13 Chapter The Costs of Production
What are Costs?
o Total Revenue, Total Cost, and Profit
Goal of a firm is to maximize profit
Total Revenue amount that the firm receives for the sale of its output
Total cost amount that the firm pays to buy inputs
Profit = firms total revenue minus its total cost
o Cost as Opportunity Costs
Economists speak of a firms cost of production, they include all the
opportunity costs of making its output of goods and services
When caroline pays $1,000 for flour, that $1,000 is an opportunity cost
because Caroline can no longer use that $1,000 to buy something else
Because these opportunity costs require the frim to pay out some money
they are called explicit costs
Explicit costs input costs that require an outlay of money by the
firm
Some of a firms opportunity costs do not require a cash outlay
Implicit costs input costs that do not require an outlay of money
by the firm
Total cost of Carolines business is the sum of the explicit costs and
implicit costs
o Cost of Capital as an Opportunity Cost
Caroline used $300,000 of her savings to buy her cookie factory
If caroline had instead left this money deposited in a savings account that
pays 5% interest rate, she would have earned 15,000 per year
Caroline has given up 15,000 a year in interest income
o IMPLICIT OPPORTUNITY COSTS of Carolines business
-= 15,000
Caroline did not have 300,000 but instead used 100,000 of her own
savings and borrowed 200,000 from a bank at 5% interest rate
Opportunity cost of owning the business is still 15,000
o OC = interest rate on bank loan (explicit cost of 10,000) +
forgone interest on savings (Implicit cost of 5000)
o Economic Profit versus Accounting Profit
Economic profit -- Economist measures a firms economic profit as the
firms total revenue minus all the opportunity costs of producing the goods
and services sold
Accounting profit -- An accountant measures the firms accounting profit
as the firms total reveniue minus only the firms explicit costs
Production and Costs
o Analysis in Short Run
o Production Function
Production function - This relationship between the quantity of inputs
(workers) and quantity of output (cookies)
Marginal Product the increase in output that arises from an additional
unit of input
As the number of workers increases the marginal product declines
(diminishing marginal product)
Diminishing Marginal Product the property whereby the
marginal product of an input declines as the quantity of the input
increases
o More and more workers are hired, each additional worker
contributes fewer additional cookies to total production
o From the Production Function to the Total-Cost Curve
Total-Cost Curve - Relationship between quantity produced and total costs
Compare the total cost curve with production function
Opposite sides of the coin
Total cost curve gets steeper as the amount produces rises, whereas
the production function gets flatter as production rises
Each additional worker adds less to production, reflecting
diminishing marginal product
When the quantity produced is large, the total-cost curve is
relatively steep
Various Measures of Cost
o Firms total cost reflects its production function
o Fixed and Variable Costs
Fixed costs costs that do not vary with the quantity of output produced
Include rent, bookkeeper to pay bills, incurred even if firm
produces nothing at all
Variable costs costs that vary with quantity of output produced
Include cost of coffee beans, milk, sugar, paper cups, salaries of
extra workers hired to make output,
Total cost = fixed costs + Variable Costs
o Average and Marginal Cost
Average total cost -Total cost divided by the quantity of output
average total cost can be expressed as the sum of average fixed cost and
average variable cost
average fixed cost fixed cost divided by quantity of output
average variable cost variable cost divided by the quantity of output
marginal cost the increase in total cost arises that from an extra unit of
production
Average total cost tells us the cost of a typical unit of output if total cost is
divided evenly over all the units produced. Marginal cost tells us the
increase in total cost that arises from producing an additional unit of
output
o Cost Cures and their Shapes
Rising Marginal Cost
Conrads marginal cost rises with the quantity of output produced
= diminishing marginal product
Conrad produces small quantity of coffee, he has few workers, and
much of his equipment is not used
o Marginal product of an extra worker is large, and the
marginal cost of an extra cup of coffee is small
U-Shaped Average Total Cost
Average-total-cost curve is U shaped
o ATC = AVC+AFC
o AVC typically rises as output increases because of
diminishing marginal product
o AFC always declines as output rises because the FC is
spread over a larger number of units
Bottom of U-Shape occurs at the quantity that minimizes average
total cost
o Called EFFICINT SCALE of the firm
o Efficient scale the quantity of output that minimizes
average total cost
Two forces are balanced to yield the lowest average
cost
The relationship between marginal cost and Average Total Cost
o Whenever marginal cost is less than average total cost,
average total cost is falling.
o Whenever marginal cost is greater than average total cost,
average total cost is rising
o The relationship between average total cost and marginal
cost has an important corollary
Marginal-cost curve crosses the average-total-cost
curve at its minimum
Low levels of output marginal cost is
below average total cost so average total
cost is falling
After curves cross, marginal cost rises above
ATC
o Typical Cost Curves
The second or third worker might have a higher marginal product than the
first because a team of workers can divide tasks and work more
productively than a single worker.
Firms exhibiting this pattern would experience increasing marginal
product for a while before diminishing marginal product set it
Marginal cost evenetuallr rises with the quantity of output
ATC curve is U-shaped
Marginal cost-curve crosses the ATC curve at the minimum of average
total cost
Costs in the SR and LR
o The relationship b/w SR and LR ATC (Average Total Cost)
Over a peiod of several years, Ford can expand the size of its factories,
buil new factories, or close old ones the cost of its factories is a
variable cost in the long run
A firms long run cost curves differ from its SR cost curves
LR ATC curve is a much flatter U-Shape than the SR ATC curve
All the short run curves lie on or above the LR curve
o Firms have greater flexibility in the LR
o Firm gets to choose which SR Curve it wants to use
o In the SR, has to use whatever SR curve it has chosen in the
past
o Economies and Diseconomies of Scale
Economies of scale the property whereby LRATC cost falls as the
quantity of output increases
LRATC declines as output increases
Diseconomies of scale the property whereby LRATC rises as the
quantity of output increases
LRATC rises as output increases
Constant returns to scale the property whereby LRATC stays the same as
the quantity of output changes
Economies of scaled often arise because higher production levels allow
specialization among workers workers to become better at a specific
task
Ford and assembly lines
Diseconomies of scale can arise because of coordination problems that are
inherent in any large organization
Ford produces more cars more stretched management team
becomes and less effective managers are at keeping costs down
LRATC are U shaped
Low levels of production, firm benefits from increased size
greater specialization opportunities
High levels of production specialization already happened,
coordination problems become more severe
LRATC is falling at low levels of production because of increasing
specialization and rising at high levels of production because of
increasing coordination problems
o