Costs of production may be divided into fixed costs and variable costs.

Fixed and Variable Costs
Fixed costs are those costs that do not vary with the quantity of output produced.
Variable costs are those costs that do vary with the quantity of output produced.

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

Table 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand
Copyright©2004 South-Western

Fixed and Variable Costs
Average Costs
Average costs can be determined by dividing the firm’s costs by the quantity of output it produces.
The average cost is the cost of each typical unit of product.

Fixed and Variable Costs
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

Average Costs

Table 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand
Copyright©2004 South-Western

Fixed and Variable Costs
Marginal Cost
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?

Marginal Cost

Marginal Cost
Thirsty Thelma’s Lemonade Stand

Figure 4 Thirsty Thelma’s Total-Cost Curves
Copyright © 2004 South-Western
Total Cost
$15.00
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
Quantity
of Output
(glasses of lemonade per hour)
0
1
4
3
2
7
6
5
9
8
10
Total-cost curve

Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity
of Output
(glasses of lemonade per hour)
0
1
4
3
2
7
6
5
9
8
10
MC
ATC
AVC
AFC

Cost Curves and Their Shapes
Marginal cost rises with the amount of output produced.
This reflects the property of diminishing marginal product.

Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity
of Output
(glasses of lemonade per hour)
0
1
4
3
2
7
6
5
9
8
10
MC

Cost Curves and Their Shapes
The average total-cost curve is U-shaped.
At very low levels of output average total cost is high because fixed cost is spread over only a few units.
Average total cost declines as output increases.
Average total cost starts rising because average variable cost rises substantially.

Cost Curves and Their Shapes
The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity
of Output
(glasses of lemonade per hour)
0
1
4
3
2
7
6
5
9
8
10
ATC

Cost Curves and Their Shapes
Relationship between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is rising.

Cost Curves and Their Shapes
Relationship Between Marginal Cost and Average Total Cost
The marginal-cost curve crosses the average-total-cost curve at the efficient scale.
Efficient scale is the quantity that minimizes average total cost.

Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantity
of Output
(glasses of lemonade per hour)
0
1
4
3
2
7
6
5
9
8
10
ATC
MC

Typical Cost Curves
It is now time to examine the relationships that exist between the different measures of cost.

Big Bob’s Cost Curves

Figure 6 Big Bob’s Cost Curves
Copyright © 2004 South-Western
(a) Total-Cost Curve
$18.00
16.00
14.00
12.00
10.00
8.00
6.00
4.00
Quantity of Output (bagels per hour)
TC
4
2
6
8
14
12
10
2.00
Total
Cost
0

Figure 6 Big Bob’s Cost Curves
Copyright © 2004 South-Western
(b) Marginal- and Average-Cost Curves
Quantity of Output (bagels per hour)
Costs
$3.00
2.50
2.00
1.50
1.00
0.50
0
4
2
6
8
14
12
10
MC
ATC
AVC
AFC

Typical Cost Curves
Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity of output.
The average-total-cost curve is U-shaped.
The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

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.
In the long run, fixed costs become variable costs.

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 differ from its short-run cost curves.

Figure 7 Average Total Cost in the Short and Long Run
Copyright © 2004 South-Western
Quantity of
Cars per Day
0
Average
Total
Cost
1,200
$12,000

Economies and Diseconomies of Scale
Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.
Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.
Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases

Figure 7 Average Total Cost in the Short and Long Run
Copyright © 2004 South-Western
Quantity of
Cars per Day
0
Average
Total
Cost

Summary
The goal of firms is to maximize profit, which equals total revenue minus total cost.
When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.
Some opportunity costs are explicit while other opportunity costs are implicit.

Summary
A firm’s costs reflect its production process.
A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.
A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.

Summary
Average total cost is total cost divided by the quantity of output.
Marginal cost is the amount by which total cost would rise if output were increased by one unit.
The marginal cost always rises with the quantity of output.
Average cost first falls as output increases and then rises.