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The Costs of ProductionPrinciples of Microeconomics
Boris Nikolaev
Brainstorming costs
You run Ford Motor Company. • List three different costs you have. • List three different
business decisions that are affected by your costs.
In this chapter
• What is a production function? What is marginal product? How are they related?
• What are the various costs? 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”?
It’s business time.
• Firms are in the business of making profits.
Profit = Total Revenue (TR) – Total Cost (TC)
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production
Sneak Preview
MR=MC
Profits
• Are profits bad?• What is the function of profits in a free market
economy?• In a competitive market profits come not from
increase in price, but from decrease in the cost of production. Why?
• Fortune 500 most profitable companies [see here]
The Weed Trail [read here]
Profits and Insurance
• Recollect risk-aversion & uncertainty.
Corporate Profits after tax
CP/GDP
Marxist View
• The stagnating wages since the 1970s– Technology– World war II– Outsourcing– Women in the labor force– Immigration
• Problem of effective demand– Work more hours– Borrowing binge (mortgage debt, credit cards)
• Greatest profit boom (in the history of the world)– Marginal productivity, wages, and profits
Productivity vs Wages
What do you do with the profits?
• CEO salaries [Forbes list]• Mergers & Acquisitions• Lend to employees (e.g. GM, IBM, etc.)
Costs
• Resources are scarce, productive, and have alternative uses.
Explicit costs are the direct cash payments you make to use resources you don’t own such as wages, rent, insurance, taxes, etc.
Implicit costs is the opportunity cost of the resource you own (the benefit you could have extracted from it from its next best use). Do not require direct cast payments.
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.
Economic vs Accounting Profit
• 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.
Example 1
The equilibrium rent on office space has just increased by $500/month. Determine the effects on accounting profit and economic profit if:
a. you rent your office spaceb. you own your office space
Answers
The rent on office space increases $500/month. a. You rent your office space.
Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.
b.You own your office space.Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it) so economic profit falls by $500/month.
Practice QuestionYour current job pays $50K/year. You have $20K savings that earn you $3K interest a year. You own a garage, which you rent for $12K/ year. You decide to invest your savings and use your garage to start your own business.
Did you make a good economic decision?
Total Revenue $105KExplicit Costs
labor $21Kfood $20K
Total Cost $41K
Accounting Profit _____
Implicit Costssalary _____interest _____rent _____
Total Implicit Cost _____
Economic Profit / Loss______
Production in the Short Run
Q= f(L,K)
A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qu
anti
ty o
f o
utp
ut
EXAMPLE 1: Production Function
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
Marginal Product (MP)
• If you hire one more worker, your output rises by the marginal product of labor.
• 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
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
EXAMPLE 1: Total & Marginal Product
200
400
600
800
1000
MPL
∆Q = 1000∆L = 1
∆Q = 800∆L = 1
∆Q = 600∆L = 1
∆Q = 400∆L = 1
∆Q = 200∆L = 1
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.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qu
anti
ty o
f o
utp
ut
EXAMPLE 1: MPL = Slope of Prod Function
30005200
28004400
24003600
18002800
100011000
00
MPLQ
(bushels of wheat)
L(no. of
workers)
Why MPL Is Important
• Recall one of the Ten Principles: Rational people think at the margin.
• When you hire an extra worker, – your costs rise by the wage he pays the worker– your output rises by MPL
• Comparing them helps you decide whether he should hire the worker.
Class demonstration
The Law of Diminishing Marginal Returns
• Diminishing marginal product: The marginal product of an input declines as the quantity of the input increases (other things equal).
• Why does it decline?
Practice Question# fishermen Fish caught MP of labor MRP
1 152 353 584 805 956 1057 1088 105
Input (L) TP = f(L)
Assume that only one input (L) is relevant in production.The wage / worker = $175 and one pound of fish is selling for $10
Let’s go back to our farm example…
• You must pay $1000 per month for the land, regardless of how much wheat you grow.
• The market wage for a farm worker is $2000 per month.
• Your cots are related to how much wheat you produce…
EXAMPLE 1: Your Costs
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total cost
30005
28004
24003
18002
10001
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$1,000
$1,000
$1,000
$1,000
$1,000
$1,00000
Cost of labor
Cost of land
Q(bushels of wheat)
L(no. of
workers)
EXAMPLE 1: Total Cost Curve
Q (bushels of wheat)
Total Cost
0 $1,000
1000 $3,000
1800 $5,000
2400 $7,000
2800 $9,000
3000 $11,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
0 1000 2000 3000
Quantity of wheat
To
tal c
ost
Marginal Cost
• Marginal Cost (MC) is the increase in Total Cost from producing one more unit: ∆TC
∆QMC =
EXAMPLE 1: Total and Marginal Cost
$10.00
$5.00
$3.33
$2.50
$2.00
Marginal Cost (MC)
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
∆Q = 1000 ∆TC = $2000
∆Q = 800 ∆TC = $2000
∆Q = 600 ∆TC = $2000
∆Q = 400 ∆TC = $2000
∆Q = 200 ∆TC = $2000
MC usually rises as Q rises, as in this example.
EXAMPLE 1: The Marginal Cost Curve
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
TC
$10.00
$5.00
$3.33
$2.50
$2.00
MC
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
$0
$2
$4
$6
$8
$10
$12
0 1,000 2,000 3,000Q
Mar
gin
al C
ost
($)
Why MC Is Important
• You are rational and want to maximize your profits. To increase profit, should you produce more or less wheat?
• To find the answer, you need to “think at the margin.”
• If MC > MR then producing one more unit will decrease profits.
Fixed and Variable Costs
• Fixed costs (FC) do not vary with the quantity of output produced. – In our example, FC = $1000 for land– Other examples:
cost of equipment, loan payments, rent• Variable costs (VC) vary with the quantity produced.
– In our example, VC = wages you pay workers– Other example: cost of materials
• Total cost (TC) = FC + VC
EXAMPLE 2: Costs
7
6
5
4
3
2
1
620
480
380
310
260
220
170
$100
520
380
280
210
160
120
70
$0
100
100
100
100
100
100
100
$1000
TCVCFCQ
$0
$100
$200
$300
$400
$500
$600
$700
$800
0 1 2 3 4 5 6 7
Q
Co
sts
FC
VC
TC
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
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.)
EXAMPLE 2: Marginal Cost
6207
4806
3805
3104
2603
2202
1701
$1000
MCTCQ
140
100
70
50
40
50
$70
∆TC∆Q
MC =
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Average Fixed Cost
1007
1006
1005
1004
1003
1002
1001
14.29
16.67
20
25
33.33
50
$100
n/a$1000
AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Average Variable Cost
5207
3806
2805
2104
1603
1202
701
74.29
63.33
56.00
52.50
53.33
60
$70
n/a$00
AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7Q
Co
sts
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
74.2914.29
63.3316.67
56.0020
52.5025
53.3333.33
6050
$70$100
n/an/a
AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
Usually, as in this example, the ATC curve is U-shaped.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
TCQ
EXAMPLE 2: The Various Cost Curves Together
AFCAVCATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
Calculating costsFill in the blank spaces of this table.
210
150
100
30
10
VC
43.33358.332606
305
37.5012.501504
36.672016.673
802
$60.00$101
n/an/an/a$500
MCATCAVCAFCTCQ
60
30
$10
AnswersUse AFC = FC/QUse AVC = VC/QUse relationship between MC and TCUse ATC = TC/QFirst, deduce FC = $50 and use FC + VC = TC.
210
150
100
60
30
10
$0
VC
43.33358.332606
40.003010.002005
37.502512.501504
36.672016.671103
40.001525.00802
$60.00$10$50.00601
n/an/an/a$500
MCATCAVCAFCTCQ
60
50
40
30
20
$10
EXAMPLE 2: ATC and MC
ATCMC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
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.
Cost in the Long Run
• Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
• Long run: All inputs are variable (e.g., firms can build more factories or sell existing ones).
EXAMPLE 3: LRATC with 3 factory sizes
ATCSATCM ATCL
Q
AvgTotalCost
Firm can choose from three factory sizes: S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run.
A Typical LRATC Curve
Q
ATCIn the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this:
LRATC
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.
LRATC
Q
ATC
Sources of Economies of Scale
• Spread of “overhead,” fixed cost over bigger
production.
• Labor specialization.
• Technology.
• Learning by doing.
• Agglomeration economies.
Note on International Trade• What goods are produced and where?
• David Ricardo (1800’s) – comparative advantage.
• Heckscher & Ohlin (1920-30’s) – differences in factor endowments. Example: Developed countries export more capital intensive goods (cars, airplanes, etc…) and import from developing countries more labor intensive goods (clothing, agricultural products, etc…)
• Empirical studies.
Krugman’s Model
Uses economies of scale to explain international trade.
1. Mass production decreases average cost (ES)
2. Consumers prefer diversity of products
Each country specializes and then trades. This is how countries with similar factor endowments engage in trade (e.g. Japan sells Toyota to US, US sells GM to Germany, etc…)
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