The Costs of Production

What are Costs?
Total revenue
Amount a firm receives for the sale of its output
Total cost
Market value of the inputs a firm uses in production
Profit
Total revenue minus total cost

What are Costs?
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
Making its output of goods and services

What are Costs?
Costs as opportunity costs
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

What are Costs?
The cost of capital as an opportunity cost
Implicit cost
Interest income not earned
On financial capital
Owned as saving
Invested in business
Not shown as cost by an accountant

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

Economists versus accountants
1
Economists include all opportunity costs when analyzing a firm, whereas accountants measure only explicit costs. Therefore, economic profit is smaller than accounting profit

Production and Costs
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
Rational people think at the margin
Marginal product
Increase in output
Arising from an additional unit of input

Production and Costs
Diminishing marginal product
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

A production function and total cost: Caroline’s cookie factory
1

Caroline’s production function and total-cost curve
2
(a) Production function
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.
(b) Total-cost curve

The Various Measures of Cost
Fixed costs
Do not vary with the quantity of output produced
Variable costs
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

The various measures of cost: Conrad’s coffee shop
2

Conrad’s total-cost curve
3
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.

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

The Various Measures of Cost
Average total cost
Cost of a typical unit of output
If total cost is divided evenly over all the units produced
Marginal cost
Increase in total cost
From producing an additional unit of output

The Various Measures of Cost
Cost curves and their shapes
Rising marginal cost
Because of diminishing marginal product
U-shaped average total cost: ATC = AVC + AFC
AFC – always declines as output rises
AVC – typically rises as output increases
Diminishing marginal product
The bottom of the U-shape
At quantity that minimizes average total cost

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

Conrad’s average-cost and marginal-cost curves
4
This figure shows the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC) for Conrad’s Coffee Shop. All of these curves are obtained by graphing the data in Table 2. These cost curves show three features that are typical of many firms: (1) Marginal cost rises with the quantity of output. (2) The average-total-cost curve is U-shaped. (3) The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.

The Various Measures of Cost
Typical cost curves
Marginal cost eventually rises with the quantity of output
Average-total-cost curve is U-shaped
Marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost

Cost curves for a typical firm
5
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.

Costs in Short Run and in Long Run
Many decisions
Fixed in the short run
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

Average total cost in the short and long runs
6
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.

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

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