The Costs of Production

Dr. Dwi Cahyaningdyah, SE, MSi

The Market Forces of Supply and Demand
• Supply and demand are the two words that economists use most
often.
• Supply and demand are the forces that make market economies
work.
• Modern microeconomics is about supply, demand, and market
equilibrium.
• The economy is made up of thousands of firms that produce the
goods and services you enjoy every day: General Motors produces
automobiles, General Electric produces lightbulbs, and General Mills
produces breakfast cereals.
• Some firms, such as these three, are large; they employ thousands of
workers and have thousands of stockholders who share the firms’
profits.
• Other firms, such as the local barbershop or café, are small; they
employ only a few workers and are owned by a single person or
family.
• In previous chapters, we used the supply curve to summarize firms’
production decisions.
• According to the law of supply, firms are willing to produce and sell a
greater quantity of a good when the price of the good is higher.
• This response leads to a supply curve that slopes upward.
• For analyzing many questions, the law of supply is all you need to
know about firm behavior.
• In this chapter, we examine firm behavior in more detail.
• This topic will give you a better understanding of the decisions behind the
supply curve.
• In addition, it will introduce you to a part of economics called industrial
organization—the study of how firms’ decisions about prices and quantities depend
on the market conditions they face.
• The town in which you live, for instance, may have several pizzerias but only one
cable television company. This raises a key question: How does the number of firms
affect the prices in a market and the efficiency of the market outcome?
• The field of industrial organization addresses exactly this question.
• Before turning to these issues, we need to discuss the costs of production.
• All firms, from Delta Air Lines to your local deli, incur costs while making the goods
and services that they sell. As we will see in the coming chapters, a firm’s costs are a
key determinant of its production and pricing decisions.
• In this chapter, we define some of the variables that economists use to measure a
firm’s costs, and we consider the relationships among these variables.
WHAT ARE COSTS?
• According to 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.

• The Firm’s Objective

• The economic goal of the firm is to maximize profits
Total Revenue, Total Cost, and Profit
• Total Revenue
• The amount a firm receives for the sale of its output.
• Total Cost
• The market value of the inputs a firm uses in production.

• Profit is the firm’s total revenue minus its total cost.

• Total Revenue equals the quantity of output the firm produces times the price
at which it sells its output.

Profit = Total revenue - Total cost

Costs as Opportunity Costs
• The cost of something is what you give up to get it.
• Recall that the opportunity cost of an item refers to all the things that
must be forgone to acquire that item.
• A firm’s cost of production includes all the opportunity costs of
making its output of goods and services.
• Economists take into account, Explicit and Implicit Costs
• A firm’s cost of production include explicit costs and implicit costs.
• Explicit costs are input costs that require a direct outlay of money by the firm.
• Implicit costs are input costs that do not require an outlay of money by the firm
• The distinction between explicit and implicit costs highlights an
important difference between how economists and accountants
analyze a business.
• Economists are interested in studying how firms make production and
pricing decisions.
• Because these decisions are based on both explicit and implicit costs,
economists include both when measuring a firm’s costs.
• By contrast, accountants have the job of keeping track of the money
that flows into and out of firms.
• As a result, they measure the explicit costs but usually ignore the
implicit costs.
Economic Profit versus Accounting Profit
• Economists measure a firm’s economic profit as total revenue minus
total cost, including both explicit and implicit costs.
• When total revenue exceeds both explicit and implicit costs, the firm
earns economic profit.
• Economic profit is smaller than accounting profit.
• Accountants measure the accounting profit as the firm’s total revenue
minus only the firm’s explicit costs.
Figure 1 Economic versus Accountants
Production and Costs
• Firms incur costs when they buy inputs to produce the goods and services
that they plan to sell.
• In this section, we examine the link between a firm’s production process
and its total cost.
• Lets consider Caroline’s Cookie Factory.
• In the analysis that follows, we make an important simplifying assumption:
• We assume that the size of Caroline’s factory is fixed and that Caroline can vary the
quantity of cookies produced only by changing the number of workers she employs.
• This assumption is realistic in the short run but not in the long run. That is, Caroline
cannot build a larger factory overnight, but she could do so over the next year or
two.
• This analysis, therefore, describes the production decisions that Caroline faces in the
short run.
The Production Function
• Table 1 shows how the quantity of cookies produced per hour at
Caroline’s factory depends on the number of workers.
• As you can see in columns (1) and (2), if there are no workers in the
factory, Caroline produces no cookies.
• When there is 1 worker, she produces 50 cookies. When there are 2
workers, she produces 90 cookies and so on
Table 1 A Production Function and Total Cost:
Hungry Helen’s Cookie Factory
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.
• The figure of The production function
shows the relationship between the
number of workers hired and the
quantity of output produced.
• Here the number of workers hired (on
the horizontal axis) is from column (1)
in Table 1, and the quantity of output
produced (on the vertical axis) is from
column (2).
• The production function gets flatter as
the number of workers increases,
reflecting diminishing marginal
product
The total-cost curve
• The total-cost curve shows the
relationship between the quantity
of output produced and total cost
of production.
• Here the quantity of output
produced (on the horizontal axis) is
from column (2) in Table 1, and the
total cost (on the vertical axis) is
from column (6).
• The total-cost curve gets steeper as
the quantity of output increases
because of diminishing marginal
product.
• Marginal Product
• The marginal product of any input in the production process is the increase in
output that arises from an additional unit of that input.
• 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
• 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.
THE VARIOUS MEASURES OF COST
• Costs of production may be divided into fixed costs and variable costs.
• Fixed costs are those costs that do not vary with the quantity of
output produced. (Capital, rent) constant over the output
• Incur even if the firm produces nothing
• Variable costs are those costs that do vary with the quantity of output
produced. (labor)
• Total cost: the sum of fixed and variable. Most opportunity costs will
be fixed costs
 TC = TFC + TVC
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
Table 2 The Various Measures of Cost: Thirsty
Thelma’s Lemonade Stand
Fixed and Variable Costs
• Average Costs
• Average costs can be determined by dividing the firm’s costs by the quantity
of output it produces.
• The average cost is the cost of each typical unit of product

•ATC = AFC + AV
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
Average Costs
Table 2 The Various Measures of Cost: Thirsty
Thelma’s Lemonade Stand
Marginal Cost
• Marginal cost (MC) measures the increase in total cost that arises
from an extra unit of production.
• MC is the cost of producing one more unit of output.
• These are the costs in which the firm exercises the most control
• Marginal cost helps answer the following question:
• How much does it cost to produce an additional unit of output?
Marginal Cost
Thirsty Thelma’s Lemonade Stand
Figure 4 Thirsty Thelma’s Total-Cost Curves
Figure 5 Thirsty Thelma’s Average-Cost and
Marginal-Cost Curves
Cost Curves and Their Shapes
• Marginal cost rises with the amount of output produced.
• This reflects the property of diminishing marginal product.
• Once all of the equipment is being utilized and a business hires an additional
worker the marginal product of that worker will be low, but the marginal cost
will be high.
Figure 5 Thirsty Thelma’s Average-Cost and
Marginal-Cost Curves
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
Cost Curves and Their Shapes
• The bottom of the U-shaped ATC curve occurs at the quantity that
minimizes average total cost. This quantity is sometimes called the
efficient scale of the firm
Figure 5 Thirsty Thelma’s Average-Cost and
Marginal-Cost Curves
Cost Curves and Their Shapes
• 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.
• Example: cumulative GPA – average total cost and marginal cost – grade in next course
• The marginal-cost curve crosses the average-total-cost curve at the efficient
scale.
• Efficient scale is the quantity that minimizes average total cost
Figure 5 Thirsty Thelma’s Average-Cost and
Marginal-Cost Curves
Marginal Cost
• MC crosses ATC and AVC at
their lowest points
• No relationship between MC
and AFC
• MC at lowest point when
Marginal Product (MP) is at its
highest point. These curves
are mirror images
Cost Curves
• Fixed costs can’t change in
the short run
• Variable costs can change
in the short run
• No relationship between
MC and AFC
Typical Cost Curves
• It is now time to examine the relationships that exist between the
different measures of cost
Big Bob’s Cost Curves
Figure 6 Big Bob’s Cost Curves
Short Run Production Costs
Figure 6 Big Bob’s Cost Curves
Typical Cost Curves
• 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
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.
• In the long run, fixed costs become variable costs.
• 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
Figure 7 Average Total Cost in the Short and
Long Run
Economies and Diseconomies of Scale
• Economies of scale refer to the property whereby long-run average
total cost falls as the quantity of output increases. (Specialization)
• Economies occur because increasing size allows for increasingly
specialized equipment and increasingly specialized labor, both of
which increase output beyond the level of the increased inputs
• Economies of scale happen when inputs are increased by a factor of X
and output increases by more than a factor of X
Economies and Diseconomies of Scale
• Constant returns to scale refers to the property whereby long-run
average total cost stays the same as the quantity of output increases
• When inputs increase by a factor of X and output increases by that
same amount
Figure 7 Average Total Cost in the Short and
Long Run
Long Run ATC – All resources variable, none
fixed
• Economies of scale due to
labor and managerial
specialization, efficient
capital => per unit costs
decreased => ATC
decreasing
• Constant Returns to scale
=> per unit costs same =>
ATC constant
• Diseconomies of Scale due
to inefficiencies from large
impersonal bureaucracy =>
per unit costs increase =>
ATC increasing
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.
• 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
do not change when the firm alters the quantity of output produced;
variable costs do change as the firm alters quantity of output produced.
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.
• Average cost first falls as output increases and then rises.
• 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.
• In particular, many costs are fixed in the short run but variable in the long
run.