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The Costs

of Production

CHAPTER

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PowerPoint Slides prepared by:

V. Andreea CHIRITESCU

Eastern Illinois University

N. GREGORY MANKIW PRINCIPLES OF MICROECONOMICS Eight Edition

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

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

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

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

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

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

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.

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

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

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

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

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.

Total

Cost

$90

Quantity

of Output

(cookies

per hour)

100

160

140

120

(a) Production function

(b) Total-cost curve

Number of

Workers Hired

Production

function

Total-cost curve

Quantity

of Output

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

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

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

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.

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)

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

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

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

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

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:

Marginal cost 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

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)

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

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.

Costs

1.00

0.50

2.00

1.50

2.50

$3.00

Quantity of Output

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

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

Average

Total

Cost

Quantity of Cars per Day

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

Costs in Short and Long Run

Diseconomies of scale

Long-run average total cost rises as the quantity of output increases

Increasing coordination problems

Table 3 The Many Types of Cost: A Summary