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

2. 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

3. 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

4. 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.

5. 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

6. 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.

7. 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
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8. 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.

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

10. 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

11. Average Costs

12. 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

13. 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

14. Figure 2 Total cost curve80 65 60
quantity 1 2 3 4 5 6

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

16. 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

17. 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

18. Marginal Cost

19. 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

20. Profit
Fixed cost
Optimal price
Price

21. 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

22. Profit
Optimal price
Price
Fixed cost

23. Example (from Mankiw-Taylor, Thirsty Thelma)

24. 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)
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25. 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.

26. 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 © South-Western

27. 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 © South-Western

28. 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.

29. 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 © South-Western

30. 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.

31. 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.

32. 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.

33. 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

34. 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 © South-Western

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

36. Big Bob’s Cost Curves

37. 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 © South-Western

38. 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 © South-Western

39. 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).

40. 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.

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

42. 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?

43. 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

44. 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

45. 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.

46. 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.

47. 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.

48. 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.