1. Principles of Microeconomics Chapter 13
Understanding Production Costs

2. Production Choices of Firms
All firms have one goal in mind: MAX PROFITS
PROFITS = TOTAL REVENUE – TOTAL COST
Two ways to reach this goal:
Maximize total revenue
Total Revenue = Price X Quantity
Minimize total costs
Total Costs = Fixed Costs + Variable Costs

3. Production Costs
Economic Costs for producers include explicit and implicit costs - Explicit Costs: Financial costs - Implicit Costs: Opportunity costs Example: Caroline can use $300,000 of her savings to start her firm which is in a savings account paying 5% interest. OR Caroline borrow $200,000 from a bank at the same interest rate and used $100,000 from her savings. Which should she do?

4. Example of Economic Costs
Choice A:
Caroline’s cost to start her business:
Explicit Cost = $300,000
Implicit Cost = ($300,000 X 5%) = $15,000
Total Economic Cost = $315,000
Total Accounting Cost = $300,000
Choice B:
Explicit Cost = $200,000 + $100,000 + ($200,000 X 5%) = $310,000
Implicit Cost = ($100,000 X 5%) = $5,000
Total Accounting Cost = $310,000

5. Application Reflection
Why does this matter?
This example illustrates the difference between economic costs and accounting costs
Economists always factor in opportunity costs into the decisions people and firms make
This will be important when we talk about economic profits – zero economic profits reflect revenue minus economic costs which include the implicit opportunity costs of a decision. They are not zero profits in the economic sense – the business can still be making an accounting profit but break even with their economic profit!
What’s the most important takeaway?
Economists always factor in opportunity costs
Economic Costs will therefore be higher than accounting costs
Economic Profits reflect total revenue and total economic costs
MUDDIEST POINT?

6. Determining Production via Production Function
Production Function: Relationship between quantity of inputs and total output Q = f(Land, Labor, Capital) Example: Determine the production of good A if its production function is: Q = 100 K1/ L1/2 Assume the firm uses one machine and increases its workers by 10.

7. Determining Production via Production Function
Production Function: Relationship between quantity of inputs and total output Q = f(Land, Labor, Capital) Example: Determine the production of good A if its production function is: Q = 100 K1/ L1/2

8. Production Function Example
Q = 100 K1/ L1/2
CAPITAL
LABOR
Prod. Function
OUTPUT 1 5
100*11/2 + 25*51/2
156 6
100*11/2 + 25*61/2
161 7
100*11/2 + 25*71/2
166 8
100*11/2 + 25*81/2
171 9
100*11/2 + 25*91/2
175 10
100*11/2 + 25*101/2
179
No. of Machines
Constant

9. Production Function Example
Q = 100 K1/ L1/2
CAPITAL
LABOR
Prod. Function
OUTPUT 1 5
100*11/2 + 25*51/2
156 6
100*11/2 + 25*61/2
161 7
100*11/2 + 25*71/2
166 8
100*11/2 + 25*81/2
171 9
100*11/2 + 25*91/2
175 10
100*11/2 + 25*101/2
179
No. of Workers
Increasing by 1

10. Production Function Example
Q = 100 K1/ L1/2
CAPITAL
LABOR
Prod. Function
OUTPUT 1 5
100*11/2 + 25*51/2
156 6
100*11/2 + 25*61/2
161 7
100*11/2 + 25*71/2
166 8
100*11/2 + 25*81/2
171 9
100*11/2 + 25*91/2
175 10
100*11/2 + 25*101/2
179
Use Production Function
To calculate how much we produce

11. Production Costs Rent Price of Capital = $800  FIXED COST
Wages of workers = $25  VARIABLE COST
CAPITAL
LABOR
Cost of CAPITAL
Cost of LABOR
TOTAL COST 1 5 6 7 8 9 10

12. Production Costs Rent Price of Capital = $800  FIXED COST
Wages of workers = $25  VARIABLE COST
CAPITAL
LABOR
Cost of CAPITAL
Cost of LABOR
TOTAL COST 1 5
800
125
925 6
150
950 7
175
975 8
200
1000 9
225
1025 10
250
1050

13. Marginal Product of Labor
Marginal Product – Increase in output resulting from an increase in one of the inputs MPL = Change in Output / Change in Labor
LABOR
OUTPUT
MPL 5
156 6
161
5.34 7
166
4.91 8
171
4.57 9
175
4.29 10
179
4.06

14. Increasing Labor Only
Diminishing Marginal Returns: Output is increasing at a decreasing rate

15. Production Costs
K * $100
L * $25
Fixed + Variable
LABOR
OUTPUT
FIXED COST
VARIABLE COST
TOTAL COST
AFC
AVC
ATC MC 5
156
800
125
925 6
161
150
950 7
166
175
975 8
171
200
1000 9
225
1025 10
179
250
1050
To analyze the production decisions of a firm, recall that a firm conducts “marginal analysis”
Decisions are based on per-unit calculations
Therefore, need to calculate costs/unit

16. Costs per unit of output produced
Production Costs
FC/Q
VC/Q
TC/Q
LABOR
OUTPUT
FIXED COST
VARIABLE COST
TOTAL COST
AFC
AVC
ATC MC 5
156
800
125
925
5.13
0.80
8.34 6
161
150
950
4.96
0.93
8.68
4.686 7
166
175
975
4.82
1.05
9.03
5.095 8
171
200
1000
4.69
1.17
9.37
5.474 9
225
1025
4.57
1.29
9.71
5.828 10
179
250
1050
4.47
1.40
10.05
6.162
Costs per unit of output produced

17. Average Fixed Cost Curve
AFC Q

18. Average Variable Cost Curve
AVC Q

19. Average Total Cost Curve
ATC Q

20. Marginal Cost Curve When MC < ATC  ATC is fallingQ
When MC < ATC  ATC is falling
When MC > ATC  ATC is rising
MC crosses ATC at minimum – EFFICIENT SCALE

21. Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the future, it is facing the following SRATC:
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run, how many locations should it have?
Graph the SRATC and LRATC.
Average Total Cost
Number of Locations
Q = 100
Q = 200
Q = 300
Q = 400 1 30 20 25 2 44 3 50 35

22. Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the future, it is facing the following SRATC:
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run, how many locations should it have?
Graph the SRATC and LRATC.
Average Total Cost
Number of Locations
Q = 100
Q = 200
Q = 300
Q = 400 1 30 20 25 2 40 15 3 50 35

23. Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the future, it is facing the following SRATC:
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run, how many locations should it have?
Graph the SRATC and LRATC.
Average Total Cost
Number of Locations
Q = 100
Q = 200
Q = 300
Q = 400 1 30 20 25 2 40 15 3 50 35

24. Application
Mila’s Coffee Shop currently has only 2 locations. However if it expands in the future, it is facing the following SRATC:
If Mila’s Coffee Shop is currently serving 200 customers, what is it’s SRATC?
If it was expecting to serve 200 customers over the next several years, how many locations should it have?
If instead it was expecting to increase its customer base to 400 in the long run, how many locations should it have?
Graph the SRATC and LRATC.
Average Total Cost
Number of Locations
Q = 100
Q = 200
Q = 300
Q = 400 1 30 20 25 2 40 15 3 50 35

25. Long Run vs. Short Run Total Cost
ATC
SRATC 1
One Cafe
SRATC 2
Two Cafes
SRATC 3
Three Cafes
LRATC 1
Output
Economies of Scale
ATC is falling with
increase in output
Diseconomies of Scale
ATC is rising with
increase in output

26. Application Reflection
Why does this matter?
Costs differ in the short run and long run, because in the short run some costs are fixed, in the long run all costs are variable.
A firm can adjust its size to match the lowest ATC over time
It is limited in how much it can change in the short run - it is difficult to just build a new location in one month or one week, but over the course of several months or years, any firm can adjust its size
What’s the most important takeaway?
Costs differ in short run and long run
In the long run, firms will adjust production to try to reach lowest possible ATC and therefore the LRATC touches the lowest points on the SRATC
MUDDIEST POINT?

27. Key Takeaways
All firms are profit maximizing and therefore want to minimize their costs
To make their production decisions – need to consider ATC, AVC, AFC and MC
NEXT: Merge cost curves with revenue to understand how different types of firms make production decisions