1. Unit II
Dr. R. Jayaraj, M.A., Ph.D.,
UPES

2. The Costs of Production

3. Production
An entrepreneur must put together resources -- land, labour, capital -- and produce a product- people will be willing and able to purchase

4. Profit, the firm’s objective
The economic goal of a firm is to maximize its profit. Profit = Total revenue - Total cost

5. Total Revenue, Total Cost, and Profit
The money a firm receives from the sale of its output.
TR = P  Q
We saw this is in previous Unit.
Total Cost
The market value of all the inputs (resources) a firm uses in production.

6. Explicit and Implicit Costs
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs are costs that require a direct outlay of money by the firm’s owner(s).
Implicit costs are costs that do not require an outlay of money by the firm
If some of the resources used in production are provided by the owner(s) of the firm, the firm may not have to pay for them.
The market value of such resources is the implicit cost.
Implicit costs are included in total cost.

7. Implicit Costs: Examples
You own a restaurant and you work eighteen hours a day in it
You could have worked elsewhere and earned a wage. This lost income is an implicit cost
You have invested $20,000 of your own savings in your restaurant
You could have earned interest had you put that money in a bank instead. This lost interest income is an implicit cost

8. Economic Profit versus Accounting Profit
Economists measure a firm’s economic profit as total revenue minus total cost, which includes both explicit and implicit costs.
Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.
As a result, accounting profit exceeds economic profit

9. 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

10. Economic Profit and Firm Sustainability
Non-negative economic profit is essential for the long-run viability of a firm
Hungry Helen’s Cookies earns
total revenue of $700 per hour and has
total explicit costs of $650 per hour (for labor and raw materials) and
Total implicit costs of $110 per hour (in wages Helen could have earned as a computer programmer)
Accounting profit = $50 per hour. This indicates short-run financial viability
Economic profit = – $60 per hour. This indicates a dire long-run future. Dissatisfied with the $50 per hour profit, Helen will eventually shut down the firm and take a programming job

11. PRODUCTION AND COSTS 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.

12. Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory

13. Note that the marginal product diminishes as more of the resource is used. This is a common assumption in economics.
Marginal Product
The marginal product of any input in the production process is the increase in output that arises from one additional unit of that input.

14. 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.

15. 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.

16. Figure 2 Caroline’s Production Function
Quantity of
Output
(cookies
per hour)
150
Production function
140
130
120
Note that this production function graph shows diminishing marginal product.
110
100 90 80 70 60 50 40 30 20 10 1 2 3 4 5
Number of Workers Hired

17. Table 1 A Production Function and Total Cost: Caroline’s Cookie Factory
Fixed Cost
Variable Cost
Number
of workers
Output
(quantity of cookies
produced per hour)
Marginal
product
of labor
Cost of
factory
workers
Total cost of inputs
(cost of factory +
cost of workers) 1 2 3 4 5 6 50 90
120
140
150
155
$30 30 $0 10 20 40 60 70 80 50 40 30 20 10 5
Turning these two columns into a graph yields the cost curve. See next slide.

18. Figure 2 Caroline’s production function and total-cost curve
Quantity
of Output
(cookies
per hour)
100 80 60 40 20
160
140
120
(a) Production function
(b) Total-cost curve
Total
Cost 50 40 30 20 10 80 70 60
$90
Production
function
Total-cost curve
Number of
Workers Hired 1 2 3 4 5 6
Quantity
of Output
(cookies per hour) 20 40 60 80
100
120
140
160

19. THE VARIOUS MEASURES OF COST
The Total Cost of production may be divided into fixed costs and variable costs.
Fixed costs are those costs that do not vary with the quantity produced.
Variable costs are those costs that vary with the quantity produced.
TC = FC + VC

20. The various measures of cost: Conrad’s coffee shop
Quantity
of coffee
(cups per hour)
Total
Cost
Fixed
Variable
Average
Marginal 1 2 3 4 5 6 7 8 9 10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
3.00
$0.00
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00 -
1.00
0.75
0.60
0.50
0.43
0.38
0.33
$0.30
0.40
0.70
0.90
1.10
1.20
$3.30
1.90
1.35
1.30
1.33
1.38
1.43
$0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
Check that TC = FC + VC

21. Figure Conrad’s Coffee Shop Total-Cost Curve
$15.00
Total-cost curve
14.00
Quantity
of coffee
(cups per hour)
Total
Cost 1 2 3 4 5 6 7 8 9 10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
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
(cups of coffee per hour)

22. Average Costs The average cost is also called the per-unit cost.
Average costs can be determined by dividing the firm’s total costs by the quantity of output it produces.

23. Average Costs

24. Average Fixed and Variable Costs
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
We know that TC = FC + VC
Therefore, TC/Q = FC/Q + VC/Q
Therefore, ATC = AFC + AVC

25. The various measures of cost: Conrad’s coffee shop
Quantity
of coffee
(cups per hour)
Total
Cost
Fixed
Variable
Average
Marginal 1 2 3 4 5 6 7 8 9 10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
3.00
$0.00
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00 -
1.00
0.75
0.60
0.50
0.43
0.38
0.33
$0.30
0.40
0.70
0.90
1.10
1.20
$3.30
1.90
1.35
1.30
1.33
1.38
1.43
$0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
Check that ATC = AFC + AVC

26. Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves
Costs
$3.50
AFC = FC/Q. As FC is constant, FC/Q decreases as Q increases. Therefore, AFC decreases as Q increases
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
AFC
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(cups of coffee per hour)

27. Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves
Costs
AFC decreases as Q increases,
AVC increases as Q increases, because of diminishing returns.
As ATC = AFC + AVC, ATC is U-shaped: as Q increases, it decreases initially and then begins to increase.
$3.50
3.25
3.00
2.75
2.50
2.25
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
(cups of coffee per hour)

28. Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves
The quantity at which ATC is lowest is called the efficient scale output.
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
ATC
1.25
For Conrad’s Coffee Shop, the efficient scale is 5 or 6 cups of coffee per hour
1.00
0.75
0.50
0.25 1 2 3 4 5 6 7 8 9 10
Quantity
of Output
(cups of coffee per hour)

29. 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 the fixed cost is spread over only the few units that are produced.
Average fixed cost declines as output increases.
Average variable cost rises as output increases.
These features of a firm’s costs explains the U-shape of the ATC curve
Recall that ATC = AFC + AVC

30. Marginal Cost
Marginal cost (MC) is the increase in total cost (TC) that arises from an extra unit of production.
The increase in cost that arises from an extra unit of production is entirely due to the use of additional raw materials and labor
Therefore, marginal cost can also be defined as the increase in total variable cost (VC) that arises from an extra unit of production.

31. Marginal Cost

32. The various measures of cost: Conrad’s coffee shop
Quantity
of coffee
(cups per hour)
Total
Cost
Fixed
Variable
Average
Marginal 1 2 3 4 5 6 7 8 9 10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
3.00
$0.00
0.30
0.80
1.50
2.40
3.50
4.80
6.30
8.00
9.90
12.00 -
1.00
0.75
0.60
0.50
0.43
0.38
0.33
$0.30
0.40
0.70
0.90
1.10
1.20
$3.30
1.90
1.35
1.30
1.33
1.38
1.43
$0.30
0.50
0.70
0.90
1.10
1.30
1.50
1.70
1.90
2.10
Check that MC = TC/ Q = VC / Q

33. Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves
Marginal cost rises with the amount of output produced. This reflects the assumption of diminishing marginal product
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
(cups of coffee per hour)

34. Figure 4 Conrad’s Coffee Shop 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
(cups of coffee per hour)

35. 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 must be decreasing.
Whenever marginal cost is greater than average total cost, average total cost must be increasing.

36. 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.

37. Figure 4 Conrad’s Coffee Shop 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
(cups of coffee per hour)

38. A Typical Firm’s Costs

39. Figure 5 Cost Curves of a Typical Firm
(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

40. Figure 5 Cost Curves of a Typical Firm
(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

41. COSTS IN THE SHORT RUN AND IN THE LONG RUN

42. 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.
Because some costs are fixed in the short run and variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

43. Figure 6 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
$12,000
ATC
in long run
1,200
Quantity of
Cars per Day

44. Economies and Diseconomies of Scale
Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases.
Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output increases
Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases.

45. Figure 6 Average Total Cost in the Short and Long Run
ATC
in short
run with
small factory
ATC
in short
run with
medium factory
ATC
in short
run with
large factory
Cost
ATC
in long run
Economies of
scale
Diseconomies of
scale
1,200
$12,000
1,000
10,000
Constant
returns to
scale
Quantity of
Cars per Day

46. 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.

47. Summary A firm’s costs reflect its production process.
A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.
A firm’s total costs are 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.

48. 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.

49. Summary The average-total-cost curve is U-shaped.
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.

50. Isoquant Analysis

51. What is Isoquant?
An Isoquant shows the various combinations of two inputs (labour and Capital) that can be used to produce a specific level of output.
A higher Isoquant refers to a larger output, where as a lower Isoquant refers to a smaller output.
If the two variable inputs (capital and labour) are used in production, we are in long run. If the two variable inputs used with other fixed inputs (say land), we would still be in short run.

52. An isoquant Units of K 40 20 10 6 4 Units of L 5 12 20 30 50 Point on
diagram a b c d e
Units of capital (K)
Units of labour (L)

53. An isoquant a Units of K 40 20 10 6 4 Units of L 5 12 20 30 50
Point on
diagram a b c d e
Units of capital (K)
Units of labour (L)

54. An isoquant a Units of K 40 20 10 6 4 Units of L 5 12 20 30 50
Point on
diagram a b c d e
Units of capital (K) b
Units of labour (L)

55. An isoquant a Units of K 40 20 10 6 4 Units of L 5 12 20 30 50
Point on
diagram a b c d e
Units of capital (K) b c d e
Units of labour (L)

56. Characteristics of Isoquant Curves Isoquants further from the origin represent greater output levels There is a different isoquant for every output level the firm could possibly produce, with isoquants further from the origin indicating higher levels of output. Isoquants slope down to the right Along a given isoquant, the quantity of labour employed is inversely related to the quantity of capital employed, so isoquants have negative slopes. Isoquants do not intersect Since each isoquant refers to a specific level of output, no two isoquants intersect, for such an intersection would indicate that the same combination of resources could, with equal efficiency, produce two different amounts of output.

57. Isoquants are usually convex to the origin
Finally, isoquants are usually convex to the origin, meaning that the slope of the isoquant gets flatter down along the curve. To understand why, keep in mind that the slope of the isoquant measures the ability of additional units of one resource — in this case, labour (L) — to substitute in production for another — in this case, capital (K). As we said, the isoquant has a negative slope. The slope of the isoquant is the marginal rate of technical substitution (or MRTS), defined between any two resources as:
MRTS = DK / DL

58. Marginal rate of substitution
Marginal rate of substitution –MRTSLK indicates the rate at which additional units of labour (ΔL) can be substituted for fewer units of capital (–ΔK) while keeping output (TP) constant. When much capital and little labour are used, the marginal productivity of labour is relatively great and the marginal productivity of capital is relatively small, so one unit of labour will substitute for a relatively large amount of capital.

59. Diminishing marginal rate of factor substitution
MRS = DK / DL
DK = 2
MRS = 2 h
DL = 1
Units of capital (K)
isoquant
Units of labour (L)

60. Diminishing marginal rate of factor substitution
MRS = 2
MRS = DK / DL
DK = 2 h
DL = 1
Units of capital (K) j
MRS = 1
DK = 1 k
DL = 1
isoquant
Units of labour (L)

61. An isoquant map

62. An isoquant map Units of capital (K) I5 I4 I3 I2 I1
Units of labour (L)

63. Returns to scale

64. Constant returns to scale
600
Units of capital (K) b
500
400 a
300
200
Units of labour (L)

65. Increasing returns to scale (beyond point b)
700
600
Units of capital (K) b
500
400 a
300
200
Units of labour (L)

66. Decreasing returns to scale (beyond point b)
500
Units of capital (K) b
400 a
300
200
Units of labour (L)

67. Isocosts

68. An isocost Assumptions PK = £20 000 W = £10 000 TC = £300 000
Units of capital (K)
Units of labour (L)

69. An isocost Assumptions PK = £20 000 W = £10 000 TC = £300 000
Units of capital (K) b c
TC = £ d
Units of labour (L)

70. The least-cost method of production

71. Finding the least-cost method of production
Assumptions
PK = £20 000
W = £10 000
TC = £
Units of capital (K)
TC = £
TC = £
TC = £
Units of labour (L)

72. Finding the least-cost method of production
TPP1 s t
TC = £
Units of capital (K)
TC = £ r
Units of labour (L)

73. The Cobb-Douglas Production Function

74. In economics, the Cobb-Douglas functional form of production functions is widely used to represent the relationship of an output to inputs. It was proposed by Knut Wicksell ( ), and tested against statistical evidence by Charles Cobb and Paul Douglas in
For production, the function is
Y = ALαKβ, where:
Y = total production (the monetary value of all goods produced in a year)
L = labor input
K = capital input
A = total factor productivity
α and β are the output elasticities of labor and capital, respectively. These values are constants determined by available technology.

75. Output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus. For example if α = 0.15, a 1% increase in labor would lead to approximately a 0.15% increase in output.
Further, if:
α + β = 1, the production function has constant returns to scale. That is, if L and K are each increased by 20%, Y increases by 20%. If
α + β < 1,returns to scale are decreasing, and if
α + β > 1, returns to scale are increasing

76. The Cobb-Douglas Production Function
Y = AKL(1-)

77. History
Developed by Paul Douglas and C. W. Cobb in the 1930’s

78. The General Problem
An increase in a nation’s capital stock or labor force means more output.
Is there a mathematical formula that relates capital, labor and output?

79. The General Form

80. An Illustration
The Cobb-Douglas Production Function

81. An Illustration
The Cobb-Douglas Production Function

82. An Illustration
A =3
L =10
K =10
The Cobb-Douglas Production Function

83. RETURNS TO SCALE
DIMINISHING RETURNS REFER TO RESPONSE OF OUTPUT TO AN INCREASE OF A SINGLE INPUT WHILE OTHER INPUTS ARE HELD CONSTANT.
WE HAVE TO SEE THE EFFECT BY INCREASING ALL INPUTS.
WHAT WOULD HAPPEN IF THE PRODUCTION OF WHEAT IF LAND, LABOUR, FERTILISERS, WATER ETC,. ARE ALL DOUBLED. THIS REFERS TO THE RETURNS TO SCALE OR EFFECT OF SCALE INCREASES OF INPURTS ON THE QUANTITY PRODUCED.

84. CONSTANT RETURNS TO SCALE
THIS DENOTES A CASE WHERE A CHANGE IN ALL INPUTS LEADS TO A PROPORTIONAL CHANGE IN OUTPUT.
FOR EXAMPLE IF LABOUR, LAND CAPITAL AND OTHER INPUTS DOUBLED, THEN UNDER CONSTANT RETURNS TO SCALE OUTPUT WOULD ALSO DOUBLE.

85. INCREASING RETURNS TO SCALE
THIS IS ALSO CALLED ECONOMIES OF SCALE. THIS ARISES WHEN AN INCREASE IN ALL INPUTS LEADS TO A MORE-THAN-PROPORTIONAL INCREASE IN THE LEVEL OF OUTPUT.
FOR EXAMPLE AN ENGINEER PLANNING A SMALL SCALE CHEMICAL PLANT WILL GENERALLY FIND THAT BY INCREASING INPUTS OF LABOUR, CAPITAL AND MATERIALS BY 10% WILL INCREASE THE TOTAL OUTPUT BY MORE THAN 10%.

86. DECREASING RETURNS TO SCALE
THIS OCCURS WHEN A BALANCED INCREASE OF ALL INPUTS LEADS TO A LESS THAN PORPORTIONAL INCREASE IN TOTAL OUTPUT.
IN MANY PROCESS, SCALING UP MAY EVENTUALLY REACH A POINT BEYOND WHIH INEFFICIENCIES SET IN. THESE MIGHT ARISE BECAUSE THE COSTS OF MANAGEMENT OR CONTROL BECOME LARGE.
THIS WAS VERY EVIDENT IN ELECTRICITY GENERATION WHEN PLANTS GREW TOO LARGE, RISK OF PLANT FAILURE INCREASED.

87. An Illustration

88. Constant Returns to Scale

89. Doubling Capital Diminishing Returns to Scale

90. Diminishing Returns to Scale Reduction in Substitution variable

91. Increasing returns to Scale