Principles of Economics

Ohio Wesleyan UniversityGoran Skosples

8. The Costs of Production

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A C T I V E L E A R N I N G 1: BrainstormingA C T I V E L E A R N I N G 1: Brainstorming

You run General Motors.

List 3 different costs you have.

List 3 different business decisions that are affected by your costs.

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3

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”?

LEARNING OBJECTIVES

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Total Revenue, Total Cost, Profit

We assume that the firm’s goal is to _________ ________.

Profit = Total revenue – Total cost

the amount a firm ______ from the sale of its output

the market value of the inputs a firm ______ in production

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Costs: Explicit vs. Implicit

Explicit costs – ________ an outlay of money,

Implicit costs – _____________ a cash outlay,

The cost of something is what you ______________.

This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.

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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 =

Case 2: use $40,000 of your savings, borrow the other $60,000• explicit cost =• implicit cost =

In both cases, total (exp + imp) costs are ______.

$_______ interest on loan

$______ (5%) interest on the loan

$______ (5%) foregone interest you could have earned on your $40,000

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Economic Profit vs. Accounting Profit

Accounting profit

= total revenue minus total explicit costs

Economic profit

= total revenue minus total costs (including explicit and implicit costs)

Accounting profit ignores ___________ costs, so it’s higher than economic profit.

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A C T I V E L E A R N I N G 2: Economic profit vs. accounting profitA C T I V E L E A R N I N G 2: Economic profit vs. accounting profit

Darcy runs a local coffee shop “Coffee Shaq.” Her annual revenue is $100,000, her costs of coffee beans, milk, electricity, and labor she hires are $55,000. She owns the property where the coffee shop is located, so she does not have to pay rent, which would otherwise be $12,000 per year.

Last week, Darcy was recently approached by the head-hunter who offered her a job for $35,000 a year.

What should Darcy do?8

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A C T I V E L E A R N I N G 2: AnswersA C T I V E L E A R N I N G 2: Answers Profit at Darcy’s “Coffee Shaq”

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Revenue

Explicit cost

Accounting profit

Implicit cost of business

Foregone rent

Foregone income

Economic profit

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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 _____, _________, or ______.

Example 1:• Farmer Jack grows wheat. • He has 5 acres of land. • He can hire as many workers as he wants.

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0

500

1,000

1,500

2,000

2,500

3,000

0 1 2 3 4 5

No. of workers

Qu

anti

ty o

f o

utp

ut

Example 1: Farmer Jack’s Production Function

30005

28004

24003

18002

10001

00

Q (bushels of wheat)

L(no. of

workers)

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Marginal Product The marginal product of any input is the

_______________ 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 ____________________.

Notation: ∆ (delta) = “change in…”

Examples: ∆Q = change in output, ∆L = change in labor

Marginal product of labor (MPL) =

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30005

28004

24003

18002

10001

00

Q (bushels of wheat)

L(no. of

workers)

EXAMPLE 1: Total & Marginal Product

MPL

∆Q = 1000∆L = 1

∆Q = 800∆L = 1

∆Q = 600∆L = 1

∆Q = 400∆L = 1

∆Q = 200∆L = 1

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MPL equals the _______ of the production function.

Notice that MPL ____________ as L increases.

This explains why the production function gets flatter as L increases.

EXAMPLE 1: MPL = Slope of Prod Function

30005200

28004400

24003600

18002800

100011000

00

MPLQ

(bushels of wheat)

L(no. of

workers)

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When Farmer Jack hires an extra worker, • •

Diminishing marginal product: the marginal product of an input declines as the quantity of the input increases (other things equal). Why?• If Jack increases workers but not land, the

average worker has less land to work with, so will be ______________.

• In general, MPL _________ as L rises whether the fixed input is land or capital (equipment, machines, etc.).

Marginal Product

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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….

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EXAMPLE 1: Farmer Jack’s Costs

Total Cost

30005

28004

24003

18002

10001

00

cost of labor

cost of land

Q(bushels of wheat)

L(no. of

workers)

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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 1000 2000 3000$0

$2,000

$4,000

$6,000

$8,000

$10,000

$12,000

Quantity of wheat

To

tal c

os

t

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Marginal Cost

Marginal Cost (MC) is the increase in Total Cost from producing one more unit:

∆TC∆Q

MC =

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EXAMPLE 1: Total and Marginal Cost

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

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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 1,000 2,000 3,000 $0

$2

$4

$6

$8

$10

$12

Q

Mar

gin

al C

ost

($)

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Why MC Is Important Farmer Jack is rational and wants to maximize

his profit. To increase profit, should he produce more wheat, or less?

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 if ________ he produces more.

(In the next chapter, we will learn more about how firms choose Q to maximize their profits.)

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Fixed and Variable Costs

Fixed costs (FC) – __________ with the quantity of output produced. • For Farmer Jack, FC = • Other examples:

Variable costs (VC) – _______ with the quantity produced. • For Farmer Jack, VC =• Other example:

Total cost (TC) =

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EXAMPLE 2

Our second example is more general, applies to any type of firm, producing any good with any types of inputs.

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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

Co

sts

FC

VC

TC

Our second example is more general, applies to any type of firm,

producing any good with any types of inputs.

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Recall, Marginal Cost (MC) is the change in total cost from producing one more unit:

Usually, MC rises as Q rises, due to diminishing _______________.

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

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0 1 2 3 4 5 6 7$0

$25

$50

$75

$100

$125

$150

$175

$200

Q

Co

sts

EXAMPLE 2: Marginal Cost

6207

4806

3805

3104

2603

2202

1701

$1000

MCTCQ

140

100

70

50

40

50

$70

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EXAMPLE 2: Average Fixed Cost

1007

1006

1005

1004

1003

1002

1001

$1000

AFCFCQ Average fixed cost (AFC) is fixed cost divided by the quantity of output:

Notice that AFC ___ as Q rises:

The firm is

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0 1 2 3 4 5 6 7$0

$25

$50

$75

$100

$125

$150

$175

$200

Q

Co

sts

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

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EXAMPLE 2: Average Variable Cost

5207

3806

2805

2104

1603

1202

701

$00

AVCVCQ Average variable cost (AVC) is variable cost divided by the quantity of output:

As Q rises, AVC may fall initially. In most cases, AVC will eventually rise as output rises.

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0 1 2 3 4 5 6 7$0

$25

$50

$75

$100

$125

$150

$175

$200

Q

Co

sts

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

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EXAMPLE 2: Average Total Cost

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.a.n.a.

AVCAFCTCQ Average total cost (ATC) equals total cost divided by the quantity of output:

ATC =

Also,

ATC =

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$0

$25

$50

$75

$100

$125

$150

$175

$200

0 1 2 3 4 5 6 7

Q

Co

sts

Usually, as in this example, the ATC curve is ________.

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

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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

Co

sts

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A C T I V E L E A R N I N G 3: CostsA C T I V E L E A R N I N G 3: Costs

Fill in the blank spaces of this table.

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210

150

100

30

10

VC

43.33358.332606

305

37.5012.501504

36.672016.673

802

$60.00$101

n.a.n.a.n.a.$500

MCATCAVCAFCTCQ

60

30

$10

36

$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-ShapedAs Q rises:

Initially, falling AFC

Eventually, rising AVC

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EXAMPLE 2: ATC and MC

ATCMC

$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 _______.

When MC > ATC,

ATC is _______.

The MC curve crosses the ATC curve at the ___________ ___________.

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Costs in the Short Run & Long Run

Short run: Some inputs are ________ (e.g., factories, land).

The costs of these inputs are FC.

Long run: All inputs are ___________

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).

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EXAMPLE 3: LRATC with 3 factory Sizes

Q

AvgTotalCost

Firm can choose from 3 factory sizes: ________

Each size has its own SRATC curve.

The firm can change to a different factory size in the _____ ___, but not in the ________.

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EXAMPLE 3: LRATC with 3 factory Sizes

ATCSATCM ATCL

Q

AvgTotalCost

QA QB

To produce less than QA, firm will

choose size ___in the long run.

To produce between QA

and QB, firm will

choose size ___ in the long run.

To produce more than QB, firm will

choose size ___ in the long run.

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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:

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How ATC Changes As the Scale of Production Changes

Economies of scale: ATC ____as Q increases.

Constant returns to scale: ATC _______________

as Q increases.

Diseconomies of scale: ATC _____ as Q increases.

LRATC

Q

ATC

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How ATC Changes As the Scale of Production Changes

Economies of scale occur when increasing production allows greater _____________: workers more efficient when focusing on a narrow task.• More common when Q is ______.

Diseconomies of scale are due to coordination problems in large organizations.

• More common when Q is _______.

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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.

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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.

CHAPTER SUMMARY

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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.

CHAPTER SUMMARY

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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.

CHAPTER SUMMARY

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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.

CHAPTER SUMMARY