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C H A P T E R
The Costs of Production
EconomicsP R I N C I P L E S O F
N. Gregory Mankiw
Premium PowerPoint Slides by Ron Cronovich
13
You run General Motors. List 3 different costs you have. List 3 different
business decisions that are affected by your costs.
A C T I V E L E A R N I N G 1 Brainstorming costs
2
THE COSTS OF PRODUCTION 3
Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize profit.
Profit = Total revenue – Total cost
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production
THE COSTS OF PRODUCTION 4
The Production Function A production function shows the relationship
between the quantity of inputs used to produce a good and the quantity of output of that good.
It can be represented by a table, equation, or graph.
Example 1: Farmer Jack grows wheat. He has 5 acres of land. He can hire as many workers as he wants.
THE COSTS OF PRODUCTION 5
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qua
ntity
of o
utpu
t
Example 1: Farmer Jack’s Production Function
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
THE COSTS OF PRODUCTION 6
Marginal Product If Jack hires one more worker, his output rises
by the marginal product of labor. The marginal product of any input is the
increase in output arising from an additional unit of that input, holding all other inputs constant.
Notation: ∆ (delta) = “change in…”Examples: ∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) = ∆Q∆L
THE COSTS OF PRODUCTION 7
30005
28004
24003
18002
10001
00
Q (bushels of wheat)
L(no. of
workers)
EXAMPLE 1: Total & Marginal Product
200
400
600
800
1000
MPL
∆Q = 1000∆L = 1
∆Q = 800∆L = 1
∆Q = 600∆L = 1
∆Q = 400∆L = 1
∆Q = 200∆L = 1
THE COSTS OF PRODUCTION 8
MPL equals the slope of the production function.
Notice that MPL diminishes as L increases.
This explains why the production function gets flatter as L increases.
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qua
ntity
of o
utpu
t
EXAMPLE 1: MPL = Slope of Prod Function
30005200
28004400
24003600
18002800
100011000
00
MPLQ
(bushels of wheat)
L(no. of
workers)
THE COSTS OF PRODUCTION 9
Why MPL Is Important Recall one of the Ten Principles:
Rational people think at the margin. When Farmer Jack hires an extra worker,
his costs rise by the wage he pays the worker his output rises by MPL
Comparing them helps Jack decide whether he would benefit from hiring the worker.
THE COSTS OF PRODUCTION 10
Why MPL Diminishes Farmer Jack’s output rises by a smaller and
smaller amount for each additional worker. Why? As Jack adds workers, the average worker has
less land to work with and will be less productive. In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment, machines, etc.).
Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal)
THE COSTS OF PRODUCTION 11
Average Product of Labor Average product is calculated by dividing the
total product produced by the total number or workers.
APP = TP/TL For Farmer Jack, when he has three workers on
the farm, his APP= 2400/3, or 800 bushels per worker.
But that doesn’t mean he’ll get 800 bushels when he hires the fourth worker. He’ll get 400 bushels.
THE COSTS OF PRODUCTION 12
EXAMPLE 1: Farmer Jack’s Costs Farmer Jack must pay $1000 per month for the
land, regardless of how much wheat he grows. The market wage for a farm worker is $2000 per
month. So Farmer Jack’s costs are related to how much
wheat he produces….
THE COSTS OF PRODUCTION 13
EXAMPLE 1: Farmer Jack’s Costs
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
30005
28004
24003
18002
10001
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$1,000
$1,000
$1,000
$1,000
$1,000
$1,00000
Cost of labor
Cost of land
Q(bushels of wheat)
L(no. of
workers)
THE COSTS OF PRODUCTION 14
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q (bushels of wheat)
Total Cost
0 $1,000
1000 $3,000
1800 $5,000
2400 $7,000
2800 $9,000
3000 $11,000
$0
$2,000
$4,000
$6,000
$8,000
$10,000
$12,000
0 1000 2000 3000Quantity of wheat
Tota
l cos
t
THE COSTS OF PRODUCTION 15
Marginal Cost Marginal Cost (MC)
is the increase in Total Cost from producing one more unit:
∆TC∆QMC =
THE COSTS OF PRODUCTION 16
EXAMPLE 1: Total and Marginal Cost
$10.00
$5.00
$3.33
$2.50
$2.00
Marginal Cost (MC)
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total Cost
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
∆Q = 1000 ∆TC = $2000
∆Q = 800 ∆TC = $2000
∆Q = 600 ∆TC = $2000
∆Q = 400 ∆TC = $2000
∆Q = 200 ∆TC = $2000
THE COSTS OF PRODUCTION 17
MC usually rises as Q rises, as in this example.
EXAMPLE 1: The Marginal Cost Curve
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
TC
$10.00
$5.00
$3.33
$2.50
$2.00
MC
3000
2800
2400
1800
1000
0
Q(bushels of wheat)
$0
$2
$4
$6
$8
$10
$12
0 1,000 2,000 3,000Q
Mar
gina
l Cos
t ($)
THE COSTS OF PRODUCTION 18
$0
$2
$4
$6
$8
$10
$12
0 1,000 2,000 3,000Q
Mar
gina
l Cos
t ($)
THE COSTS OF PRODUCTION 19
Why MC Is Important Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce more or less wheat?
To find the answer, Farmer Jack needs to “think at the margin.”
If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then Jack’s profits rise if he produces more.
THE COSTS OF PRODUCTION 20
Revenue and Profit Revenue
TR = P x Q
Profit TR – TC, or P*Q – TC
As more output is sold (at a constant price), TR increases, but so does TC (at a different rate!)
The goal is to find the level of output where profit is maximized.
THE COSTS OF PRODUCTION
Max’s Lemonade Stand ($2 a cup)
OutputIn Cups
Total Revenue(P*Q)
Total Cost$
Profit$
0 0 1.00 -$1.00
1 2 1.25
2 1.75
3 2.50
4 3.50
5 4.75
6 6.25
7 8.00
8 10.00
9 12.25
10 14.75
Find the total number of cups Max should sell to make the most profit
21.
THE COSTS OF PRODUCTION 22
Do Now Get a book – sharing P. 286, #7
THE COSTS OF PRODUCTION 23
Fixed and Variable Costs Fixed costs (FC) do not vary with the quantity of
output produced. For Farmer Jack, FC = $1000 for his land Other examples:
cost of equipment, loan payments, rent Variable costs (VC) vary with the quantity
produced. For Farmer Jack, VC = wages he pays workers Other example: cost of materials
Total cost (TC) = FC + VC
THE COSTS OF PRODUCTION 24
EXAMPLE 2 Our second example is more general,
applies to any type of firm producing any good with any types of inputs.
THE COSTS OF PRODUCTION 25
EXAMPLE 2: Costs
7
6
5
4
3
2
1
620
480
380
310
260
220
170
$100
520
380
280
210
160
120
70
$0
100
100
100
100
100
100
100
$1000
TCVCFCQ
$0
$100
$200
$300
$400
$500
$600
$700
$800
0 1 2 3 4 5 6 7
Q
Cos
ts
FCVCTC
THE COSTS OF PRODUCTION 26
Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.)
EXAMPLE 2: Marginal Cost
6207
4806
3805
3104
2603
2202
1701
$1000
MCTCQ
140
100
70
50
40
50
$70∆TC∆QMC =
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7Q
Cos
ts
THE COSTS OF PRODUCTION 27
EXAMPLE 2: Average Fixed Cost
1007
1006
1005
1004
1003
1002
1001
14.29
16.67
20
25
33.33
50
$100
n/a$1000
AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output:
AFC = FC/Q
Notice that AFC falls as Q rises: The firm is spreading its fixed costs over a larger and larger number of units.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7Q
Cos
ts
THE COSTS OF PRODUCTION 28
EXAMPLE 2: Average Variable Cost
5207
3806
2805
2104
1603
1202
701
74.29
63.33
56.00
52.50
53.33
60
$70
n/a$00
AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:
AVC = VC/Q
As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7Q
Cos
ts
THE COSTS OF PRODUCTION 29
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
74.2914.29
63.3316.67
56.0020
52.5025
53.3333.33
6050
$70$100
n/an/a
AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output:
ATC = TC/Q
Also,
ATC = AFC + AVC
THE COSTS OF PRODUCTION 30
Usually, as in this example, the ATC curve is U-shaped.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cos
ts
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
6207
4806
3805
3104
2603
2202
1701
$1000
TCQ
THE COSTS OF PRODUCTION 31
EXAMPLE 2: The Various Cost Curves Together
AFCAVCATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cos
ts
A C T I V E L E A R N I N G 3 Calculating costs
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Fill in the blank spaces of this table.
210
150
100
30
10
VC
43.33358.332606
305
37.5012.501504
36.672016.673
802
$60.00$101
n/an/an/a$500
MCATCAVCAFCTCQ
60
30
$10
A C T I V E L E A R N I N G 3 Answers
33
Use AFC = FC/QUse AVC = VC/QUse relationship between MC and TCUse ATC = TC/QFirst, deduce FC = $50 and use FC + VC = TC.
210
150
100
60
30
10
$0
VC
43.33358.332606
40.003010.002005
37.502512.501504
36.672016.671103
40.001525.00802
$60.00$10$50.00601
n/an/an/a$500
MCATCAVCAFCTCQ
60
50
40
30
20
$10
THE COSTS OF PRODUCTION 34
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cos
ts
EXAMPLE 2: Why ATC Is Usually U-ShapedAs Q rises:
Initially, falling AFC pulls ATC down.
Eventually, rising AVC pulls ATC up.
Efficient scale:The quantity that minimizes ATC.
THE COSTS OF PRODUCTION 35
EXAMPLE 2: ATC and MCATCMC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Cos
ts
When MC < ATC,ATC is falling.
When MC > ATC,ATC is rising.
The MC curve crosses the ATC curve at the ATC curve’s minimum.
THE COSTS OF PRODUCTION 36
Costs in the Short Run & Long Run
Short run: The short run isn’t a specific time period
Some inputs are fixed (e.g., factories, land). The costs of these inputs are FC. Once you sign a lease you can’t get out of it for
several years.
THE COSTS OF PRODUCTION 37
Costs in the Short Run & Long Run
• Long run: All inputs are variable After a few years you can expand your space or lease a smaller one
• 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).
THE COSTS OF PRODUCTION 38
EXAMPLE 3: LRATC with 3 factory Sizes
ATCS ATCM ATCL
Q
AvgTotalCost
Firm can choose from 3 factory sizes: S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run.
THE COSTS OF PRODUCTION 39
EXAMPLE 3: LRATC with 3 factory Sizes
ATCS ATCM ATCL
Q
AvgTotalCost
QA QB
LRATC
To produce less than QA, firm will choose size S in the long run. To produce between QA and QB, firm will choose size M in the long run. To produce more than QB, firm will choose size L in the long run.
THE COSTS OF PRODUCTION 40
A Typical LRATC Curve
Q
ATCIn the real world, factories come in many sizes, each with its own SRATC curve.
So a typical LRATC curve looks like this:
LRATC
THE COSTS OF PRODUCTION 41
How ATC Changes as the Scale of Production Changes
Economies of scale: ATC falls as Q increases.
Constant returns to scale: ATC stays the same as Q increases.
Diseconomies of scale: ATC rises as Q increases.
LRATC
Q
ATC
THE COSTS OF PRODUCTION 42
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.
THE COSTS OF PRODUCTION 43
Costs: Explicit vs. Implicit Explicit costs require an outlay of money,
e.g., paying wages to workers. Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time. Remember one of the Ten Principles:
The cost of something is what you give up to get it.
This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
THE COSTS OF PRODUCTION 44
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest rate is 5%.
Case A: borrow $100,000 explicit cost = $5000 interest on bank loan
Case B: use $100,000 of your savings explicit cost = $0 No loan, no interest paid to
bank implicit cost = $5000 (5%) foregone interest you
could have earned on your $100,000.
In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION 45
Economic Profit vs. Accounting Profit
Your revenues for Year 1 are $103,000 Accounting profit = total revenue minus total
explicit costs In Case A, your accountant reports a profit!
Economic profit = total revenue minus total costs (including explicit and implicit costs) In Case B, your economist reports a loss!
WHY??
THE COSTS OF PRODUCTION 46
Accountants ignore opportunity costs
Accounting profit ignores implicit costs, so it’s higher than economic profit.
Accountant EconomistRevenue $103,000 $103,000
Labor and Materials (explicit)
-95,000 -95,000
Interest on Bank Loan (explicit)
-5,000 0
Foregone Interest (implicit)
-5,000
Foregone Salary (implicit)
-75,000
Profit $3,000 -$72,000
The equilibrium rent on office space has just increased by $500/month.
Compare the effects on accounting profit and economic profit if
a. you rent your office spaceb. you own your office space
A C T I V E L E A R N I N G 2 Economic profit vs. accounting profit
47
The rent on office space increases $500/month. a. You rent your office space.
Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.
b.You own your office space.Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month.
A C T I V E L E A R N I N G 2 Answers
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THE COSTS OF PRODUCTION 49
CONCLUSION Costs are critically important to many business
decisions, including production, pricing, and hiring.
This chapter has introduced the various cost concepts.
The following chapters will show how firms use these concepts to maximize profits in various market structures.
CHAPTER SUMMARY
Implicit costs do not involve a cash outlay, yet are just as important as explicit costs to firms’ decisions.
Accounting profit is revenue minus explicit costs. Economic profit is revenue minus total (explicit + implicit) costs.
The production function shows the relationship between output and inputs.
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CHAPTER SUMMARY
The marginal product of labor is the increase in output from a one-unit increase in labor, holding other inputs constant. The marginal products of other inputs are defined similarly.
Marginal product usually diminishes as the input increases. Thus, as output rises, the production function becomes flatter, and the total cost curve becomes steeper.
Variable costs vary with output; fixed costs do not.
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CHAPTER SUMMARY
Marginal cost is the increase in total cost from an extra unit of production. The MC curve is usually upward-sloping.
Average variable cost is variable cost divided by output.
Average fixed cost is fixed cost divided by output. AFC always falls as output increases.
Average total cost (sometimes called “cost per unit”) is total cost divided by the quantity of output. The ATC curve is usually U-shaped.
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CHAPTER SUMMARY
The MC curve intersects the ATC curve at minimum average total cost. When MC < ATC, ATC falls as Q rises. When MC > ATC, ATC rises as Q rises.
In the long run, all costs are variable. Economies of scale: ATC falls as Q rises.
Diseconomies of scale: ATC rises as Q rises. Constant returns to scale: ATC remains constant as Q rises.
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