1. The Costs of Production Principles of Microeconomics Boris Nikolaev

2. Brainstorming costs You run Ford Motor Company.
List three different costs you have.
List three different business decisions that are affected by your costs.

3. In this chapter
What is a production function? What is marginal product? How are they related?
What are the various costs? How are they related to each other and to output?
How are costs different in the short run vs. the long run?
What are “economies of scale”?

4. It’s business time. Firms are in the business of making profits.
Profit = Total Revenue (TR) – Total Cost (TC)
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production

5. Sneak Preview
MR=MC

6. Profits Are profits bad?
What is the function of profits in a free market economy?
In a competitive market profits come not from increase in price, but from decrease in the cost of production. Why?
Fortune 500 most profitable companies [see here]

7. The Weed Trail [read here]

8. Profits and Insurance
Recollect risk-aversion & uncertainty.

9. Corporate Profits after tax

10. CP/GDP

11. Marxist View The stagnating wages since the 1970s
Technology
World war II
Outsourcing
Women in the labor force
Immigration
Problem of effective demand
Work more hours
Borrowing binge (mortgage debt, credit cards)
Greatest profit boom (in the history of the world)
Marginal productivity, wages, and profits

12. Productivity vs Wages

13. What do you do with the profits?
CEO salaries [Forbes list]
Mergers & Acquisitions
Lend to employees (e.g. GM, IBM, etc.)

14. Costs Resources are scarce, productive, and have alternative uses.
Explicit costs are the direct cash payments you make to use resources you don’t own such as wages, rent, insurance, taxes, etc.
Implicit costs is the opportunity cost of the resource you own (the benefit you could have extracted from it from its next best use). Do not require direct cast payments.

15. Example
You need $100,000 to start your business. The interest rate is 5%.
Case 1: borrow $100,000
explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings, borrow the other $60,000
explicit cost = $3000 (5%) interest on the loan
implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.

16. Economic vs Accounting Profit
= total revenue minus total explicit costs
Economic profit
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs, so it’s higher than economic profit.

17. Example 1
The equilibrium rent on office space has just increased by $500/month.
Determine the effects on accounting profit and economic profit if:
a. you rent your office space
b. you own your office space

18. Answers The rent on office space increases $500/month.
a. You rent your office space.
Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.
b. You own your office space.
Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it) so economic profit falls by $500/month.

19. Practice Question
Your current job pays $50K/year. You have $20K savings that earn you $3K interest a year. You own a garage, which you rent for $12K/ year. You decide to invest your savings and use your garage to start your own business.
Did you make a good economic decision?
Total Revenue $105K
Explicit Costs
labor $21K
food $20K
Total Cost $41K
Accounting Profit _____
Implicit Costs
salary _____
interest _____
rent _____
Total Implicit Cost _____
Economic Profit / Loss ______
Depreciation or opportunity cost of capital

20. Production in the Short Run
Q= f(L,K)
A production function shows the relationship between the quantity of inputs used to produce a good and the quantity of output of that good.

21. EXAMPLE 1: Production Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
Q (bushels of wheat)
L (no. of workers)
1000 1
1800 2
2400 3
2800 4
3000 5 21

22. Marginal Product (MP)
If you hire one more worker, your output rises by the marginal product of labor.
The marginal product of any input is the increase in output arising from an additional unit of that input, holding all other inputs constant.
Notation: ∆ (delta) = “change in…”
Examples: ∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) = ∆Q ∆L 22

23. EXAMPLE 1: Total & Marginal Product
3000 5
2800 4
2400 3
1800 2
1000 1
Q (bushels of wheat)
L (no. of workers)
MPL
∆Q = 1000
∆L = 1
1000
∆Q = 800
∆L = 1
800
∆Q = 600
∆L = 1
600
∆Q = 400
∆L = 1
400
∆Q = 200
∆L = 1
200 23

24. EXAMPLE 1: MPL = Slope of Prod Function
500
1,000
1,500
2,000
2,500
3,000 1 2 3 4 5
No. of workers
Quantity of output
L (no. of workers)
Q (bushels of wheat)
MPL
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
1000 1
1000
800 2
1800
600 3
2400
400 4
2800
200 5
3000 24

25. Why MPL Is Important your costs rise by the wage he pays the worker
Recall one of the Ten Principles: Rational people think at the margin.
When you hire an extra worker,
your costs rise by the wage he pays the worker
your output rises by MPL
Comparing them helps you decide whether he should hire the worker. 25

26. Class demonstration

27. The Law of Diminishing Marginal Returns
Diminishing marginal product: The marginal product of an input declines as the quantity of the input increases (other things equal).
Why does it decline?

28. Practice Question # fishermen Fish caught MP of labor MRP 1 15 2 35 358 4 80 5 95 6
105 7
108 8
Input (L)
TP = f(L)
Assume that only one input (L) is relevant in production.
The wage / worker = $175 and one pound of fish is selling for $10

29. Let’s go back to our farm example…
You must pay $1000 per month for the land, regardless of how much wheat you grow.
The market wage for a farm worker is $2000 per month.
Your cots are related to how much wheat you produce…

30. EXAMPLE 1: Your Costs L (no. of workers) Q (bushels of wheat)
L (no. of workers)
Q (bushels of wheat)
Cost of land
Cost of labor
Total cost
$1,000
$10,000
$8,000
$6,000
$4,000
$2,000 $0
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000 1
1000 2
1800 3
2400 4
2800 5
3000 30

31. EXAMPLE 1: Total Cost Curve
Q (bushels of wheat)
Total Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000 31

32. Marginal Cost
Marginal Cost (MC) is the increase in Total Cost from producing one more unit:
∆TC ∆Q
MC = 32

33. EXAMPLE 1: Total and Marginal Cost
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
Q (bushels of wheat)
Marginal Cost (MC)
∆Q = 1000
∆TC = $2000
$2.00
∆Q = 800
∆TC = $2000
$2.50
∆Q = 600
∆TC = $2000
$3.33
∆Q = 400
∆TC = $2000
$5.00
∆Q = 200
∆TC = $2000
$10.00 33

34. EXAMPLE 1: The Marginal Cost Curve
Q (bushels of wheat) TC MC
MC usually rises as Q rises, as in this example.
$1,000
$10.00
$5.00
$3.33
$2.50
$2.00
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000 34

35. Why MC Is Important
You are rational and want to maximize your profits. To increase profit, should you produce more or less wheat?
To find the answer, you need to “think at the margin.”
If MC > MR then producing one more unit will decrease profits. 35

36. Fixed and Variable Costs
Fixed costs (FC) do not vary with the quantity of output produced.
In our example, FC = $1000 for land
Other examples: cost of equipment, loan payments, rent
Variable costs (VC) vary with the quantity produced.
In our example, VC = wages you pay workers
Other example: cost of materials
Total cost (TC) = FC + VC 36

37. EXAMPLE 2: Costs Q FC VC TC 100 $100 520 380 280 210 160 120 70 $0 620
EXAMPLE 2: Costs
$800 FC Q FC VC TC VC
$700
100
$100
520
380
280
210
160
120 70 $0
620
480
380
310
260
220
170
$100 TC
$600 1
$500 2
Costs
$400 3
$300 4
$200 5
$100 6 $0 7 1 2 3 4 5 6 7 Q 37

38. EXAMPLE 2: Marginal CostQ TC MC
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
$100
$70 1
170
∆TC ∆Q
MC = 50 2
220 40 3
260
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.) 50 4
310 70 5
380
100 6
480
140 7
620 38

39. EXAMPLE 2: Average Fixed CostQ FC
AFC
Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
$100
14.29
16.67 20 25
33.33 50
$100
n/a 1
100 2
100 3
100
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units. 4
100 5
100 6
100 7
100 39

40. EXAMPLE 2: Average Variable CostQ VC
AVC
Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q $0
74.29
63.33
56.00
52.50
53.33 60
$70
n/a 1 70 2
120 3
160
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises. 4
210 5
280 6
380 7
520 40

41. EXAMPLE 2: Average Total Cost
EXAMPLE 2: Average Total Cost
Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q Q TC
ATC
74.29
14.29
63.33
16.67
56.00 20
52.50 25
53.33
33.33 60 50
$70
$100
n/a
AVC
AFC
$100
88.57 80 76
77.50
86.67
110
$170
n/a 1
170 2
220 3
260
Also,
ATC = AFC + AVC 4
310 5
380 6
480 7
620 41

42. EXAMPLE 2: Average Total Cost$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs Q TC
ATC
Usually, as in this example, the ATC curve is U-shaped.
$100
n/a 1
170
$170 2
220
110 3
260
86.67 4
310
77.50 5
380 76 6
480 80 7
620
88.57 42

43. EXAMPLE 2: The Various Cost Curves Together$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
ATC
AVC
AFC MC 43

44. Fill in the blank spaces of this table.
Calculating costs
Fill in the blank spaces of this table. Q VC TC
AFC
AVC
ATC MC
$50
n/a
n/a
n/a
$10 1 10
$10
$60.00 2 30 80 30 3
16.67 20
36.67 4
100
150
12.50
37.50 5
150 30 60 6
210
260
8.33 35
43.33

45. Answers Use AFC = FC/Q Use ATC = TC/Q
First, deduce FC = $50 and use FC + VC = TC.
Use relationship between MC and TC
Use AVC = VC/Q Q VC TC
AFC
AVC
ATC MC $0
$50
n/a
n/a
n/a
$10 1 10 60
$50.00
$10
$60.00 20 2 30 80
25.00 15
40.00 30 3 60
110
16.67 20
36.67 40 4
100
150
12.50 25
37.50 50 5
150
200
10.00 30
40.00 60 6
210
260
8.33 35
43.33

46. EXAMPLE 2: ATC and MC ATC When MC < ATC, ATC is falling. MC$0
$25
$50
$75
$100
$125
$150
$175
$200 1 2 3 4 5 6 7 Q
Costs
ATC
When MC < ATC,
ATC is falling.
When MC > ATC,
ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum. MC 46

47. Cost in the Long Run
Short run: Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC.
Long run: All inputs are variable (e.g., firms can build more factories or sell existing ones).

48. EXAMPLE 3: LRATC with 3 factory sizes
Firm can choose from three factory sizes: S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run. Q
Avg Total Cost
ATCS
ATCM
ATCL 48

49. A Typical LRATC Curve
In the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this: Q
ATC
LRATC 49

50. How ATC Changes as the Scale of Production Changes
Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scale: ATC rises as Q increases. Q
ATC
LRATC 50

51. Sources of Economies of Scale
Spread of “overhead,” fixed cost over bigger production.
Labor specialization.
Technology.
Learning by doing.
Agglomeration economies.

52. Note on International Trade
What goods are produced and where?
David Ricardo (1800’s) – comparative advantage.
Heckscher & Ohlin ( ’s) – differences in factor endowments. Example: Developed countries export more capital intensive goods (cars, airplanes, etc…) and import from developing countries more labor intensive goods (clothing, agricultural products, etc…)
Empirical studies.

53. Krugman’s Model
Uses economies of scale to explain international trade.
Mass production decreases average cost (ES)
Consumers prefer diversity of products
Each country specializes and then trades. This is how countries with similar factor endowments engage in trade (e.g. Japan sells Toyota to US, US sells GM to Germany, etc…)