THE COSTS OF PRODUCTION 1

Chapter 13: The Costs of Production

Econ 2100

THE COSTS OF PRODUCTION 2

Course Outline

Chapter 13 Outline

THE COSTS OF PRODUCTION 4

THE COSTS OF PRODUCTION 5

Total Revenue, Total Cost, Profit• We assume that the firm’s goal is to maximize

profit.

Profit = Total revenue – Total cost

the amount a firm receives from the sale of its output

the market value of the inputs a firm uses in production

THE COSTS OF PRODUCTION 6

Costs: Explicit vs. Implicit• Explicit costs require an outlay of money,

e.g., paying wages to workers.• Implicit costs do not require a cash outlay,

e.g., the opportunity cost of the owner’s time.• Remember one of the Ten Principles:

The cost of something is what you give up to get it.

• This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.

THE COSTS OF PRODUCTION 7

Explicit vs. Implicit Costs: An ExampleYou 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.In both cases, total (exp + imp) costs are $5000.

THE COSTS OF PRODUCTION 8

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 implicit costs, so it’s higher than economic profit.

Chapter 13 Outline

THE COSTS OF PRODUCTION 9

THE COSTS OF PRODUCTION 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 table, equation, or graph.

• Example 1:– Farmer Jack grows wheat. – He has 5 acres of land. – He can hire as many workers as he wants.

THE COSTS OF PRODUCTION 11

Example 1: Farmer Jack’s Production Function

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

30005

28004

24003

18002

10001

00

Q (bushels of wheat)

L(no. of

workers)

THE COSTS OF PRODUCTION 12

Marginal Product• If Jack hires one more worker, his 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

THE COSTS OF PRODUCTION 13

EXAMPLE 1: Total & Marginal Product

30005

28004

24003

18002

10001

00

Q (bushels of wheat)

L(no. of

workers)

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

THE COSTS OF PRODUCTION 14

EXAMPLE 1: MPL = Slope of Prod Function

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

30005200

28004400

24003600

18002800

100011000

00

MPLQ

(bushels of wheat)

L(no. of

workers)

THE COSTS OF PRODUCTION 15

Why MPL Is Important• Recall one of the Ten Principles:

Rational people think at the margin.• When Farmer Jack hires an extra worker,

– his costs rise by the wage he pays the worker– his output rises by MPL

• Comparing them helps Jack decide whether he would benefit from hiring the worker.

THE COSTS OF PRODUCTION 16

Why MPL Diminishes• Farmer Jack’s output rises by a smaller and smaller

amount for each additional worker. Why? • As Jack adds workers, the average worker has less land

to work with and will be less productive. • In general, MPL diminishes as L rises

whether the fixed input is land or capital (equipment, machines, etc.).

• Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)

Think of Einstein’s Bagels

• What happens if 1 person is working in the place?How many customers can be served

in a given time period?• What if 2 are working?

Greater or lesser number of customers?

•What if 25 are working?Greater or lesser number of

customers?17

Aircraft Scheduling & Marginal Product - Simplified

• ORD – LHR 10.5 hrs• Crew: 4 pilots & 11 FAs• One Crew – A/C can fly

one way in 24 hrs• Two Crews – A/C can fly

round trip in 24 hrs• Three Crews and more –

A/C can only fly round trip in 24 hrs

18

747-100Built 1971

747-100Built 1971

A/C is fixed factor of productionA/C is fixed factor of production

Chapter 13 Outline

THE COSTS OF PRODUCTION 19

THE COSTS OF PRODUCTION 20

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….

THE COSTS OF PRODUCTION 21

EXAMPLE 1: Farmer Jack’s 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)

THE COSTS OF PRODUCTION 22

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

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

0 1000 2000 3000

Quantity of wheat

To

tal c

ost

THE COSTS OF PRODUCTION 23

Marginal Cost• Marginal Cost (MC)

is the increase in Total Cost from producing one more unit:

∆TC∆Q

MC =

THE COSTS OF PRODUCTION 24

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

THE COSTS OF PRODUCTION 25

EXAMPLE 1: The Marginal Cost Curve

MC usually rises as Q rises, as in this example.

$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

($)

Relationship Between Marginal Product and Marginal Cost

Employee Marginal

Product

Per Hour(Sandwiches)

Total

Product

Per hour(Sandwiches)

Salary

Per Hour

Marginal Cost

Per Unit

First 10 10 $10 $1

Second 15 25 $10 $0.67

Third 10 35 $10 $1

Fourth 5 40 $10 $226

How manyEmployees?

THE COSTS OF PRODUCTION 27

Why MC Is Important• Farmer Jack is rational and wants to maximize

his profit. To increase profit, should he produce more or less wheat?

• 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 rise if he produces more.

THE COSTS OF PRODUCTION 28

Fixed and Variable Costs• Fixed costs (FC) do not vary with the quantity of output

produced. – For Farmer Jack, FC = $1000 for his land– Other examples:

cost of equipment, loan payments, rent• Variable costs (VC) vary with the quantity produced.

– For Farmer Jack, VC = wages he pays workers– Other example: cost of materials

• Total cost (TC) = FC + VC

THE COSTS OF PRODUCTION 29

EXAMPLE 2• Our second example is more general,

applies to any type of firm producing any good with any types of inputs.

THE COSTS OF PRODUCTION 30

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

THE COSTS OF PRODUCTION 31

EXAMPLE 2: Marginal Cost

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Co

sts

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.) 6207

4806

3805

3104

2603

2202

1701

$1000

MCTCQ

140

100

70

50

40

50

$70

∆TC

∆QMC =

THE COSTS OF PRODUCTION 32

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

THE COSTS OF PRODUCTION 33

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

THE COSTS OF PRODUCTION 34

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

THE COSTS OF PRODUCTION 35

EXAMPLE 2: Average Total Cost

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

88.57

80

76

77.50

86.67

110

$170

n/a

ATC

6207

4806

3805

3104

2603

2202

1701

$1000

TCQ

THE COSTS OF PRODUCTION 36

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

THE COSTS OF PRODUCTION 37

EXAMPLE 2: Why ATC Is Usually U-Shaped

$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Co

sts

As Q rises:

Initially, falling AFC pulls ATC down.

Eventually, rising AVC pulls ATC up.

Efficient scale:The quantity that minimizes ATC.

THE COSTS OF PRODUCTION 38

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.

Chapter 13 Outline

THE COSTS OF PRODUCTION 39

Short-Run Versus Long-Run

• The short run is a period of time for which two conditions hold:1. The firm is operating under a fixed scale

(or fixed factor) of production, and2. Firms can neither enter nor exit the

industry.

40

But can shut downBut can shut down

Short-Run Versus Long-Run

• The long run is a period of time for which there are no fixed factors of production. Firms can increase or decrease scale of operation, and new firms can enter and existing firms can exit the industry.

41

THE COSTS OF PRODUCTION 42

Costs in the Short Run & 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).

• 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).

THE COSTS OF PRODUCTION 43

EXAMPLE 3: LRATC with 3 factory Sizes

ATCSATCM ATCL

Q

AvgTotalCost

Firm can choose from 3 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.

THE COSTS OF PRODUCTION 44

EXAMPLE 3: LRATC with 3 factory Sizes

ATCSATCM ATCL

Q

AvgTotalCost

QA QB

LRATC

To produce less than QA, firm will

choose size S in the long run.

To produce between QA

and QB, firm will

choose size M in the long run.

To produce more than QB, firm will

choose size L in the long run.

THE COSTS OF PRODUCTION 45

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

Chapter 13 Outline

THE COSTS OF PRODUCTION 46

Weekly Costs Showing Economies of Scale in Egg Production

$/Egg

.050

.010

.006

.007

47

JONES FARM TOTAL WEEKLY COSTS

15 hours of labor (implicit value $8 per hour) $120Feed, other variable costs 25Transport costs 15Land and capital costs attributable to egg production 17

$177Total output 2,400 eggsAverage cost $.074 per egg

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS

Labor $ 5,128Feed, other variable costs 4,115Transport costs 2,431Land and capital costs 19,230

$30,904Total output 1,600,000 eggsAverage cost $.019 per egg

$/Egg

.003

.002

.002

.012

THE COSTS OF PRODUCTION 48

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

Cost of ComplexityTwo Daughters

AgRegistrar

UnivRegistrar

Bursar

Univ.Admissions

Ag Admissions

Student

Registrar/Bursar

Admissions

49

13,000 Students 1,800 Students

THE COSTS OF PRODUCTION 50

How ATC Changes as the Scale of Production Changes

• Economies of scale occur when increasing production allows greater specialization: workers more efficient when focusing on a narrow task.– More common when Q is low.

• Diseconomies of scale are due to coordination problems in large organizations. E.g., management becomes stretched, can’t control costs. – More common when Q is high.

Test Bank Questions

THE COSTS OF PRODUCTION 51

Questions 22 & 28

THE COSTS OF PRODUCTION 52

a. explicit costs only.b. implicit costs only.c. explicit costs + implicit costs.d. explicit costs + implicit costs + total

revenue.

22. A firm's opportunity costs of production are equal to its

a. a lease payment.b. the cost of raw materials.c. the value of the business

owner’s time.d. All of the above are correct.

28. An example of an opportunity cost that is also an implicit cost is

Questions 35 & 3

THE COSTS OF PRODUCTION 53

a. wages John could earn washing windows

b. dividends John's money was earning in the stock market before John sold his stock and bought a shoe-shine booth

c. the cost of shoe polishd. Both b and c are correct.

35. John owns a shoe-shine business. His accountant most likely includes which of the following costs on his financial statements?

a. The production function depicts the relationship between the quantity of labor and the quantity of output.

b. The slope of the production function measures marginal cost.

c. The quantity of output determines the maximum amount of labor the firm will hire.

d. All of the above are correct.

3. Which of the following statements about a production function is correct for a firm that uses labor to produce output?

Questions 6 & 8

THE COSTS OF PRODUCTION 54

Number of

Workers

Output (number of pet visits)

0 01 202 453 604 70

Alyson’s Pet Sitting Service

a. 15b. 20c. 22.5d. 25

6. Refer to Table 13-1. What is the marginal product of the second worker?

a. first worker.b. second worker.c. third worker.d. fourth worker.

8. Refer to Table 13-1. Alyson’s pet sitting service experiences diminishing marginal productivity with the addition of the

Question 13 & 8

THE COSTS OF PRODUCTION 55

a. The firm can vary both the size of its factory and the number of workers it employs.

b. The firm can vary the size of its factory but not the number of workers it employs.

c. The firm can vary the number of workers it employs but not the size of its factory.

d. The firm can vary neither the size of its factory nor the number of workers it employs.

13. Which of these assumptions is often realistic for a firm in the short run?

a.

author royalties of 5% per book

b.

the costs of paper and binding

c.

shipping and postage expenses

d.

composition, typesetting, and jacket design for the book

8. Which of the following costs of publishing a book is a fixed cost?

Questions 11 &43

THE COSTS OF PRODUCTION 56

a.

building the lemonade stand.

b.

hiring an artist to design a logo for her sign.

c.

lemons and sugar.

d.

All of the above are correct.

11. Suppose Jan started up a small lemonade stand business last month. Variable costs for Jan's lemonade stand now include the cost of

(i) change in total cost divided by change in quantity produced.

(ii) change in variable cost divided by change in quantity produced.

(iii) the average fixed cost of the current unit.

a. (i) and (ii) onlyb. (ii) and (iii) onlyc. (i) onlyd. (i), (ii), and (iii)

43. Marginal cost equals

Questions 139, 141 and 143

THE COSTS OF PRODUCTION 57

A

B

C

D

1 2 3 4 5 6 7 8 9 10 11 12 Quantity

1

2

3

4

5

6

7

8

9

10

11

Costa. marginal costb. average total costc. average variable costd. average fixed cost

139. Curve A represents which type of cost curve?

a. marginal costb. average total costc. average variable costd. average fixed cost

141.Curve C represents which type of cost curve?

a. marginal costb. average total costc. average variable costd. average fixed cost

143. Curve D represents which type of cost curve?

Questions 3 & 19

THE COSTS OF PRODUCTION 58

a. it cannot alter variable costs.

b. total cost and variable cost are usually the same.

c. average fixed cost rises as output increases.

d. it cannot adjust the quantity of fixed inputs.

3. When a factory is operating in the short run,

19. Economies of scale arise when

a. an economy is self-sufficient in production.

b. individuals in a society are self-sufficient.

c. fixed costs are large relative to variable costs.

d. workers are able to specialize in a particular task.

Questions 47, 49 & 50

THE COSTS OF PRODUCTION 59

a. time horizons.b. products.c. firms.d. factory sizes.

47. The three average total cost curves on the diagram labeled ATC1, ATC2, and

ATC3 most likely correspond to three

different

a. Q1 to Q2.b. Q2 to Q3.c. Q3 to Q4.d. Q4 to Q5.

49. The firm experiences diseconomies of scale if it changes its level of output from

a. Q1 to Q2.b. Q2 to Q4.c. Q1 to Q3.d. Q4 to Q5.

50. The firm experiences constant returns to scale if it changes its level of output from