1. Background to Supply: Firms in Competitive Markets6
Background to Supply: Firms in Competitive Markets
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2. The Costs Of Production
A firm’s costs are a key determinant of its production and pricing decisions.
Most firms in competitive markets are small
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3. What Are The TS Costs?
We will use Paolo’s Pizza Factory as an example of a small business.
Paolo has to pay for:
The ingredients used to make pizzas
Equipment
Workers to run his equipment
Utilities
Rent
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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.
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5. Production And Costs Time Periods
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.
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6. The Production Function
The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.
Marginal Product marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.
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7. Table 1 A Production Function and Total Cost: Paolo’s Pizza Factory

8. The Production Function
Diminishing 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.
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9. Figure 1a. Paolo’s Production Function
Quantity of
Output
(pizzas
per hour)
150
Production function
140
130
120
110
100 90 80 70 60 50 40 30 20 10 1 2 3 4 5
Number of Workers Hired
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10. The Production Function
Diminishing Marginal Product
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.
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11. From The Production Function To The Total Cost Curve
The relationship between the quantity a firm can produce and its costs determines pricing decisions.
The total cost curve shows this relationship graphically.
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12. Table 1 A Production Function and Total Cost: Paolo’s Pizza Factory

13. Figure 1b. Paolo’s Total Cost Curve
€ 80
Total-cost
curve 70 60 50 40 30 20 10 10 20 30 40 50 60 70 80 90
100
110
120
130
140
150
Quantity
of Output
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(pizzas per hour)

14. The Various Measures Of Cost
Costs of production may be divided into fixed costs and variable costs.
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15. Fixed 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 Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC
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16. Table 2 The Various Measures of Cost: Luciano’s Lemonade Stand
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17. Fixed and Variable 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.
Types of Average Cost
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC
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18. Types of Average Costs
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19. Fixed and Variable Costs
Marginal Cost
Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.
Marginal cost helps answer the following question:
How much does it cost to produce an additional unit of output?
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20. Marginal Cost Luciano’s Lemonade Stand
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21. Figure 2 Luciano’s Total Cost Curve
€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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22. Figure 3a. Luciano’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)

23. Cost Curves and Their Shapes
Marginal cost rises with the amount of output produced.
This reflects the property of diminishing marginal product.
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24. Figure 3b. Luciano’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
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)

25. Cost Curves and Their Shapes
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.
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26. 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.
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27. Figure 3c. Luciano’s Average Cost and Marginal Cost Curves
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)

28. 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.
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29. Cost Curves and Their Shapes
Relationship Between Marginal Cost and Average Total Cost
The marginal cost curve crosses the average total cost curve at the efficient scale.
Efficient scale is the quantity that minimizes average total cost.
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30. Figure 3d. Luciano’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)

31. Typical Cost Curves
It is now time to examine the relationships that exist between the different measures of cost.
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32. Berit’s Cost Curves
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33. Figure 4a. Berit’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)

34. Figure 4b. Berit’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)

35. Typical Cost Curves Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity of output.
The average total cost curve is U-shaped.
The marginal cost curve crosses the average total cost curve at its lowest point.
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36. Costs In The Short Run And In The Long Run
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37. Costs In The Short And In Long Run
The division of total costs into fixed and variable costs will vary from firm to firm.
Some costs are fixed in the short run, but all are variable in the long run.
For example, in the long run a firm could choose the size of its factory.
Once a factory is chosen, the firm must deal with the short-run costs associated with that plant size.
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38. The Relationship Between Short-Run and Long-Run Average Cost
The long-run average-total-cost curve lies along the lowest points of the short- run average-total-cost curves because the firm has more flexibility in the long run to deal with changes in production.
The long-run average total cost curve is typically U-shaped, but is much flatter than a typical short-run average-total-cost curve.
The length of time for a firm to get to the long run will depend on the firm involved.
In the short-run some factors of production cannot be changed.
In the long-run all factors of production can be altered.
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39. Returns to Scale
Constant returns to scale the property whereby long-run average total cost stays the same as the quantity of output change
Economies of scale the property whereby long-run average total cost falls as the quantity of output increases.
Diseconomies of scale the property whereby long- run average total cost rises as the quantity of output increases
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40. Returns to Scale Causes of Economies and Diseconomies of Scale.
Specialization among workers and technology that can be used.
Negotiate more favourable borrowing rates or can secure lower supply costs because they are buying in larger quantities and can agree discounts from suppliers.
External economies arising from locating where there is a specialist pool of labour or the infrastructure is better.
Diseconomies arise because of coordination and communication problems that are inherent in any large organization.
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41. Returns to Scale The Implications of Economies of Scale.
Large-scale production that result in lower average or unit costs. that offers …
…opportunity to either increase in profits or reduction in price dependent of level of competition.
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