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Principles of Economics
Ohio Wesleyan UniversityGoran Skosples
8. The Costs of Production
2
A C T I V E L E A R N I N G 1: BrainstormingA C T I V E L E A R N I N G 1: Brainstorming
You run General Motors.
List 3 different costs you have.
List 3 different business decisions that are affected by your costs.
2
3
What is a production function? What is marginal product? How are they related?
What are the various costs, and 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”?
LEARNING OBJECTIVES
4
Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to _________ ________.
Profit = Total revenue – Total cost
the amount a firm ______ from the sale of its output
the market value of the inputs a firm ______ in production
5
Costs: Explicit vs. Implicit
Explicit costs – ________ an outlay of money,
Implicit costs – _____________ a cash outlay,
The cost of something is what you ______________.
This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
6
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest rate is 5%.
Case 1: borrow $100,000• explicit cost =
Case 2: use $40,000 of your savings, borrow the other $60,000• explicit cost =• implicit cost =
In both cases, total (exp + imp) costs are ______.
$_______ interest on loan
$______ (5%) interest on the loan
$______ (5%) foregone interest you could have earned on your $40,000
7
Economic Profit 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 ___________ costs, so it’s higher than economic profit.
8
A C T I V E L E A R N I N G 2: Economic profit vs. accounting profitA C T I V E L E A R N I N G 2: Economic profit vs. accounting profit
Darcy runs a local coffee shop “Coffee Shaq.” Her annual revenue is $100,000, her costs of coffee beans, milk, electricity, and labor she hires are $55,000. She owns the property where the coffee shop is located, so she does not have to pay rent, which would otherwise be $12,000 per year.
Last week, Darcy was recently approached by the head-hunter who offered her a job for $35,000 a year.
What should Darcy do?8
9
A C T I V E L E A R N I N G 2: AnswersA C T I V E L E A R N I N G 2: Answers Profit at Darcy’s “Coffee Shaq”
9
Revenue
Explicit cost
Accounting profit
Implicit cost of business
Foregone rent
Foregone income
Economic profit
10
The Production Function
A production function shows the relationship between the quantity of inputs used to produce a good, and the quantity of output of that good.
It can be represented by a _____, _________, or ______.
Example 1:• Farmer Jack grows wheat. • He has 5 acres of land. • He can hire as many workers as he wants.
11
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: Farmer Jack’s Production Function
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
12
Marginal Product The marginal product of any input is the
_______________ arising from an additional unit of that input, holding all other inputs constant.
E.g., if Farmer Jack hires one more worker, his output rises by the ____________________.
Notation: ∆ (delta) = “change in…”
Examples: ∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) =
13
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
EXAMPLE 1: Total & Marginal Product
MPL
∆Q = 1000∆L = 1
∆Q = 800∆L = 1
∆Q = 600∆L = 1
∆Q = 400∆L = 1
∆Q = 200∆L = 1
14
MPL equals the _______ of the production function.
Notice that MPL ____________ as L increases.
This explains why the production function gets flatter as L increases.
EXAMPLE 1: MPL = Slope of Prod Function
30005200
28004400
24003600
18002800
100011000
00
MPLQ
(bushels of wheat)
L(no. of
workers)
15
When Farmer Jack hires an extra worker, • •
Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal). Why?• If Jack increases workers but not land, the
average worker has less land to work with, so will be ______________.
• In general, MPL _________ as L rises whether the fixed input is land or capital (equipment, machines, etc.).
Marginal Product
16
EXAMPLE 1: Farmer Jack’s Costs
Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Jack’s costs are related to how much wheat he produces….
17
EXAMPLE 1: Farmer Jack’s Costs
Total Cost
30005
28004
24003
18002
10001
00
cost of labor
cost of land
Q(bushels of wheat)
L(no. of
workers)
18
EXAMPLE 1: Farmer Jack’s 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 1000 2000 3000$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
Quantity of wheat
To
tal c
os
t
19
Marginal Cost
Marginal Cost (MC) is the increase in Total Cost from producing one more unit:
∆TC∆Q
MC =
20
EXAMPLE 1: Total and Marginal Cost
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
21
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 1,000 2,000 3,000 $0
$2
$4
$6
$8
$10
$12
Q
Mar
gin
al C
ost
($)
22
Why MC Is Important Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce more wheat, or less?
To find the answer, Farmer Jack needs to “think at the margin.”
If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack’s profits if ________ he produces more.
(In the next chapter, we will learn more about how firms choose Q to maximize their profits.)
23
Fixed and Variable Costs
Fixed costs (FC) – __________ with the quantity of output produced. • For Farmer Jack, FC = • Other examples:
Variable costs (VC) – _______ with the quantity produced. • For Farmer Jack, VC =• Other example:
Total cost (TC) =
24
EXAMPLE 2
Our second example is more general, applies to any type of firm, producing any good with any types of inputs.
25
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
Our second example is more general, applies to any type of firm,
producing any good with any types of inputs.
26
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
Usually, MC rises as Q rises, due to diminishing _______________.
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
27
0 1 2 3 4 5 6 7$0
$25
$50
$75
$100
$125
$150
$175
$200
Q
Co
sts
EXAMPLE 2: Marginal Cost
6207
4806
3805
3104
2603
2202
1701
$1000
MCTCQ
140
100
70
50
40
50
$70
28
EXAMPLE 2: Average Fixed Cost
1007
1006
1005
1004
1003
1002
1001
$1000
AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output:
Notice that AFC ___ as Q rises:
The firm is
29
0 1 2 3 4 5 6 7$0
$25
$50
$75
$100
$125
$150
$175
$200
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
30
EXAMPLE 2: Average Variable Cost
5207
3806
2805
2104
1603
1202
701
$00
AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.
31
0 1 2 3 4 5 6 7$0
$25
$50
$75
$100
$125
$150
$175
$200
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
32
EXAMPLE 2: Average Total Cost
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.a.n.a.
AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output:
ATC =
Also,
ATC =
33
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
Usually, as in this example, the ATC curve is ________.
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
34
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
35
A C T I V E L E A R N I N G 3: CostsA C T I V E L E A R N I N G 3: Costs
Fill in the blank spaces of this table.
35
210
150
100
30
10
VC
43.33358.332606
305
37.5012.501504
36.672016.673
802
$60.00$101
n.a.n.a.n.a.$500
MCATCAVCAFCTCQ
60
30
$10
36
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Why ATC Is Usually U-ShapedAs Q rises:
Initially, falling AFC
Eventually, rising AVC
37
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 _______.
When MC > ATC,
ATC is _______.
The MC curve crosses the ATC curve at the ___________ ___________.
38
Costs in the Short Run & Long Run
Short run: Some inputs are ________ (e.g., factories, land).
The costs of these inputs are FC.
Long run: All inputs are ___________
In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q (e.g., the factory size with the lowest ATC).
39
EXAMPLE 3: LRATC with 3 factory Sizes
Q
AvgTotalCost
Firm can choose from 3 factory sizes: ________
Each size has its own SRATC curve.
The firm can change to a different factory size in the _____ ___, but not in the ________.
40
EXAMPLE 3: LRATC with 3 factory Sizes
ATCSATCM ATCL
Q
AvgTotalCost
QA QB
To produce less than QA, firm will
choose size ___in the long run.
To produce between QA
and QB, firm will
choose size ___ in the long run.
To produce more than QB, firm will
choose size ___ in the long run.
41
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:
42
How ATC Changes As the Scale of Production Changes
Economies of scale: ATC ____as Q increases.
Constant returns to scale: ATC _______________
as Q increases.
Diseconomies of scale: ATC _____ as Q increases.
LRATC
Q
ATC
43
How ATC Changes As the Scale of Production Changes
Economies of scale occur when increasing production allows greater _____________: workers more efficient when focusing on a narrow task.• More common when Q is ______.
Diseconomies of scale are due to coordination problems in large organizations.
• More common when Q is _______.
44
CONCLUSION
Costs are critically important to many business decisions, including production, pricing, and hiring.
This chapter has introduced the various cost concepts.
The following chapters will show how firms use these concepts to maximize profits in various market structures.
45
Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms’ decisions.
Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs.
The production function shows the relationship between output and inputs.
CHAPTER SUMMARY
46
The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly.
Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper.
Variable costs vary with output; fixed costs do not.
CHAPTER SUMMARY
47
Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping.
Average variable cost is variable cost divided by output.
Average fixed cost is fixed cost divided by output. AFC always falls as output increases.
Average total cost (sometimes called “cost per unit”) is total cost divided by the quantity of output. The ATC curve is usually U-shaped.
CHAPTER SUMMARY
48
The MC curve intersects the ATC curve at minimum average total cost. When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises.
In the long run, all costs are variable.
Economies of scale: ATC falls as Q rises. Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises.
CHAPTER SUMMARY