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PowerPoint Slides prepared by: V. Andreea CHIRITESCU Eastern Illinois University

N. GREGORY MANKIW

PRINCIPLES OF

ECONOMICS Eight Edition

The Costs of Production

CHAPTER

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What are Costs?

•  Industrial organization – The study of how firms’ decisions about

prices and quantities depend on the market conditions they face

•  Assumption – The goal of a firm is to maximize profit

•  Profit – Total revenue minus total cost

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What are Costs?

•  Total revenue, TR = P × Q – Amount a firm receives for the sale of its

output – Quantity of output the firm produces times

the price at which it sells its output •  Total cost, TC

– Market value of the inputs a firm uses in production

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What are Costs?

•  Costs as opportunity costs – The cost of something is what you give up

to get it •  Firm’s cost of production

– Include all the opportunity costs of making its output of goods and services

– Explicit costs – Implicit costs

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What are Costs?

•  Explicit costs – Input costs that require an outlay of

money by the firm •  Implicit costs

– Input costs that do not require an outlay of money by the firm

– Ignored by accountants •  Total costs

= Explicit costs + Implicit costs 5

What are Costs?

•  The cost of financial capital as an opportunity cost – Implicit cost – Interest income not earned on financial

capital •  Owned as saving •  Invested in business

– Not shown as cost by an accountant

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What are Costs?

•  Economic profit – Total revenue minus total cost

•  Total costs includes both explicit and implicit costs

•  Accounting profit – Total revenue minus total explicit cost – Usually larger than economic profit

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Figure 1 Economists versus Accountants

Economists include all opportunity costs when analyzing a firm, whereas accountants measure only explicit costs. Therefore, economic profit is smaller than accounting profit.

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Production and Costs

•  Production function – Relationship between

•  Quantity of inputs used to make a good •  And the quantity of output of that good

– Gets flatter as production rises •  Marginal product

– Increase in output that arises from an additional unit of input

– Slope of the production function 9

Table 1 A Production Function and Total Cost: Caroline’s Cookie Factory

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Production and Costs

•  Diminishing marginal product – Marginal product of an input declines as

the quantity of the input increases – Production function gets flatter as more

inputs are being used – The slope of the production function

decreases

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Production and Costs

•  Total-cost curve – Relationship between quantity produced

and total costs – Gets steeper as the amount produced

rises •  Diminishing marginal product •  Producing one additional unit of output

requires a lot of additional units of inputs: very costly

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Figure 2 Caroline’s Production Function and Total-Cost Curve

The production function in panel (a) 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 in panel (b) 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.

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Total Cost

50 40

20 10

$90

Quantity of Output (cookies

per hour)

100 80

40 20

160

140

120

(a) Production function (b) Total-cost curve

Number of Workers Hired

0 1 2 3 4 5 6

Production function Total-cost curve

Quantity of Output

0 20 40 60 80 100 120 140 160

The Various Measures of Cost

•  Fixed costs, FC – Costs that do not vary with the quantity of

output produced •  Variable costs, VC

– Costs that vary with the quantity of output produced

•  Total cost, TC = Fixed cost + Variable cost

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The Various Measures of Cost

•  Average fixed cost, AFC – Fixed cost divided by the quantity of

output •  Average variable cost, AVC

– Variable cost divided by the quantity of output

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Table 2 The Various Measures of Cost: Conrad’s Coffee Shop

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Figure 3 Conrad’s Total-Cost Curve

Here the quantity of output produced (on the horizontal axis) is from column (1) in Table 2, and the total cost (on the vertical axis) is from column (2). As in Figure 2, the total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product.

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Total Cost

5.00 4.00 3.00 2.00 1.00

8.00 7.00 6.00

9.00 10.00 11.00 12.00 13.00 14.00

$15.00

Quantity of Output (cups of coffee per hour)

0 1 2 3 4 5 6 7 8 9 10

Total-cost curve

The Various Measures of Cost

•  Average total cost, ATC – Total cost divided by the quantity of output – Average total cost = Total cost / Quantity –  ATC = TC / Q – Cost of a typical unit of output

•  If total cost is divided evenly over all the units produced

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The Various Measures of Cost

•  Marginal cost, MC – Increase in total cost arising from an extra

unit of production – Marginal cost = Change in total cost /

Change in quantity – MC = ΔTC / ΔQ – Increase in total cost

•  From producing an additional unit of output

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The Various Measures of Cost

•  Rising marginal cost curve – Because of diminishing marginal product

•  U-shaped average total cost curve – ATC = AVC + AFC – AFC – always declines as output rises – AVC – typically rises as output increases

•  Because of diminishing marginal product – The bottom of the U-shape

•  At quantity that minimizes average total cost 20

The Various Measures of Cost

•  Efficient scale – Quantity of output that minimizes ATC

•  Relationship between MC and ATC – When MC < ATC: average total cost is

falling – When MC > ATC: average total cost is

rising – The marginal-cost curve crosses the

average-total-cost curve at its minimum

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Figure 4 Conrad’s Average-Cost and Marginal-Cost Curves

This figure shows the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC) for Conrad’s Coffee Shop. All of these curves are obtained by graphing the data in Table 2. These cost curves show three common features: (1)  Marginal cost rises with the

quantity of output. (2)  The average-total-cost curve is

U-shaped. (3)  The marginal-cost curve

crosses the average-total-cost curve at the minimum of average total cost.

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Costs

1.25 1.00 0.75 0.50 0.25

2.00 1.75 1.50

2.25 2.50 2.75 3.00 3.25

$3.50

Quantity of Output (cups of coffee per hour)

0 1 2 3 4 5 6 7 8 9 10

AVC

AFC

ATC

The Various Measures of Cost

•  Typical cost curves – Marginal cost eventually rises with the

quantity of output – Average-total-cost curve is U-shaped – Marginal-cost curve crosses the average-

total-cost curve at the minimum of average total cost

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Figure 5 Cost Curves for a Typical Firm

Many firms experience increasing marginal product before diminishing marginal product. As a result, they have cost curves shaped like those in this figure. Notice that marginal cost and average variable cost fall for a while before starting to rise.

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Costs

1.00

0.50

2.00

1.50

2.50

$3.00

Quantity of Output 0 2 4 6 8 10 12 14

ATC

AVC

AFC

Costs in Short and Long Run

•  Many decisions – Fixed in the short run – Variable in the long run

•  Firms – greater flexibility in the long-run – Long-run cost curves

•  Differ from short-run cost curves •  Much flatter than short-run cost curves

– Short-run cost curves •  Lie on or above the long-run cost curves

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Figure 6 Average Total Cost in Short & Long Runs

Because fixed costs are variable in the long run, the average-total-cost curve in the short run differs from the average-total-cost curve in the long run

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Average Total Cost

Quantity of Cars per Day 0

ATC in short run with small factory

ATC in short run with medium factory ATC in short run

with large factory

ATC in long run

10,000

$12,000

1,000 1,200

Economies of scale

Diseconomies of scale

Constant returns to scale

Costs in Short and Long Run

•  Economies of scale – Long-run average total cost falls as the

quantity of output increases – Increasing specialization among workers

•  Constant returns to scale – Long-run average total cost stays the

same as the quantity of output changes

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Costs in Short and Long Run

•  Diseconomies of scale – Long-run average total cost rises as the

quantity of output increases – Increasing coordination problems

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Table 3 The Many Types of Cost: A Summary

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