S121 ECO504 BUSINESS ECONOMICS

1

Firm behavior and the organization

of industry

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

2

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

3

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

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

4

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

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

Total

Cost

50

40

30

20

10

80

70

60

$90

Quantity

of Output

(cookies

per hour)

100

80

60

40

20

160

140

120

(a) Production function

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 the first column in Table 1, and

the quantity of output produced (on the vertical axis) is from the second column. 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 the second column in Table 1, and the total cost (on the vertical axis) is

from the sixth column. The total-cost curve gets steeper as the quantity of output increases because of diminishing

marginal product.

(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

Caroline’s Production Function and Total-Cost Curve

5

The Various Measures of Cost

• Fixed costs

– Costs that do not vary with the quantity of

output produced

• Variable costs

– Costs that vary with the quantity of output

produced

• Total cost

= 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

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

6

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

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

Conrad’s Total-Cost Curve

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

Here the quantity of output

produced (on the

horizontal axis) is from the

first column in Table 2, and

the total cost (on the

vertical axis) is from the

second column. As in

Figure 2, the total-cost

curve gets steeper as the

quantity of output

increases because of

diminishing marginal

product.

Quantity of Output

(cups of coffee per hour)

0 1 2 3 4 5 6 7 8 9 10

Total-cost curve

7

Conrad’s Average-Cost and Marginal-Cost Curves

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

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 features that are

typical of many firms: (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. Quantity of Output (cups of coffee per hour)

0 1 2 3 4 5 6 7 8 9 10

AVC

AFC

ATC

MC

Figure 5 Cost Curves for a Typical Firm

Costs

1.00

0.50

2.00

1.50

2.50

$3.00 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.

Quantity of Output

0 2 4 6 8 10 12 14

MC

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

8

Figure 6 Average Total Cost in the Short and Long Runs

Average

Total

Cost

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.

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

Table 3 The Many Types of Cost: A Summary