Chapter 3

Production and
Costs

Leaning Objective
1.
2.
3.
4.

Cost concepts
Short run production
Short run cost
Economies of scale

THE COSTS OF
PRODUCTION
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.

THE COSTS OF
PRODUCTION
According to the Law of Supply:
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.

1. Cost concept
Total Revenue
The amount a firm receives for the sale of
its output.

Total Cost
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

Explicit and Implicit 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.

Implicit Costs Illustration

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.

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.

Economic Profit versus

Accounting Profit
Accounting profit = TR total explicit costs

Economic profit = TR (explicit

costs + implicit costs)

Figure 1: Economists versus

Accountants
How an
Accountan
t Views a
Firm

How an
Economist
Views a
Firm

Economic
profit
Accounting
profit
Revenue

Implicit costs

Explicit costs

Revenue

Total
Opportunity
Costs

Explicit costs

Normal Profit
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.

Time Horizon:
The Short Run and the Long Run
Long-runinvolves a time horizon long
enough for a firm to vary all of its inputs
Short-runinvolves any time horizon
over which at least one of the firms
inputs cannot be varied

2. Short run production

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: Factory, Machines

Variable input

An input whose usage can change as the

level of output changes
For example: Labor, Raw material

Production in the Short Run

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

Figure 3: Total and Marginal

Product
Units of Output
Total Product

196
184
161

Q from hiring fourth worker

130

Q from hiring third worker

90
Q from hiring second worker
30

Q from hiring first worker

1

increasin
g
marginal
returns

diminishing
marginal
returns

Number of Workers

The Law of Diminishing

Returns
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
As more and more workers are hired
MP first increases
Then decreases

Increasing Marginal Returns to

Labor
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

Diminishing Marginal Returns

To Labor
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

3. Short run cost

Fixed costs
Costs of a firms fixed inputs
Variable costs
Costs of obtaining the firms
variable inputs

Short-Run Costs Formulas

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

Figure 4: The Firms Total Cost

Curves In The Short Run
Dollars
TC

$435
375

TVC

TFC

315
255
195
135
TFC
0

30

90

130

161

184 196

Units of Output

Average Costs
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
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

Figure 5: Average And Marginal

Costs In The Short Run
Dollars

MC

$4

3
AFC

ATC
AVC

1
AFC
0

30

90

130

161
196
Units of Output

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.
The marginal-cost curve crosses the averagetotal-cost curve at the efficient scale.
scale
Efficient scale is the quantity that minimizes
average total cost.

Different Scale of Production

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

Figure 8: The Shape Of

LRATC
Dollars
$4.00
3.00
LRATC

2.00
1.00
130

0
Economies of Scale

184

Constant
Returns to
Scale

Diseconomies of Scale
Units of Output

4. Economies of scale
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

Why Would A Firm Experience The

Economies of 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

Constant Return to Scale

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

Diseconomies of 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

Why Would A Firm Experience The

Diseconomies of Scale?
As a firm become large beyond
some level
~increasing bureaucratic
and red tape
~management coordination
problems
~out of control situations