The Costs of Production

1
The Costs of Production

• The Law of Supply
• Firms are willing to produce and sell a greater
  quantity of a good when the price of a good is
  high, due to typical productivity and cost
  behaviour.

Supply
2
Total Revenue, Total Cost, Profit

• We assume that the firms goal is to maximize
  profit.
• Profit Total revenue Total cost
• TR-the amount a firm receives from the sale of
  its output
• TC-the market value of the inputs a firm uses in
  production

3
Costs as Opportunity Costs

• The firms costs include Explicit Costs and
  Implicit Costs
• Explicit Costs costs that involve a direct
  money outlay for factors of production.
• Implicit Costs costs that do not involve a
  direct money outlay (e.g. opportunity costs of
  the owners own inputs used - implicit wages,
  implicit rent, cost of capital).

4
Costs as Opportunity Costs

• Accountants measure the explicit costs but often
  ignore the implicit costs.
• Economists include all opportunity costs when
  measuring costs.
• Accounting Profit TR - Explicit Costs
• Economic Profit TR - Explicit Costs - Implicit
  Costs

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, total (exp imp) costs are 5000.

6
Marginal Product

• The marginal product of any input is the increase
  in output 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 marginal product of labour.
• Notation ? (delta) change in
• Examples ?Q change in output, ?L change in
  labour
• Marginal product of labour (MPL) delta Q/delta
  L

7
Why MPL Diminishes

• Diminishing marginal product the marginal
  product of an input declines as the quantity of
  the input increases (other things equal)
• E.g., Farmer Jacks output rises by a smaller
  and smaller amount for each additional worker.
  Why?
• If Jack increases workers but not land, the
  average worker has less land to work with, so
  will be less productive.
• In general, MPL diminishes as L rises whether
  the fixed input is land or capital (equipment,
  machines, etc.).

8
Short-Run vs. Long-Run

• Two different time horizons are important when
  analyzing costs.
• Short-Run Time period over which some inputs are
  variable (labour, materials) and some inputs are
  fixed (plant size).
• Long-Run Time period over which all inputs are
  variable, including plant size.

9
Short-Run Costs

• Costs of production may be divided into two
  categories in the short-run
• Fixed Costs
• Those costs that do not vary with the amount of
  output produced.
• Variable Costs
• Those costs that do vary with the amount of
  output produced.

10
Marginal Cost

• Marginal Cost (MC) is the increase in Total Cost
  from producing one more unit
• MC delta TC/delta Q

11
The Shape of Short-Run Cost Curves

• Short-run cost behaviour is based on the
  productivity of the inputs (resources).
• As the firm continues to expand output,in a
  fixed plant-size situation, eventuallythe
  marginal product of each successive worker hired
  will decrease.
• The diminishing marginal product causesthe
  marginal cost to increase in the short-run. This
  in turn affects the behaviour of average total
  cost.

12
The Shape of Typical Cost Curves

• U-Shaped Average Total Cost (ATC)
• At low levels of output, as the firm expands
  production, ATC declines.
• At higher production levels, as output is
  increased, ATC increases.
• The bottom of the U-Shape occurs at the quantity
  that minimizes average total cost.
• This is called the Efficient Size of the firm.

13
The Relationship Between Marginal Cost and
Average Total Cost

• Why is ATC U - shaped?
• When marginal cost is less than average total
  cost, average total cost is falling.
• MC lt ATC ATC
• When marginal cost is greater than average total
  cost, average total cost is rising.
• MC gt ATC ATC

14
The Relationship Between Marginal Cost and
Average Total Cost
MC
ATC
Cost (s)
The marginal cost curve always crosses the
average total cost curve at the minimum average
total cost!
Quantity
15
Costs in the Short Run Long Run

• Short run Some inputs are fixed (e.g.,
  factories, land). The costs of these inputs are
  FC.
• Long run All inputs are variable (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).

16
Long-Run Costs
Per Unit
LRATC Curve
Disecon. of Scale
Econ. of Scale
Constant Returns to Scale
Scale of Operation (Q)
17
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, cant control
  costs.
• More common when Q is high.
• Constant returns to scale if more output neither
  increases or decreases cost. (flat portion of
  LRATC)