10/11/2017

The Market Forces of Supply and

Demand
• 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,
The Costs of demand, and market equilibrium.
Production

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WHAT ARE COSTS? WHAT ARE COSTS?

• The Firm’s Objective
• The economic goal of the firm is to maximize
profits.

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Total Revenue, Total Cost, and Profit Total Revenue, Total Cost, and Profit

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Costs as Opportunity Costs Economic Profit versus Accounting Profit

• A firm’s cost of production includes all the • Economists measure a firm’s economic profit as
opportunity costs of making its output of goods total revenue minus total cost, including both
and services. explicit and implicit costs.
• Explicit and Implicit Costs • Accountants measure the accounting profit as
• A firm’s cost of production include explicit costs the firm’s total revenue minus only the firm’s
and implicit costs. explicit 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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Figure 1 Economic versus Accountants

Economic Profit versus Accounting Profit
How an Economist How an Accountant
Views a Firm Views a Firm
• When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit. Economic
profit
• Economic profit is smaller than accounting profit.
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

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Table 1 A Production Function and Total Cost:

Hungry Helen’s Cookie Factory
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.

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The Production Function The Production Function

• Marginal Product • Diminishing Marginal Product
• The marginal product of any input in the production • Diminishing marginal product is the property
process is the increase in output that arises from an whereby the marginal product of an input declines
additional unit of that input. 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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Figure 2 Hungry Helen’s Production Function

The Production Function
Quantity of
Output
(cookies
per hour) • Diminishing Marginal Product
• The slope of the production function measures the
150 Production function
140
130 marginal product of an input, such as a worker.
120
110 • When the marginal product declines, the production
function becomes flatter.
100
90
80
70
60
50
40
30
20
10

0 1 2 3 4 5Number of Workers Hired

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Table 1 A Production Function and Total Cost:

From the Production Function to the Total- Hungry Helen’s Cookie Factory
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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Figure 3 Hungry Helen’s Total-Cost Curve

THE VARIOUS MEASURES OF
Total
Cost
COST
$80 Total-cost
curve

70

60

50

40

30

20

10

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity

of Output
(cookies per hour)
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Table 2 The Various Measures of Cost: Thirsty

Thelma’s Lemonade Stand
Fixed and Variable Costs

• Total Costs
• Total Fixed Costs ( TFC)
• Total Variable Costs ( TVC)
• Total Costs (TC)
• TC = TFC + TVC

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Fixed and Variable Costs Fixed and Variable Costs

• Average Costs • Average Costs

• Average costs can be determined by dividing the • Average Fixed Costs ( AFC)
firm’s costs by the quantity of output it produces. • Average Variable Costs ( AVC)
• The average cost is the cost of each typical unit of • Average Total Costs ( ATC)
product. • ATC = AFC + AVC

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Table 2 The Various Measures of Cost: Thirsty

Average Costs Thelma’s Lemonade Stand

Fixed cost FC
AFC  
Quantity Q

Variable cost VC
AVC  
Quantity Q

Total cost TC
ATC  
Quantity Q
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Fixed and Variable Costs Marginal Cost

• Marginal Cost
• Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production. (change in total cost) TC
• Marginal cost helps answer the following question: MC  
• How much does it cost to produce an additional unit of (change in quantity) Q
output?

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Marginal Cost Figure 4 Thirsty Thelma’s Total-Cost Curves

Thirsty Thelma’s Lemonade Stand Total Cost

$15.00 Total-cost curve
14.00
13.00

Quantity Total Marginal Quantity Total Marginal 12.00

Cost Cost Cost Cost 11.00

10.00

0 $3.00 — 9.00

1 3.30 $0.30 6 $7.80 $1.30 8.00

7.00
2 3.80 0.50 7 9.30 1.50 6.00

3 4.50 0.70 8 11.00 1.70 5.00

4.00
4 5.40 0.90 9 12.90 1.90 3.00

5 6.50 1.10 10 15.00 2.10 2.00

1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost

Curves
Cost Curves and Their Shapes
Costs

• Marginal cost rises with the amount of output

$3.50
3.25
3.00
produced.
2.75
2.50 • This reflects the property of diminishing marginal
2.25
MC product.
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost

Curves
Cost Curves and Their Shapes
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

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost

Curves
Cost Curves and Their Shapes
Costs

• The bottom of the U-shaped ATC curve occurs

$3.50
3.25

at the quantity that minimizes average total 3.00

2.75
cost. This quantity is sometimes called the 2.50

efficient scale of the firm. 2.25

2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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Cost Curves and Their Shapes 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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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost

Curves
Typical Cost Curves
Costs

It is now time to examine the

$3.50
3.25

relationships that exist between the

3.00
2.75

different measures of cost.

2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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Figure 6 Big Bob’s Cost Curves

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

0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)

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Figure 6 Big Bob’s Cost Curves

Typical Cost Curves
(b) Marginal- and Average-Cost Curves

Costs • Three Important Properties of Cost Curves

$3.00 • Marginal cost eventually rises with the quantity of
output.
2.50
MC • The average-total-cost curve is U-shaped.
2.00
• The marginal-cost curve crosses the average-total-
1.50
ATC cost curve at the minimum of average total cost.
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)

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Summary Summary
• The goal of firms is to maximize profit, which • A firm’s costs reflect its production process.
equals total revenue minus total cost. • A typical firm’s production function gets flatter
• When analyzing a firm’s behavior, it is as the quantity of input increases, displaying the
important to include all the opportunity costs of property of diminishing marginal product.
production. • A firm’s total costs are divided between fixed
• Some opportunity costs are explicit while other and variable costs. Fixed costs do not change
opportunity costs are implicit. when the firm alters the quantity of output
produced; variable costs do change as the firm
alters quantity of output produced.

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Summary Summary
• Average total cost is total cost divided by the • The average-total-cost curve is U-shaped.
quantity of output. • The marginal-cost curve always crosses the
• Marginal cost is the amount by which total cost average-total-cost curve at the minimum of
would rise if output were increased by one unit. ATC.
• The marginal cost always rises with the • A firm’s costs often depend on the time horizon
quantity of output. being considered.
• Average cost first falls as output increases and • In particular, many costs are fixed in the short
then rises. run but variable in the long run.

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