Production

and Costs

Supply and demand are the two

words that economists use most
often.
Supply and demand are the forces that
make market economies work.
Modern microeconomics is about
supply, demand, and market
equilibrium.

According to the Law of Supply:

Firms are willing to produce and sell a
greater quantity of a good when the
price of the good is high.
This results in a supply curve that
slopes upward.

The Firms Objective

The economic goal of the firm is to maximize profits.

Total Revenue

Total Cost

The amount a firm receives for the sale of its output.

The market value of the inputs a firm uses in
production.

Profit

The firms total revenue minus its total cost.

Profit = Total revenue - Total cost

A firms cost of production includes all the

opportunity costs of making its output of
goods and services.
Explicit and Implicit Costs

A firms 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.

Example:
Helen uses $300 000 of her savings to buy her
cookie factory from the previous owner.
If she had left her money in a savings account that
pays an interest at a rate of 5 percent, she would
have earned $15 000 a year.
Helen by buying a cookie factory has foregone $15
000 a year in interest income.
This foregone $15 000 is an implicit opportunity
cost of Helens business.
The accountant will not show this cost.

Economists measure a firms

economic profit as total revenue
minus total cost, including both
explicit and implicit costs.
Accountants measure the
accounting profit as the firms total
revenue minus only the firms
explicit costs.

Accounting profit = TR total explicit costs

Economic profit = TR (explicit costs +

implicit costs)

How an
Accountant
Views a Firm

How an
Economist
Views a Firm

Economic
profit

Accounting
profit
Revenue

Implicit costs

Revenue
Total
Opportunity
Costs

Explicit costs

Explicit costs

Zero economic profit = normal profit

Define as
the minimum profit to keep a firm in operation.
A firm that earns normal profits earns total
revenue equal to its total implicit costs +
explicit costs.

Useful to categorize firms decisions into

Long-run decisionsinvolves a time horizon long
enough for a firm to vary all of its inputs
To guide the firm over the next several years (long run lens)

Short-run decisionsinvolves any time horizon over

which at least one of the firms inputs cannot be
varied
To determine what the firm should do next week ( short run

lens)

There is nothing they can do about their fixed inputs

Stuck with whatever quantity they have
However, can make choices about their variable
inputs
Fixed inputs
An input whose quantity must remain constant,
regardless of how much output is produced
For example: ???????

Variable input
An input whose usage can change as the level of
output changes
For example: ????????

Total product

Maximum quantity of output that can be produced

from a given combination of inputs

Marginal product (MP) is the change in total

product (Q) divided by the change in the number
of workers hired (L)

Q
MP
L
Tells us the rise in output produced when one
more worker is hired

Units of Output
Total Product

196
184
161

DQ from hiring fourth worker

130

DQ from hiring third worker

90
DQ from hiring second worker
30

DQ from hiring first worker

1
increasing
marginal
returns

diminishing
marginal
returns

Number of Workers

As more and more workers are hired

MP first increases
Then decreases

Pattern is believed to be typical at many types

of firms

When the marginal product of labor increases

as employment rises, we say there are
increasing marginal returns to labor

Each time a worker is hired, total output rises by

more than it did when the previous worker was
hired

When the marginal product of labor is

decreasing
There are diminishing marginal returns to labor
Output rises when another worker is added so
marginal product is positive
But the rise in output is smaller and smaller with
each successive worker
Law of diminishing (marginal) returns states that
beyond some point the marginal product decreases as
additional units of a variable factor are added to a fixed
factor. (holding the other inputs constant)
Its marginal product will eventually decline

Fixed costs

Costs of a firms fixed inputs

Variable costs

Costs of obtaining the firms variable

inputs

Types of total costs

Total fixed costs

Cost of all inputs that are fixed in the short run

Total variable costs

Cost of all variable inputs used in producing a

particular level of output

Total cost

Cost of all inputsfixed and variable

TC = TFC + TVC

Dollars
TC

$435
375

TVC

TFC

315
255
195
135

TFC
0

30

90

130

161

184 196

Units of Output

Average fixed cost (AFC)

Total fixed cost per unit of output produced

TFC
AFC
Q
Average variable cost (TVC)

Total variable cost per unit of output produced

TVC
AVC
Q
Average total cost (TC)

Total cost per unit of output produced

TC
ATC
Q

Marginal Cost

Increase in total cost from producing one more unit or

output

Marginal cost is the change in total cost (TC)

divided by the change in output (Q)
TC
MC
Q
Tells us how much cost rises per unit increase in
output
Marginal cost for any change in output is equal to
shape of total cost curve along that interval of
output

Dollars

MC

$4

3
AFC

ATC
AVC

AFC
0

30

90

130

161
196
Units of Output

When marginal cost is below average cost,

average cost falls.
When marginal cost is above average cost,
average cost rises.
When marginal cost is equals average cost,
average cost is at its minimum point.

Add
marginal cost
to the table

Total
Input
(L)
0
1
2
3
4
5
6
7
8
9

Q
0
1,000
3,000
6,000
8,000
9,000
9,500
9,850
10,000
9,850

MP
1,000
2,000
3,000
2,000
1,000
500
350
150
-150

TVC
(wL)
0
500
1,000
1,500
2,000
2,500
3,000
3,500
4,000
4,500

MC
0.50
0.25
0.17
0.25
0.50
1.00
1.43
3.33

Important Map Observations

AFC declines steadily over the range of

production. Why?

In general, ATC is u-shaped. Why?

MC intersects the minimum point (q*) on ATC.

Why?

Goal: earn the highest possible profit

To do this, it must follow the least cost rule
To produce any given level of output the firm will

choose the input mix with the lowest cost

Firm must decide what combination of inputs to use
in producing any level of output

Long-run total cost (LRTC)

The cost of producing each quantity of output when
the least-cost input mix is chosen in the long run
Long-run average total cost (LRATC)
The cost per unit of output in the long run, when all
inputs are variable
LRTC
LRATC
Q

ATC curve tells us how average cost behaves

in the short run, given plant size fixed

moving along the current ATC curve

To produce any level of output in the long

run, the firm will always choose that ATC
curve with lowest ATC among all of the
ATC curves available

move from one ATC curve to another by varying

the size of its plant
Will also be moving along its LRATC curve
This insight tells us how we can graph the firms
LRATC curve

Plant - collection of fixed inputs at a firms

disposal
Can distinguish between the long run and
the short run

In the long run, the firm can change the size of

its plant
In the short run, it is stuck with its current plant
size

Dollars
$4.00

ATC1
ATC0

LRATC

ATC3

ATC2

3.00

2.00

B
A

D
E

1.00
0

30
Use 0
automated
lines

90

130

161 184
175 196

Use 1
automated
lines

250

Use 2
automated
lines

300

Use 3
automated
lines

Units of Output

For some output levels, LRTC is smaller than

TC
Long-run total cost of producing a given level
of output can be less than or equal to, but never
greater than, short-run total cost (LRTC TC)
Long-run average cost of producing a given
level of output can be less than or equal to, but
never greater than, shortrun average total cost
(LRATC ATC)

According to whether the LRATC decreases /

does not change / increase as output increases,
there are three types of issues:
Economies of scale (decreasing LRATC) at relatively
low levels of output
Constant returns to scale (constant LRATC) at some
intermediate levels of output
Diseconomies of scale (increasing LRATC) at
relatively high levels of output

LRATC curves are typically U-shaped

Dollars
$4.00
3.00
LRATC

2.00

1.00
130

Economies of Scale

184

Constant
Returns to
Scale

Diseconomies of Scale
Units of Output

An increase in output causes LRATC to

decrease

The more output produced, the lower the cost

per unit
LRATC curve slopes downward
Long-run total cost rises proportionately less
than output
Increasing return to scale

Gains from specialization

Labour
Managerial
Efficiency of capital
Some types of inputs cannot be increased in tiny
increments, but rather must be increased in large
jumps, therefore must be purchased in large
lumps
Low cost per unit is achieved only at high levels of

output
More efficient use of lumpy inputs will have more
impact on LRATC at low levels of outputs

An increase in output causes LRATC to

remain

The more output produced but the cost per unit

is not change
LRATC curve remains flat
Long-run total cost rises proportionately with
output
constant return to scale

LRATC increases as output increases

LRATC curve slopes upward

LRTC rises more than in proportion to output
More likely at higher output levels

As output continues to increase, most firms

will reach a point where bigness begins to cause
problems

As a firm become large beyond

some level
~increasing bureaucratic and red
tape (financial/accounting)
~management coordination
problems
~out of control situations