1. The Costs of Production
PART FIVE: FIRM BEHAVIOR AND THE ORGANISATION OF INDUSTRY
The Costs of Production
Chapter 13

2. What did we learn so far?
Below is a summary of the first half of the semester
Part One introduced us to economics
Ten principles (Ch.1); Thinking like an economist (Ch.2); Exchange and trade (Ch.3)
Part Two told us how markets work
Supply and Demand (Ch.4); Elasticities (Ch.5); Markets and government policies (Ch.6)
Part Three introduced welfare and efficiency
Consumer and Producer surplus(Ch.7); Costs of taxation (Ch.8); International trade (Ch.9)
Part Four looked at the public sector
Externalities (Ch.10); Public goods and common resources (Ch.11); Tax systems (Ch.12)

3. What do we learn in this book?
With Part Four, we finished our general introduction to the science of economics
Now we go into the details of microeconomics
Millions of producer firms, of all sizes and kinds, producing all types of goods or services constitute the backbone of a modern market economy
Some firms employ hundreds of thousands, operate globally and are household names everywhere
Others employ very few people and may not even be known locally
Yet, they must have many characteristics in common to coexist in the market place
It is time we take a close look at them

4. Plan of Part Five
Ch.13 analyses the cost structure of producers and defines all the cost elements upon which we build the remaining chapters
The cost structure established in Ch.13 will be used in the remaining chapters
Ch.14 establishes the determinants of supply in markets with a very high degree of competition
Ch. 15 looks at the extreme case of a single supplier in a market: monopoly
Ch. 16 deals with markets where a a small number of large firms dominate: oligopoly
Ch. 17 takes the case of fierce competition among large number of firms: monopolistic competition

5. Law of supply and firm’s objective
Remember the Law of Supply
Firms are willing to produce and sell a greater quantity of a good or service when its price is higher and a smaller quantity when its price is lower
This results in a supply curve that slopes upward
The question becomes: why?
We start by establishing the objective of the firm
Firms exist to make as much money as possible for their owners
In other words, the economic goal of the firm is to maximise its profits
“Profit maximising firm” is a key concept for what follows

6. Revenue, cost and profit
To see how firms maximise profits, we must begin by defining the flows of income and expenditure of the firm that results in profits
Profits will be the difference between the revenues and the costs of the firm
Total Revenue is the amount that the firm receives for the sale of its product
Total cost is the amount that the firm pays to buy inputs for production
Profit is the amount a seller is paid minus its costs
Profit = Total Revenue – Total Cost
For economic theory, profit is identical with the producer surplus of Ch.7

7. On measuring costs
The way economists handle costs differs from the way accounting or tax authorities do
Opportunity costs:
This is very important for economists even though it is not so relevant for accountants
A firm’s costs of production include all the opportunity costs of the inputs used during the production of its output of goods and services
Explicit and implicit costs:
Explicit costs involve a direct money outlay for factors of production
Implicit costs do not involve a direct money outlay but are nevertheless real costs for the firm

8. Profit: economic versus accounting
The defition of profits differ:
Economists include all opportunity costs when measuring costs
Accountants measure the explicit costs but as a rule ignore the implicit costs
The firm earn economic profits when total revenue exceeds both explicit and implicit costs
Economic profit is smaller than accounting profit
The opportunity cost of capital invested and labour spent has to be taken into account when we calculate economic profit
From this perspective a firm may have losses economically despite showing accounting profit

9. Economic profit versus accounting profit
How an Economist
Views a Firm
How an Accountant
Views a Firm
Revenue
Economic
profit
Accounting
profit
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs 9 11

10. Cost and production function
A firm’s costs reflect its production process
In order to understand the cost structure we must understand the relation between physical inputs such as equipment, raw materials and labour and the physical output obtained
For this purpose economists use the concept of the production function
Which shows the relationship between quantity of inputs used to make a good and the quantity of output of that good
We start with a fixed amount of machinery and equipment and see the impact on production of an increase in the amount of workers employed

11. A production function Quantity of Output (cookies per hour) 150 140
130
120
110
100 90 80 70 60 50 40 30 20 10
Number of Workers Hired 1 2 3 4 5
Production function

12. Marginal product
The production function constitutes the basis upon which the cost structure of the firm is built
Understanding by how much output rises in case of an additional input is very important
The marginal product of an input in production is the increase in the quantity of output obtained from an additional unit of that input
This is a key concept of the theory of the firm
It will be used again and again in the next chapters

13. Diminishing marginal product
In the production function example above, each new worker had a lower marginal product
Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases
Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment
The slope of the production function measures the marginal product of an input, such as a worker
When the marginal product declines, the production function becomes flatter 22

14. Production function and total costs
Production function allows us to understand the cost structure of the firm
Because pricing decisions are determined by the relation between the quantity a firm can produce and how much it costs to produce that quantity
The total-cost curve shows this relationship graphically
Total-cost curve is a mirror image of the production function
After total-costs we will define marginal cost and different kinds of average costs
Almost all of the decisions by the producers are based on different costs of production 25

15. A production function and total cost
Marginal
Number of
Output
Cost of
Cost of
Total Cost
Product of
Workers
(Quantity)
Factory
Workers
of Inputs
Labor
$30 $0
$30 1 50 50 30 10 40 2 90 40 30 20 50 3
120 30 30 30 60 4
140 20 30 40 70 5
150 10 30 50 80 9 26

16. Total-cost curve Total Cost $80 Total-cost curve 70 60 50 40 30 20 1020 40 60 80
100
120
140
Quantity of Output
(cookies per hour) 27

17. Various measures of cost
Costs of production of the firm can be divided into two basic categories:
Fixed costs
Variable costs
Total Fixed costs are those costs that do not vary with the quantity of output produced
Total Variable costs are those costs that do vary with the quantity of output produced.
Family of Costs:
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC 12 28

18. Family of total costs 14 32

19. Average costs ATC = AFC + AVC
Firms attach a big value to their average costs
Average costs can be determined by dividing the firm’s costs by the quantity of output produced
The average cost is the typical cost of each unit of product
Obviously, fixed, variable and total costs can also be expressed as averages, giving us the following family of average costs:
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC 33

20. Family of average costs15 35

21. Family of average costs14 36

22. Marginal cost
Economists attach a big value to marginal cost of production in firms
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production
In plain language, marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output? 16 37

23. Marginal cost 16 39

24. Shape of the marginal cost curve
Now we must establish how cost curves behave on our graphs
We begin with the marginal cost curve
Marginal cost curve rises with the amount of output produced
Due to the effect of diminishing marginal product
At low levels of output, an increase in production will occur at a relatively small cost
Increasing output is more costly when the amount being produced is already high
Usually we show marginal cost as a curve that first declines then rises
But at times only as a rising curve 19 42

25. Shape of the marginal cost curve
Costs
$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 11 12 13 14
Quantity of Output
(bagels per hour) 20 44

26. Shape of average cost curves
Average cost curves have different shapes
The average total-cost curve is U-shaped
In other words, 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
Average fixed cost curve is always downward
As its name implies, larger quantities of output means smaller fixed costs per unit produced
Average variable cost curve reflects the marginal cost curve and behaves like it 19 45

27. Shape of average cost curves
Costs
$3.00
2.75
2.50
2.25
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
0.25
AFC 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity of Output
(bagels per hour) 21 47

28. Relationship between marginal cost and average total-cost
There exists a very peculiar and important relation between marginal and average total-cost curves
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
The marginal cost curve intersects with the average total-cost curve at the efficient scale
Efficient scale is the quantity that minimizes average total-cost
In other words MC curve crosses the ATC curve at the minimun point of the latter 48

29. Relationship between marginal cost and average total cost
Costs
$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 11 12 13 14
Quantity of Output
(bagels per hour) 29 52

30. Costs in the long run
The cost structure we studied until now is based on the characteristics of the production function
Where we allowed changes in one input while the other inputs (i.e. stock of capital) were constant
In the long run all inputs become variables
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 24 53

31. Scale and long-run costs
Once we allow the stock of capital such as machinery and equipment to be variable new issues appear
An increase in the size or scale of the firm may have vaıious effects on its cost
Economies of scale occur when long-run average total-cost falls as the quantity of output increases
Diseconomies of scale occur when long-run average total-cost rises as the quantity of output increases
Constant returns to scale occur when long-run average total-cost stays the same as the quantity of output increases 24 55

32. Long-run average-total costs
ATC in short
run with
medium factory
ATC in short
run with
large factory
ATC in short
run with
small factory
Cost
Quantity of
Cars per Day 24 61

33. U-shaped long-run average total cost
ATC in long run
Economies
of scale
Constant
returns to
scale
Diseconomies
of scale
Quantity of
Cars per Day 24 66

34. Conclusion
The goal of firms is to maximize profit, which equals total revenue minus total cost
Economists calculate opportunity costs of all inputs even there is no apparent payment for some of them
Accounting practise covers only explicit cost but not implicit opportunity costs
Economic profit is usually smaller than accounting profit
The production function establishes the basis upon which costs are calculated
It shows the relation between the quantities of inputs and the quantity of output
Diminishing marginal product is assumed

35. Conclusion
A firm has fixed and variable costs: fixed costs don’t vary with quantities produced and variable costs do
Average total-cost is total-cost divided by the quantity of output
Marginal cost is the amount by which total cost rises if output is increased by one unit
Shapes of the cost curves are very important for economic analysis
Marginal cost generally rises with the quantity of output
Average total-cost first falls as output increases and then eventually rises with further output

36. Conclusion Average fixed cost falls as output increases
Average variable cost is closely related to the marginal cost and behaves similar to it
A firm’s costs often depend on the time horizon being considered
Many costs are fixed in the short run but variable in the long run
Long-run changes in the size and scale of the firm have an impact on its cost structure
When the level of production changes, average total- cost may rise more in the short run than in the long run