The Costs of
Production
Chapter 13
Copyright ? 2001 by Harcourt,Inc.
All rights reserved,Requests for permission to make copies of any part of the
work should be mailed to:
Permissions Department,Harcourt College Publishers,
6277 Sea Harbor Drive,Orlando,Florida 32887-6777.
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The Costs of Production
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.
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The Firm’s Objective
The economic goal of the firm
is to maximize profits.
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A Firm’s Total Revenue and
Total Cost
?Total Revenue
?The amount that the firm receives for
the sale of its output.
?Total Cost
?The amount that the firm pays to buy
inputs.
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A Firm’s Profit
Profit is the firm’s total revenue minus
its total cost.
Profit = Total revenue - Total cost
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Costs as Opportunity Costs
A firm’s cost of production
includes all the opportunity
costs of making its output of
goods and services.
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Explicit and Implicit Costs
A firm’s cost of production include
explicit costs and implicit costs.
?Explicit costs involve a direct money
outlay for factors of production,
?Implicit costs do not involve a direct
money outlay.
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Economic Profit versus
Accounting Profit
?Economists measure a firm’s economic
profit as total revenue minus all the
opportunity costs (explicit and implicit).
?Accountants measure the accounting
profit as the firm’s total revenue minus
only the firm’s explicit costs,In other
words,they ignore the implicit costs.
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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.
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Economic Profit versus
Accounting Profit
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
Explicit
costs
Economic
profit
Implicit
costs
Explicit
costs
Accounting
profit
How an Accountant
Views a Firm
Revenue
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A Production Function and
Total Cost
N u m b e r o f
W o rk e rs
O u t p u t M a rg i n a l
P ro d u c t o f
L a b o r
C o s t o f
F a c t o ry
C o s t o f
W o rk e rs
T o t a l C o s t o f
I n p u t s
0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
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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.
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Marginal Product
The marginal product of any input
in the production process is the
increase in the quantity of output
obtained from an additional unit of
that input.
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Marginal Product
Additional input
Additional output=Marginal
product
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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.
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A Production Function...
Quantity of
Output
(cookies
per hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired0 1 2 3 4 5
Production function
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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.
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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,
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A Production Function and
Total Cost
N u m b e r o f
W o rk e rs
O u t p u t M a rg i n a l
P ro d u c t o f
L a b o r
C o s t o f
F a c t o ry
C o s t o f
W o rk e rs
T o t a l C o s t o f
I n p u t s
0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
Hungry Helen’s Cookie Factory
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Total-Cost Curve...
Total
Cost
$80
70
60
50
40
30
20
10
Quantity of Output
(cookies per hour)
0 20 40 1401201008060
Total-costcurve
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The Various Measures of Cost
Costs of production may be
divided into fixed costs and
variable costs.
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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
change as the firm alters the
quantity of output produced.
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Family of Total Costs
?Total Fixed Costs (TFC)
?Total Variable Costs (TVC)
?Total Costs (TC)
TC = TFC + TVC
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Family of Total Costs
Quantity Total Cost Fixed Cost Variable Cost
0 $ 3.00 $3.00 $ 0.00
1 3.30 3.00 0.30
2 3.80 3.00 0.80
3 4.50 3.00 1.50
4 5.40 3.00 2.40
5 6.50 3.00 3.50
6 7.80 3.00 4.80
7 9.30 3.00 6.30
8 11.00 3.00 8.00
9 12.90 3.00 9.90
10 15.00 3.00 12.00
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Average Costs
?Average costs can be determined by
dividing the firm’s costs by the
quantity of output produced,
?The average cost is the cost of each
typical unit of product,
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Family of Average Costs
?Average Fixed Costs (AFC)
?Average Variable Costs (AVC)
?Average Total Costs (ATC)
ATC = AFC + AVC
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Family of Average Costs
AFC =
Fix e d c os t
Q ua ntit y
=
FC
Q
AV C =
V a ria ble c os t
Q ua ntit y
=
VC
Q
ATC =
Tota l c os t
Q ua ntit y
=
TC
Q
Fi x d c t
ntity
ri a bl e c t
ntity
Tota l t
ntity
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
$3.00
Family of Average Costs
Quantity AFC AVC ATC
0 — — —
1 $0.30 $3.30
2 1.50 0.40 1.90
3 1.00 0.50 1.50
4 0.75 0.60 1.35
5 0.60 0.70 1.30
6 0.50 0.80 1.30
7 0.43 0.90 1.33
8 0.38 1.00 1.38
9 0.33 1.10 1.43
10 0.30 1.20 1.50
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Marginal Cost
?Marginal cost (MC) measures the
amount total cost rises when the firm
increases production by one unit.
?Marginal cost helps answer the
following question:
?How much does it cost to produce an
additional unit of output?
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Marginal Cost
Q
TC=
q u a n t i t y ) in ( C h a n g e
c o s t ) t o t a l in ( C h a n g e
=MC
?
?
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Marginal Cost
Q u a n t i t y T o t a l
C o s t
M a r g i n a l
C o s t
Q u a n t i t y T o t a l
C o s t
M a r g i n a l
C o s t
0 $3,00 —
1 3,30 $0,30 6 $7,80 $1,30
2 3,80 0,50 7 9,30 1,50
3 4,50 0,70 8 11,00 1,70
4 5,40 0,90 9 12,90 1,90
5 6,50 1,10 10 15,00 2,10
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Total-Cost Curve...
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Tot
al
Cos
t
Total-cost
curve
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ATC
AVC
MC
Average-Cost and Marginal-Cost
Curves...
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Costs
AFC
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Cost Curves and Their Shapes
Marginal cost rises with the
amount of output produced.
?This reflects the property of
diminishing marginal product.
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Cost Curves and Their Shapes
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Co
sts
MC
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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.
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Cost Curves and Their Shapes
The bottom of the U-shape occurs at
the quantity that minimizes average
total cost,This quantity is
sometimes called the efficient scale
of the firm.
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Cost Curves and Their Shapes
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
To
tal
Co
sts
ATC
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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.
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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.
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MC
ATC
Relationship Between Marginal
Cost and Average Total Cost
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Costs
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The Various Measures of Cost
It is now time to examine the
relationships that exist between the
different measures of cost.
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The Various Measures of Cost
Big Bob’s Bagel Bin
Q u a n t i t y
o f B a g e l s
T o t a l
C o s t
F i x e d
C o s t
V a r i a b l e
C o s t
A v e r a g e
F i x e d
C o s t
A v e r a g e
V a r i a b l e
C o s t
A v e r a g e
T o t a l
C o s t
M a r g i n a l
C o s t
0 $ 2, 0 0 $ 2, 0 0 $ 0, 0 0
1 $ 3, 0 0 $ 2, 0 0 $ 1, 0 0 $ 2, 0 0 $ 1, 0 0 $ 3, 0 0 $ 1, 0 0
2 $ 3, 8 0 $ 2, 0 0 $ 1, 8 0 $ 1, 0 0 $ 0, 9 0 $ 1, 9 0 $ 0, 8 0
3 $ 4, 4 0 $ 2, 0 0 $ 2, 4 0 $ 0, 6 7 $ 0, 8 0 $ 1, 4 7 $ 0, 6 0
4 $ 4, 8 0 $ 2, 0 0 $ 2, 8 0 $ 0, 5 0 $ 0, 7 0 $ 1, 2 0 $ 0, 4 0
5 $ 5, 2 0 $ 2, 0 0 $ 3, 2 0 $ 0, 4 0 $ 0, 6 4 $ 1, 0 4 $ 0, 4 0
6 $ 5, 8 0 $ 2, 0 0 $ 3, 8 0 $ 0, 3 3 $ 0, 6 3 $ 0, 9 7 $ 0, 6 0
7 $ 6, 6 0 $ 2, 0 0 $ 4, 6 0 $ 0, 2 9 $ 0, 6 6 $ 0, 9 4 $ 0, 8 0
8 $ 7, 6 0 $ 2, 0 0 $ 5, 6 0 $ 0, 2 5 $ 0, 7 0 $ 0, 9 5 $ 1, 0 0
9 $ 8, 8 0 $ 2, 0 0 $ 6, 8 0 $ 0, 2 2 $ 0, 7 6 $ 0, 9 8 $ 1, 2 0
10 $ 1 0, 2 0 $ 2, 0 0 $ 8, 2 0 $ 0, 2 0 $ 0, 8 2 $ 1, 0 2 $ 1, 4 0
11 $ 1 1, 8 0 $ 2, 0 0 $ 9, 8 0 $ 0, 1 8 $ 0, 8 9 $ 1, 0 7 $ 1, 6 0
12 $ 1 3, 6 0 $ 2, 0 0 $ 1 1, 6 0 $ 0, 1 7 $ 0, 9 7 $ 1, 1 3 $ 1, 8 0
13 $ 1 5, 6 0 $ 2, 0 0 $ 1 3, 6 0 $ 0, 1 5 $ 1, 0 5 $ 1, 2 0 $ 2, 0 0
14 $ 1 7, 8 0 $ 2, 0 0 $ 1 5, 8 0 $ 0, 1 4 $ 1, 1 3 $ 1, 2 7 $ 2, 2 0
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Big Bob’s Cost Curves...
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
0 2 4 6 8 10 12 14 16
Quantity of Output
(bagels per hour)
To
tal
Co
st
Total Cost Curve
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AFC
AVC
MC
Big Bob’s Cost Curves...
0
0.5
1
1.5
2
2.5
3
3.5
0 2 4 6 8 10 12 14 16
Quantity of Output
Co
sts
ATC
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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.
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Costs 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.
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Costs 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.
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Average Total Cost in the Short
and Long Runs...
Quantity of
Cars per Day
0
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
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Economies and Diseconomies
of Scale
?Economies of scale occur when long-run
average total cost declines as output
increases.
?Diseconomies of scale occur when long-
run average total cost rises as output
increases.
?Constant returns to scale occur when
long-run average total cost does not
vary as output increases.
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Economies and Diseconomies
of Scale
Diseconomies
of scale
Quantity of
Cars per Day
0
Average
Total
Cost ATC in long run
Economies
of scale
Constant Returns
to scale
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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.
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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 don’t
vary with quantities produced; variable
costs do.
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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.
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Summary
?The average-total-cost curve is U-
shaped.
?The marginal-cost curve always
crosses the average-total-cost curve
at the minimum of ATC.
?A firm’s costs often depend on the
time horizon being considered.
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Graphical
Review
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Economic Profit versus
Accounting Profit
Revenue
Total
opportunity
costs
How an Economist
Views a Firm
Explicit
costs
Economic
profit
Implicit
costs
Explicit
costs
Accounting
profit
How an Accountant
Views a Firm
Revenue
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A Production Function...
Quantity of
Output
(cookies
per hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired0 1 2 3 4 5
Production function
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Total-Cost Curve...
Total
Cost
$80
70
60
50
40
30
20
10
Quantity of Output
(cookies per hour)
0 20 40 1401201008060
Total-costcurve
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Total-Cost Curve...
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Tot
al
Cos
t
Total-cost
curve
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Average-Cost and Marginal-Cost
Curves...
ATC
AVC
MC
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Costs
AFC
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Cost Curves and Their Shapes
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Co
sts
MC
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Cost Curves and Their Shapes
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
To
tal
Co
sts
ATC
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Relationship Between Marginal
Cost and Average Total Cost
MC
ATC
$0.00
$0.50
$1.00
$1.50
$2.00
$2.50
$3.00
$3.50
0 2 4 6 8 10 12
Quantity of Output
(glasses of lemonade per hour)
Costs
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Big Bob’s Cost Curves...
$0.00
$2.00
$4.00
$6.00
$8.00
$10.00
$12.00
$14.00
$16.00
$18.00
$20.00
0 2 4 6 8 10 12 14 16
Quantity of Output
(bagels per hour)
To
ta
l C
os
t
Total Cost Curve
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Big Bob’s Cost Curves...
AFC
AVC
MC
0
0.5
1
1.5
2
2.5
3
3.5
0 2 4 6 8 10 12 14 16
Quantity of Output
Co
sts
ATC
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Average Total Cost in the Short
and Long Runs...
Quantity of
Cars per Day
0
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
Harcourt,Inc,items and derived items copyright ? 2001 by Harcourt,Inc.
Economies and Diseconomies
of Scale
Diseconomies
of scale
Quantity of
Cars per Day
0
Average
Total
Cost ATC in long run
Economies
of scale
Constant Returns
to scale