EconomicsChapter 5

Supply

Costs of Production

Chapter 5Section 2

Economists divide a producer’s costs into fixed costs and variable costs.A fixed cost is a cost that does not change, no matter how much is produced.

Examples of fixed costs might

include rent and machinery repairs.

A variable cost is a cost that rises or falls depending on the quantity produced.

These include the costs of raw materials and some labor.

Fixed costs and variable costs are added together to find total cost.

A Firm’s Labor Decisions

• Business owners have to consider how the number of workers they hire will affect their total production.

• The marginal product of labor is the change in output from hiring one additional unit of labor, or worker.

Marginal Returns• There are 3 types of marginal

returns

The First Type

Increasing marginal returns occur when marginal production levels increase with new investment.

Adding each worker will result in increasing marginal returns.

Workers will be able to specialize and gain skills.

The Second Type

Diminishing marginal returns occur when marginal production levels decrease with new investment.

At some point, adding each worker will result in diminishing marginal returns.

Workers may need to wait to use a tools or machine.

As more workers are added, there will eventually be negative marginal returns.

The Third Type

Marginal revenue is the revenue gained from producing one more unit of a good – usually, the price of a unit.

Marginal cost is the cost of producing one more unit of a good.

When marginal cost is less than marginal revenue, a producer has an incentive to increase output, since it will earn a profit on the next unit produced.

When marginal cost is more than marginal revenue, a producer has an incentive to decrease output, since it will lose money on the next unit produced.

Negative marginal returns occur when the marginal product of labor becomes negative.

Increasing, Diminishing, and Negative Marginal Returns

Labor(number of workers)

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Increasing marginal returns

4 5 6 7

Diminishing marginal returns

8 9

Negative marginal returns

Marginal cost is the cost of producing one more unit of a

good.

Marginal revenue is the revenue gained from producing

one more unit of a good – usually, the price of a unit.

When marginal cost is less than marginal revenue, a producer has an incentive to increase

output, since it will earn a profit on the next unit produced.

When marginal cost is more than marginal revenue, a

producer has an incentive to decrease output, since it will lose money on the next unit

produced.

That is why profits are maximized when marginal cost

equals marginal revenue.

Negative marginal returns occur when the marginal product of labor becomes negative.

The graphic below illustrates how the marginal product of labor is derived.

A Summary of Production Costs

• A fixed cost is a cost that does not change, regardless of how much of a good is produced. Examples: rent and salaries

• Variable costs are costs that rise or fall depending on how much is produced. Examples: costs of raw materials, some labor costs.

• The total cost equals fixed costs plus variable costs.

• The marginal cost is the cost of producing one more unit of a good.

Setting Output• Marginal revenue is the

additional income from selling one more unit of a good. It is usually equal to price.

• To determine the best level of output, firms determine the output level at which marginal revenue is equal to marginal cost.