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THEORY OF FIRM BEHAVIOR
Chapter 6: COSTS OF THE FIRM
Firm’s Choice: Firm’s Costs and Production Decision A firm chooses:
What quantity of the good to produce, The price of the good (sometimes...).
Firm’s decision depends on: Costs of production. The degree of competition in the market (if there
are more sellers, more competitive).
Firm’s Choice: Firm’s Costs and Production Decision Firm’s Objective
The goal of a firm is to maximize profits.
Total Revenue, Total Cost, and Profit Profit is the firm’s total revenue minus its total
cost.
Profit = Total Profit = Total RRevenue - Total evenue - Total CCostost
Total Revenue, Total Cost, and Profit Total Revenue
The amount a firm receives for the sale of its output. For a competitive firm, TR = P x Q
Total Cost The market value of the inputs a firm uses in
production.
Economic Profit versus Accounting Profit Economic profit is not the same as
accounting profit. When calculating economic profit, we include all opportunity costs including hidden (implicit) costs.
Accounting profit (as it appears on balance sheets) refers to the firm’s total revenue minus only the firm’s open (explicit) costs.
Costs as Opportunity Costs
Example: Costs of Your Textile Factory Worker’s wages, electricity, cost of machines, rent
are open (explicit) costs. Instead of starting the textile factory, you could
work as an engineer for 2,500 liras per month. Then the hidden (implicit) cost of running the textile factory is 2,500 liras per month.
Economic Profit versus Accounting Profit A firm earns positive economic profit only if
total revenue exceeds both open and hidden opportunity costs.
Economic profit is always less than or equal to accounting profit: A firm could be making positive accounting profit but at the same time zero or negative economic profit.
PRODUCTION AND COSTS
The Production Function The production function shows the relationship
between quantity of inputs (Ex: number of workers) used to make a good and the quantity of output of that good.
1 10
Table 1: A Production Function and Total Cost: Emine’s Cookie Factory
Copyright©2004 South-Western
Fixed Variable
Figure 2 Emine’s Production Function
Copyright © 2004 South-Western
Quantity ofOutput
(cookiesper hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired
0 1 2 3 4 5
Production function
The Production Function
Marginal Product The marginal product of labor (any input) is the
change in output produced by an additional worker (additional input).
workersofNumber
Output
MPL
The Production Function
Diminishing Marginal Product Diminishing marginal product: Keeping all other
inputs fixed, marginal product of one of the inputs declines as the quantity of that input increases. Ex: As more and more workers are hired at a firm, each
additional worker contributes less and less to output because the firm has a fixed amount of machines & equipment & capacity.
Another example: a farm with fixed area, machines, technology, labor. Try planting 100 gr. seeds or 200 gr. or 300 gr. seeds.
The Production Function
Diminishing Marginal Product The slope of the production function measures the
marginal product of labor. When the marginal product of labor declines, the
production function becomes flatter.
Figure 2 Emine’s Production Function
Copyright © 2004 South-Western
Quantity ofOutput
(cookiesper hour)
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
Number of Workers Hired
0 1 2 3 4 5
Production function
Table 1 A Production Function and Total Cost: Emine’s Cookie Factory
Copyright©2004 South-Western
Fixed Variable
The Various Measures Of Cost Costs of production may be separated into fixed
costs and variable costs. Fixed costsFixed costs are those costs that do not change with
the quantity of output produced. Ex: Rent, accountant’s wage, some taxes..
Variable costsVariable costs are those costs that do change with the quantity of output produced. Ex: Labor, Electricity, Transportation,...
Fixed and Variable Costs
Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC
Table 2 The Various Measures of Cost: Osman’s Lemonade Stand
Copyright©2004 South-Western
Fixed and Variable Costs
Average Costs Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces. Average cost answers the following question:
How much does it cost to produce one unit of a good on average?
Fixed and Variable Costs
Average Costs Average Fixed Cost (AFC) =
Total Fixed Cost / Qty Average Variable Cost (AVC) =
Total Variable Cost / Qty Average Total Costs (ATC) =
Total Cost / Qty
ATC = AFC + AVC
Table 2 The Various Measures of Cost: Osman’s Lemonade Stand
Copyright©2004 South-Western
Marginal Cost
Marginal Cost Marginal cost (MC) is the additional cost of
producing the last unit. Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?
Marginal Cost Osman’s Lemonade Stand
Quantity Total Cost
Marginal Cost
Quantity Total Cost
Marginal Cost
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
Marginal Cost
M CTCQ
( ch an g e in to ta l co st)
(ch an g e in q u an tity )
Figure 4 Osman’s Total-Cost Curves
Copyright © 2004 South-Western
Total Cost
$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
Quantityof Output
(glasses of lemonade per hour)
0 1 432 765 98 10
Total-cost curve
Figure 5 Osman’s Marginal-Cost Curve
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantityof Output
(glasses of lemonade per hour)
0 1 432 765 98 10
MC
Cost Curves and Their Shapes
Marginal cost increases as we produce more and more This is due to the property of diminishing marginal
product. See example.
Figure 6 Osman’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantityof Output
(glasses of lemonade per hour)
0 1 432 765 98 10
MC
ATC
AVC
AFC
Table 2 The Various Measures of Cost: Osman’s Lemonade Stand
Copyright©2004 South-Western
Cost Curves and Their Shapes
The average total-costaverage total-cost (ATC) curve is U-shaped. At very low levels of output, ATC is high because fixed
cost is spread over only a few units. ATC declines as output increases because fixed cost
is spread over more units. As output increases further, ATC starts rising because
average variable cost rises faster than the decline in AFC.
Cost Curves and Their Shapes
The quantity where the firm achieves the lowest average cost is at the minimum point of the U-shaped ATC curve. This quantity is called the efficient scale of the firm.
Figure 7 Osman’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantityof Output
(glasses of lemonade per hour)
0 1 432 765 98 10
ATC
Cost Curves and Their Shapes
Relationship between Marginal Cost and Average Total Cost Whenever MC is smaller than ATC, ATC is falling. Whenever MC is greater than ATC, ATC is rising. ATC is like your cumulative GPA and MC is like
your last semester’s grade average. As a result, MC crosses ATC at the minimum of
ATC.
Figure 5 Osman’s Average-Cost and Marginal-Cost Curves
Copyright © 2004 South-Western
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Quantityof Output
(glasses of lemonade per hour)
0 1 432 765 98 10
ATC
MC
Cost Curves and Their Shapes
Summarize Three Important Properties of Cost Curves Marginal cost eventually rises as the quantity of
output increases. The ATC curve is U-shaped. The MC curve crosses the ATC curve at the
minimum point of ATC.
Costs In The Short Run And 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 (Ex: rent of
building and machines), some are variable (labor, energy, raw materials).
In the long-run, fixed costs become variable costs (Ex: renting decisions can change, can buy/rent new machines and equipment). All costs are variable in the long-run.
Costs In The Short Run And 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 are different from its short-run cost curves.
Figure 7 Average Total Cost in the Short and Long Run
Copyright © 2004 South-Western
Quantity ofCars per Day
0
AverageTotalCost
1,200
$12,000
ATC in shortrun with
small factory
ATC in shortrun with
medium factory
ATC in shortrun with
large factory
ATC in long run
Figure 7 Average Total Cost in the Short and Long Run
Copyright © 2004 South-Western
Quantity ofCars per Day
0
AverageTotalCost
1,200
$12,000
1,000
10,000
Economiesof
scale
ATC in shortrun with
small factory
ATC in shortrun with
medium factory
ATC in shortrun with
large factory ATC in long run
Diseconomiesof
scale
Constantreturns to
scale
Costs versus Size of the Firm
If long-run ATC falls as the quantity of output increases, the firm has Increasing Returns to Scale (=Economies of Scale).
If long-run ATC rises as the quantity of output increases, the firm has Decreasing Returns to Scale (=Diseconomies of Scale).
If long-run ATC stays constant as the quantity of output increases, the firm has Constant Returns to Scale.
Economies and Diseconomies of Scale
The shape of LRATC depends on the type of industry.
Some industries exhibit economies of scale (also called increasing returns to scale) like cable TV, GSM providers, electricity, oil extraction, high-tech goods, etc. Such industries are characterized by high fixed costs.
Some industries show decreasing returns to scale because firms are too big. Coordination problems & bureaucracy. IBM and General Motors are examples.
