Lecture 9 The Costs of Production Microeconomics 1000 Lecture 9 The Costs of Production

Profit = Total revenue - Total cost Profits The Firm’s Objective The economic goal of the firm is to maximise profits. Profit is the firm’s total revenue minus its total cost. Profit = Total revenue - Total cost

Total Revenue, Total Cost, and Profit The amount a firm receives for the sale of its output. Total Cost The market value of the inputs a firm uses in production. The relationship between the quantity a firm can produce and its costs (the total cost function) determines pricing decisions

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.

Opportunity cost Decisions require comparing costs and benefits of alternatives. Whether to go to college or to work? Whether to study or go out on a date? The opportunity cost of an item is what you could get but do not to obtain that item. 10

Economic v. 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. When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. Economic profit is smaller than accounting profit.

Figure 1 Economic versus Accountants How an Economist How an Accountant Views a Firm Views a Firm Revenue Economic profit Accounting profit Revenue Implicit costs Total opportunity costs Explicit costs Explicit costs Copyright © 2004 South-Western

THE VARIOUS MEASURES OF COST Costs of production may be divided into fixed costs and variable costs. Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do vary with the quantity of output produced.

Total costs Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC

Average 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. Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC

Average Costs

A simple example Suppose that production entails a fixed cost F and a constant unit incremental cost c Then the firm’s cost function is 𝑇𝐶=𝐹+𝑐×𝑞 In the following numerical example, F= 60 and c = 5

quantity fixed cost unit incremental cost total cost average cost average fixed cost 1 60 5 65 2 70 35 30 3 75 25 20 4 80 15 85 17 12 6 90 10 7 95 13.55 8.55 8 100 12.5 7.5 9 105 11.44 6.44

Figure 2 Total cost curve 80 65 60 quantity 1 2 3 4 5 6

Figure 3 Average cost curve total cost 65 20 5 quantity 1 2 3 4 5 6

Marginal Cost Marginal cost (MC) measures the increase in total cost due to one extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output? In our previous example, the marginal cost was referred to as the “unit incremental cost” and was equal to 5

Marginal cost In general, however, the marginal cost need not be constant It may decrease with output Greater production allows to better exploit the benefits of the division of labour “learning by doing” effects (learning curve) It may increase with output, e.g. when there are factors of production in fixed supply

Marginal Cost

What fixed costs do and do not affect Fixed costs do not affect a firm’s strategy, provided that the firm stays active Consider for example the pricing decision by a firm Recall: an optimising agent always reasons at the margin

Profit Fixed cost Optimal price Price

Yet fixed costs do matter However, fixed costs determine a firm’s decision whether to stay in the market or exit, or the entry decision (if a firm is not active yet) The firm will exit the market (or stay out of the market) if the fixed cost is very large

Profit Optimal price Price Fixed cost

Example (from Mankiw-Taylor, Thirsty Thelma)

Figure 4 Thirsty Thelma’s Total-Cost Curves $15.00 Total-cost curve 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 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) Copyright © 2004 South-Western

Cost Curves and Their Shapes In this example, marginal cost rises with the amount of output produced. This reflects the property of diminishing marginal product.

Figure 5 Thirsty Thelma’s Marginal-Cost Curve Costs $3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) Copyright © 2004 South-Western

Figure 6 Thirsty Thelma’s Average-Cost Curve Costs $3.50 3.25 3.00 2.75 2.50 2.25 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) Copyright © 2004 South-Western

Average cost curve The average total-cost curve is U-shaped. 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.

Figure 7 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves Costs $3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 1.00 0.75 0.50 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) Copyright © 2004 South-Western

Cost Curves and Their Shapes The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm.

Cost Curves and Their Shapes Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising.

Cost Curves and Their Shapes Intuition: suppose you are a basketball player and you calculate your average score Your average goes up if the marginal score (i.e., your last match score) is higher than the average score. Your average cost goes up if the marginal cost (the cost of making your last unit) is higher than the average cost. Therefore: If the average cost curve is going up, it must be below the marginal cost curve (the marginal cost curve must be above the average cost curve). And vice versa. The marginal cost curve cuts the average cost curve at the minimum of the average cost curve.

Cost Curves and Their Shapes Implications Recall, the efficient scale is defined as the quantity that minimizes average total cost Since the marginal-cost curve crosses the average-total-cost curve when the average cost is minimum, it follows that the efficient scale corresponds to the point of intersection between marginal cost and average cost

Figure 8 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves Costs $3.50 3.25 3.00 2.75 2.50 2.25 MC 2.00 1.75 1.50 ATC 1.25 AVC 1.00 0.75 0.50 AFC 0.25 1 2 3 4 5 6 7 8 9 10 Quantity of Output (glasses of lemonade per hour) Copyright © 2004 South-Western

Another example from Mankiw & Taylor Typical Cost Curves Another example from Mankiw & Taylor

Big Bob’s Cost Curves

Figure 9 Big Bob’s Cost Curves (a) Total-Cost Curve Total Cost $18.00 TC 16.00 14.00 12.00 10.00 8.00 6.00 4.00 2.00 2 4 6 8 10 12 14 Quantity of Output (bagels per hour) Copyright © 2004 South-Western

Figure 10 Big Bob’s Cost Curves (b) Marginal- and Average-Cost Curves Costs $3.00 2.50 MC 2.00 1.50 ATC AVC 1.00 0.50 AFC 2 4 6 8 10 12 14 Quantity of Output (bagels per hour) Copyright © 2004 South-Western

Three Important Properties of those Cost Curves Marginal cost eventually rises with the quantity of output (not always true). The average-total-cost curve is U-shaped (not always true). The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost (always true).

COSTS IN THE SHORT RUN AND IN THE LONG RUN For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run, some costs are fixed. In the long run, fixed costs become variable costs. Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

Bygones are bygones Often economic agents make their decisions sequentially, or have the opportunity to change their initial decisions at a later date

Bygones are bygones There are two goods, a lottery ticket and an ice cream Your w.t.p. for the lottery ticket is £2.5, for the ice-cream is £1.5 The price of each of these items is £1 If your budget was £1, you would purchase only the lottery ticket But if you have £2 to spend, you can buy both Now suppose that after purchasing your lottery ticket, but before purchasing the ice cream, you lose the lottery ticket you had just bought What would you do then?

Bygones are bygones As another example, a firm may first decide whether to enter the market, paying a fixed entry cost, and then decides what price to charge Once the fixed cost has been paid, and assuming it cannot be recovered by exiting the market, it no longer affects the firm’s choices

Recoverable and sunk costs When a firm must decide whether to stay active or exit the market, it must consider whether its fixed cost are recoverable or sunk A sunk cost is a cost that cannot be recouped if the firm stops producing Often, fixed costs are only partially sunk

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.

Summary A firm’s total costs can be divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced.

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.

Summary The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. A firm’s costs often depend on the time horizon being considered. In particular, many costs are fixed in the short run but variable in the long run.