Review of the previous lecture

The consumer optimizes by choosing the point on his budget constraint that
lies on the highest indifference curve.

When the price of a good falls, the impact on the consumers choices can
be broken down into an income effect and a substitution effect.

The income effect is the change in consumption that arises because a lower
price makes the consumer better off.

The income effect is reflected by the movement from a lower to a higher

indifference curve.

Review of the previous lecture

The substitution effect is the change in consumption that arises because a

price change encourages greater consumption of the good that has become
relatively cheaper.

The substitution effect is reflected by a movement along an indifference

curve to a point with a different slope.

The theory of consumer choice can explain:

Why demand curves can potentially slope upward.
How wages affect labor supply.
How interest rates affect household saving.

Lecture 7

The Costs of Production- I

Instructor: Prof.Dr.Qaisar Abbas
Course code: ECO 400

Lecture Outline

1. What Are Costs?

2. Costs as Opportunity Costs
3. Production and Costs

Costs
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.
Profit is the firms total revenue minus its total cost.
Profit = Total revenue - Total cost

Economic Profit versus Accounting Profit

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.

Costs
When total revenue exceeds both explicit and implicit costs, the firm earns
economic profit.
Economic profit is smaller than accounting profit.

Economic versus Accountants

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.
Production Function
Q = F(K,L)
Q is quantity of output produced.
K is capital input.
L is labor input
F is a functional form relating the inputs to output.
The maximum amount of output that can be produced with K units of
capital and L units of labor.
Short-Run vs. Long-Run Decisions
Fixed vs. Variable Inputs

Production and Costs

Linear production function: inputs are perfect substitutes.

Q F K , L aK bL

Leontief production function: inputs are used in fixed proportions.

Q F K , L min bK , cL

Cobb-Douglas production function: inputs have a degree of substitutability.

Q F K , L K a Lb

Productivity Measures: Total Product

Total Product (TP): maximum output produced with given amounts of inputs.

Example: Cobb-Douglas Production Function:

Q = F(K,L) = K.5 L.5
K is fixed at 16 units.
Short run Cobb-Douglass production function:
Q = (16).5 L.5 = 4 L.5
Total Product when 100 units of labor are used?
Q = 4 (100).5 = 4(10) = 40 units

Productivity Measures: Average Product of an Input

Average Product of an Input: measure of output produced per
unit of input.
Average Product of Labor: APL = Q/L.
Measures the output of an average worker.
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average product of labor is AP L = [(16)
0.5(16)0.5]/16 = 1.

Average Product of Capital: APK = Q/K.

Measures the output of an average unit of capital.
Example: Q = F(K,L) = K.5 L.5
If the inputs are K = 16 and L = 16, then the average product of capital is AP K =
[(16)0.5(16)0.5]/16 = 1.

Productivity Measures: Marginal Product of an Input

Marginal Product on an Input: change in total output attributable to the last

unit of an input.

Marginal Product of Labor: MPL = DQ/DL

Measures the output produced by the last worker.
Slope of the short-run production function (with respect to labor).

Marginal Product of Capital: MPK = DQ/DK

Measures the output produced by the last unit of capital.
When capital is allowed to vary in the short run, MPK is the slope of
the production function (with respect to capital).

Increasing, Diminishing and Negative Marginal Returns

Production and Costs

From the Production Function to the Total-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.

Production and Costs

A Production Function and Total Cost: Cookie factory

Production and Costs

Cookie factory Production Function

Total-Cost Curve: Cookie factory

Summary

The goal of firms is to maximize profit, which equals total revenue minus total
cost.

When analyzing a firms behavior, it is important to include all the opportunity

costs of production.

Some opportunity costs are explicit while other opportunity costs are implicit.

A firms costs reflect its production process.

Linear production function: inputs are perfect substitutes.

Leontief production function: inputs are used in fixed proportions.

Cobb-Douglas production function: inputs have a degree of substitutability.

Summary

A typical firms production function gets flatter as the quantity of input

increases, displaying the property of diminishing marginal product.