Lecture Principles of economics - Chapter 5: The costs of production

In lecture Principles of economics - Chapter 5 you will: Examine what items are included in a firm’s costs of production, analyze the link between a firm’s production process and its total costs, learn the meaning of average total cost and marginal cost and how they are related, consider the shape of a typical firm’s cost curves, examine the relationship between short-run and long-run costs.

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FIRM BEHAVIOR AND THE ORGANIZATION OF INDUSTRY

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13

The Costs of Production

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WHAT ARE COSTS?

• According to the Law of Supply: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.

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WHAT ARE COSTS?

• The Firm’s Objective

• The economic goal of the firm is to maximize profits.

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Total Revenue, Total Cost, and Profit

• The amount a firm receives for the sale of its output.

• The market value of the inputs a firm uses in production.

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Costs as Opportunity Costs

• A firm’s cost of production includes all the

opportunity costs of making its output of goods and services

• 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.

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Economic Profit versus Accounting Profit

• Economists measure a firm’s economic profit as total revenue minus total cost, including both

explicit and implicit costs

• Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s

explicit costs.

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Figure 1 Economic versus Accountants

Revenue

Total opportunity costs

How an Economist Views a Firm

How an Accountant Views a Firm

Revenue

Economic profit

Implicit costs

Explicit costs

Explicit costs Accounting profit

Trang 12

Table 1 A Production Function and Total Cost:

Hungry Helen’s Cookie Factory

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production because the firm has a limited amount of equipment.

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Figure 2 Hungry Helen’s Production Function

Quantity of

Output (cookies per hour)

150 140 130 120 110 100 90 80 70 60 50 40 30 20 10

Number of Workers Hired

Production function

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The Production Function

• 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.

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From the Production Function to the Cost Curve

Total-• The relationship between the quantity a firm can produce and its costs determines pricing decisions

• The totalcost curve shows this relationship

graphically.

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Table 1 A Production Function and Total Cost:

Hungry Helen’s Cookie Factory

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Figure 3 Hungry Helen’s Total-Cost Curve

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150

Total-cost curve

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Table 2 The Various Measures of Cost: Thirsty

Thelma’s Lemonade Stand

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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.

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Table 2 The Various Measures of Cost: Thirsty

Thelma’s Lemonade Stand

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Fixed and Variable Costs

• Marginal Cost

• Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.

• Marginal cost helps answer the following question:

• How much does it cost to produce an additional unit of output?

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Marginal Cost

Q ( c h a n g e i n t o t a l c o s t )

( c h a n g e i n q u a n t i t y )

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Marginal Cost Thirsty Thelma’s Lemonade Stand

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Figure 4 Thirsty Thelma’s Total-Cost Curves

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

Quantity

of Output (glasses of lemonade per hour)

0 1 2 3 4 5 6 7 8 9 10

Total-cost curve

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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

0 1 2 3 4 5 6 7 8 9 10

MC

ATC AVC AFC

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Cost Curves and Their Shapes

• Marginal cost rises with the amount of output produced

• This reflects the property of diminishing marginal

product.

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0 1 2 3 4 5 6 7 8 9 10

MC

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Cost Curves and Their Shapes

• The average totalcost curve is Ushaped.average totalcost

• 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

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0 1 2 3 4 5 6 7 8 9 10

ATC

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• Whenever marginal cost is greater than average total cost, average total cost is rising.

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• Efficient scale is the quantity that minimizes average total cost.

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0 1 2 3 4 5 6 7 8 9 10

ATC MC

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Typical Cost Curves

It is now time to examine the relationships that exist between the

different measures of cost.

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Big Bob’s Cost Curves

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Figure 6 Big Bob’s Cost Curves

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Figure 6 Big Bob’s Cost Curves

(b) Marginal- and Average-Cost Curves

Quantity of Output (bagels per hour)

AFC

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Typical Cost Curves

• Three Important Properties of Cost Curves

• Marginal cost eventually rises with the quantity of output.

• The averagetotalcost curve is Ushaped.

• The marginalcost curve crosses the averagetotal cost curve at the minimum of average total cost.

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COSTS IN THE SHORT RUN AND

IN THE LONG RUN

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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 longrun cost curves differ from its shortrun cost curves

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Figure 7 Average Total Cost in the Short and Long Run

Quantity of Cars per Day

ATC in short

run with medium factory

ATC in short

run with large factory

ATC in long run

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Economies and Diseconomies of Scale

whereby longrun average total cost falls as the quantity of output increases

whereby longrun average total cost rises as the quantity of output increases

whereby longrun average total cost stays the same as the quantity of output increases

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Figure 7 Average Total Cost in the Short and Long Run

Quantity of Cars per Day

ATC in short

run with small factory

ATC in short

run with medium factory

Constant returns to scale

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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

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produced; variable costs do change as the firm alters quantity of output produced.

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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

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• In particular, many costs are fixed in the short run but variable in the long run.

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