The Costs of Production

The Law of Supply:

Firms are willing to Supply
produce and sell
a greater quantity
of a good when
the price of a
good is high, due
to typical
productivity and
cost behaviour.
Principles of Microeconomics : Ch.13 First Canadian Edition
 Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to
maximize profit.
Profit = Total revenue – Total cost
TR-the amount a firm receives from the sale of its
output
TC-the market value of the inputs a firm uses in
production

Principles of Microeconomics : Ch.13 First Canadian Edition

 Costs as Opportunity Costs
The firm’s costs include Explicit Costs and
Implicit Costs:
– Explicit Costs: costs that involve a direct
money outlay for factors of production.
– Implicit Costs: costs that do not involve a
direct money outlay (e.g. opportunity
costs of the owner’s own inputs used -
implicit wages, implicit rent, cost of
capital).

Principles of Microeconomics : Ch.13 First Canadian Edition

 Costs as Opportunity Costs
Accountants measure the explicit costs but
often ignore the implicit costs.
Economists include all opportunity costs
when measuring costs.

Accounting Profit = TR - Explicit Costs

Economic Profit = TR - Explicit Costs -
Implicit Costs

Principles of Microeconomics : Ch.13 First Canadian Edition

Explicit vs. Implicit Costs: An 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.
In both cases, total (exp + imp) costs are $5000.

Principles of Microeconomics : Ch.13 First Canadian Edition

 Marginal Product
The marginal product of any input is the increase in
output arising from an additional unit of that
input, holding all other inputs constant.
E.g., if Farmer Jack hires one more worker,
his output rises by the marginal product of labour.
Notation:
∆ (delta) = “change in…”
Examples:
∆Q = change in output, ∆L = change in labour

Marginal product of labour (MPL) = delta Q/delta L

Principles of Microeconomics : Ch.13 First Canadian Edition
 Why MPL Diminishes
Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things
equal)
E.g., Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why?
If Jack increases workers but not land,
the average worker has less land to work with,
so will be less productive.
In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
Principles of Microeconomics : Ch.13 First Canadian Edition
 Short-Run vs. Long-Run
Two different time horizons are
important when analyzing costs.
Short-Run: Time period over which
some inputs are variable (labour,
materials) and some inputs are fixed
(plant size).
Long-Run: Time period over which all
inputs are variable, including plant size.

Principles of Microeconomics : Ch.13 First Canadian Edition

 Short-Run Costs
Costs of production may be divided into
two categories in the short-run:
Fixed Costs:
–Those costs that do not vary with the
amount of output produced.
Variable Costs:
–Those costs that do vary with the
amount of output produced.
Principles of Microeconomics : Ch.13 First Canadian Edition
 Marginal Cost
Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
MC = delta TC/delta Q

Principles of Microeconomics : Ch.13 First Canadian Edition

 The Shape of Short-Run Cost
Curves
Short-run cost behaviour is based on the
productivity of the inputs (resources).
As the firm continues to expand output,
in a fixed plant-size situation, eventually
the marginal product of each successive
worker hired will decrease.
The diminishing marginal product causes
the marginal cost to increase in the short-
run. This in turn affects the behaviour of
average total cost.
Principles of Microeconomics : Ch.13 First Canadian Edition
 The Shape of Typical Cost Curves
U-Shaped Average Total Cost (ATC):
– At low levels of output, as the firm
expands production, ATC declines.
– At higher production levels, as output is
increased, ATC increases.
– The bottom of the U-Shape occurs at the
quantity that minimizes average total
cost.
– This is called the Efficient Size of the firm.
Principles of Microeconomics : Ch.13 First Canadian Edition
The Relationship Between Marginal
Cost and Average Total Cost
Why is ATC U - shaped?
When marginal cost is less than average
total cost, average total cost is falling.
MC < ATC ATC
When marginal cost is greater than average
total cost, average total cost is rising.
MC > ATC ATC
Principles of Microeconomics : Ch.13 First Canadian Edition
 The Relationship Between Marginal
Cost and Average Total Cost
MC
ATC
Cost ($’s)

The marginal cost

curve always crosses
the average total cost
curve at the minimum
average total cost!

Principles of Microeconomics : Ch.13

Quantity First Canadian Edition
Costs in the Short Run & 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)
In the long run, ATC at any Q is cost per
unit using the most efficient mix of inputs
for that Q (e.g., the factory size with the
lowest ATC).
Principles of Microeconomics : Ch.13 First Canadian Edition
$ Long-Run Costs
Per
Unit

LRATC Curve
Econ. Constant Disecon
of Returns to . of
Scale Scale Scale

Scale of Operation (Q)

Principles of Microeconomics : Ch.13 First Canadian Edition
 How ATC Changes as
the Scale of Production Changes
Economies of scale occur when increasing
production allows greater specialization:
workers more efficient when focusing on a narrow
task.
– More common when Q is low.
Diseconomies of scale are due to coordination
problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
– More common when Q is high.
– Constant returns to scale if more output neither
increases or decreases cost. (flat portion of
LRATC)
Principles of Microeconomics : Ch.13 First Canadian Edition