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C H A P T E R
The Costs of Production
Economics P R I N C I P L E S O F
N. Gregory Mankiw
Premium PowerPoint Slides
by Vance Ginn & Ron Cronovich
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
1
In this chapter,
look for the answers to these questions:
What is a production function? What is marginal
product? How are they related?
What are the various costs, and how are they
related to each other and to output?
How are costs different in the short run vs.
the long run?
What are “economies of scale”?
2
THE COSTS OF PRODUCTION 3
Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize
profit. The Price System: Profits (video)
_______________________________
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
Costs: Explicit vs. Implicit
________________ require an outlay of money,
e.g., paying wages to workers.
________________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 5
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, _____________________________.
THE COSTS OF PRODUCTION 6
Economic Profit vs. Accounting Profit
_________________________________
= total revenue minus total explicit costs
_________________________________
= total revenue minus total costs (including
explicit and implicit costs)
Accounting profit ignores implicit costs,
so it’s higher than economic profit.
__________________
Economists versus accountants
1
7
Economists include all opportunity costs when analyzing a firm, whereas
accountants measure only explicit costs. Therefore, economic profit is smaller
than accounting profit
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 space
b. 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
8
The rent on office space increases $500/month.
a. You rent your office space.
Explicit costs increase $_________________.
Accounting profit & economic profit each fall
$____________________.
b. You own your office space.
Explicit costs _________________________,
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
9
THE COSTS OF PRODUCTION 10
The Production Function
A production function shows the relationship
between the
_______________________________________
______________________________________.
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 11
0
500
1,000
1,500
2,000
2,500
3,000
0 1 2 3 4 5
No. of workers
Qu
an
tity
of
ou
tpu
t
Example 1: Farmer Jack’s Production Function
3000 5
2800 4
2400 3
1800 2
1000 1
0 0
Q
(bushels
of wheat)
L
(no. of
workers)
THE COSTS OF PRODUCTION 12
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:
____________________________
Examples:
∆Q = change in output, ∆L = change in labor
Marginal product of labor (MPL) = ∆Q
∆L
THE COSTS OF PRODUCTION 13
3000 5
2800 4
2400 3
1800 2
1000 1
0 0
Q
(bushels
of wheat)
L
(no. of
workers)
EXAMPLE 1: Total & Marginal Product
200
400
____
____
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 14
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
Q
uan
tity
of
ou
tpu
t
EXAMPLE 1: MPL = Slope of Prod Function
3000 5 200
2800 4 400
2400 3 600
1800 2 800
1000 1 1000
0 0
MPL Q
(bushels
of wheat)
L
(no. of
workers)
THE COSTS OF PRODUCTION 15
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 16
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, ______________________________
whether the fixed input is land or capital
(equipment, machines, etc.).
_______________________________________:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
THE COSTS OF PRODUCTION 17
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 18
EXAMPLE 1: Farmer Jack’s Costs
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total
Cost
3000 5
2800 4
2400 3
1800 2
1000 1
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000 0 0
Cost of
labor
Cost of
land
Q
(bushels
of wheat)
L
(no. of
workers)
THE COSTS OF PRODUCTION 19
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 3000
Quantity of wheat
To
tal co
st
THE COSTS OF PRODUCTION 20
Marginal Cost
Marginal Cost (MC)
is the increase in Total Cost from
producing _______________________:
∆TC
∆Q MC =
THE COSTS OF PRODUCTION 21
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 22
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
$12
0 1,000 2,000 3,000
Q
Marg
inal
Co
st
($)
THE COSTS OF PRODUCTION 23
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.” -video
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 24
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
_____________________________
THE COSTS OF PRODUCTION 25
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 26
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
$100 0
TC VC FC Q
$0
$100
$200
$300
$400
$500
$600
$700
$800
0 1 2 3 4 5 6 7
Q
Co
sts
FC
VC
TC
THE COSTS OF PRODUCTION 27
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
620 7
480 6
380 5
310 4
260 3
220 2
170 1
$100 0
MC TC Q
140
100
70
50
40
50
$70
∆TC
∆Q MC =
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
THE COSTS OF PRODUCTION 28
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
620 7
480 6
380 5
310 4
260 3
220 2
170 1
$100 0
74.29 14.29
63.33 16.67
56.00 20
52.50 25
53.33 33.33
60 50
$70 $100
n/a n/a
AVC AFC TC Q Average total cost
(ATC) equals total
cost divided by the
quantity of output:
______________
Also,
ATC = AFC + AVC
__________________
THE COSTS OF PRODUCTION 29
EXAMPLE 2: Average Fixed Cost
100 7
100 6
100 5
100 4
100 3
100 2
100 1
14.29
16.67
20
25
33.33
50
$100
n/a $100 0
AFC FC Q 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 7
Q
Co
sts
THE COSTS OF PRODUCTION 30
EXAMPLE 2: Average Variable Cost
520 7
380 6
280 5
210 4
160 3
120 2
70 1
74.29
63.33
56.00
52.50
53.33
60
$70
n/a $0 0
AVC VC Q 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 7
Q
Co
sts
THE COSTS OF PRODUCTION 31
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
Co
sts
EXAMPLE 2: Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
620 7
480 6
380 5
310 4
260 3
220 2
170 1
$100 0
TC Q
THE COSTS OF PRODUCTION 32
EXAMPLE 2: The Various Cost Curves Together
AFC
AVC
ATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
A C T I V E L E A R N I N G 3
Calculating costs
33
Fill in the blank spaces of this table.
210
150
100
30
10
VC
43.33 35 8.33 260 6
30 5
37.50 12.50 150 4
36.67 20 16.67 3
80 2
$60.00 $10 1
n/a n/a n/a $50 0
MC ATC AVC AFC TC Q
60
30
$10
A C T I V E L E A R N I N G 3
Answers
34
Use AFC = FC/Q Use AVC = VC/Q Use relationship between MC and TC Use ATC = TC/Q First, deduce FC = $50 and use FC + VC = TC.
210
150
100
30
10
VC
43.33 35 8.33 260 6
30 5
37.50 12.50 150 4
36.67 20 16.67 3
80 2
$60.00 $10 1
n/a n/a n/a $50 0
MC ATC AVC AFC TC Q
60
30
$10
THE COSTS OF PRODUCTION 35
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
EXAMPLE 2: Why ATC Is Usually U-Shaped
As Q rises:
Initially,
falling AFC
pulls ATC down.
Eventually,
rising AVC
pulls ATC up.
______________:
The quantity that
minimizes ATC.
THE COSTS OF PRODUCTION 36
EXAMPLE 2: ATC and MC
ATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0 1 2 3 4 5 6 7
Q
Co
sts
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 37
Costs in the Short Run & Long Run
Short run:
Some _________________(e.g., factories, land).
The costs of these inputs are FC.
Long run:
All inputs ______________________
(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).
THE COSTS OF PRODUCTION 38
EXAMPLE 3: LRATC with 3 factory Sizes
ATCS ATCM
ATCL
Q
Avg
Total
Cost
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
Avg
Total
Cost
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
ATC In 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.
_______________
_____________:
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.
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.
43
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.
44
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. 45
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.
46