The Costs of Production
The Costs of Production
Total Revenue, Total Cost, and Profit
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:
Total revenue minus total cost.
Key Terms
Words accompanied by an asterisk (*) are key terms from the chapter.
Opportunity Costs
Opportunity Cost:
The cost of something is what you give up to get it.
Firm’s Cost of Production:
Includes all the opportunity costs of making its output of goods and services.
Explicit and Implicit Costs
Explicit Costs:
Input costs that require an outlay of money by the firm.
Implicit Costs:
Input costs that do not require an outlay of money by the firm.
Total Costs:
Total Costs = Explicit Costs + Implicit Costs.
The Cost of Capital as an Opportunity Cost
The implicit cost of almost every business is the opportunity cost of the money (financial capital) that has been invested in it.
For example, economists view interest income given up as an implicit cost.
Accountants will not show this as a cost because no money flows out of the business to pay for it.
Profit Measurement Differences: Economists vs. Accountants
Economic Profit:
Total revenue minus total cost, including both explicit and implicit costs.
Accounting Profit:
Total revenue minus total explicit cost.
Economic vs. Accounting Profit
Economic profit is typically smaller than accounting profit because economists include all opportunity costs.
Example: Wheeler Dealer Accounts, 2015
Total Revenue: $105,000
Less Explicit Costs:
Assistant's salary: $21,000
Material and equipment: $20,000
Accounting Profit: $64,000
Less Implicit Costs:
Wanda's forgone salary: $50,000
Forgone interest on savings: $1,000
Forgone garage rental: $1,200
Economic Profit: $11,800
Active Learning 1: Profit Calculation
Transfer the effects of an equilibrium rent increase of $500/month on accounting and economic profit in two scenarios:
A. Renting office space
B. Owning office space
The Production Function
Production Function:
The relationship between the quantity of inputs used to make a good and the quantity of output of that good.
Marginal Product:
The increase in output that arises from an additional unit of input.
Diminishing Marginal Product
Diminishing Marginal Product:
The property whereby the marginal product of an input declines as the quantity of the input increases.
Graphically, the production function gets flatter as more inputs are used, and the slope of the production function decreases.
Example: Chloe’s Cookie Factory
Table 1: A Production Function and Total Cost:
Workers
Output (cookies/hour)
Marginal Product of Labor
Cost of Factory
Cost of Workers
Total Cost of Inputs
0
0
-
$30
$0
$30
1
50
50
$30
$10
$40
2
90
40
$30
$20
$50
3
120
30
$30
$30
$60
4
140
20
$30
$40
$70
5
150
10
$30
$50
$80
6
155
5
$30
$60
$90
Production and Total Cost Curves
Figure 2 illustrates:
The production function showing the relationship between the number of workers hired and the quantity of output produced.
The total-cost curve depicting the relationship between the quantity of output and total cost of production.
The total-cost curve becomes steeper due to diminishing marginal product.
The Relationship Between Production Function and Total-Cost Curve
Total-Cost Curve:
The relationship between quantity produced and total costs.
As production rises, the total-cost curve grows steeper, indicating rising costs of production due to diminishing marginal product.
Fixed and Variable Costs
Fixed Costs:
Costs that do not vary with the quantity of output produced.
Variable Costs:
Costs that vary with the quantity of output produced.
Total Cost:
Total Cost = Fixed Costs + Variable Costs.
Example: Caleb’s Coffee Shop
Table 2: The Various Measures of Cost:
Output (cups/hour)
Total Cost
Fixed Cost
Variable Cost
Average Fixed Cost
Average Variable Cost
Average Total Cost
Marginal Cost
0
$3.00
$3.00
$0.00
-
-
-
-
1
$3.30
$3.00
$0.30
$3.00
$0.30
$3.30
$0.30
2
$3.80
$3.00
$0.80
$1.50
$0.40
$1.90
$0.50
3
$4.50
$3.00
$1.50
$1.00
$0.50
$1.50
$0.70
4
$5.40
$3.00
$2.40
$0.75
$0.60
$1.35
$0.90
5
$6.50
$3.00
$3.50
$0.60
$0.70
$1.30
$1.10
6
$7.80
$3.00
$4.80
$0.50
$0.80
$1.30
$1.30
7
$9.30
$3.00
$6.30
$0.43
$0.90
$1.33
$1.50
8
$11.00
$3.00
$8.00
$0.38
$1.00
$1.38
$1.70
9
$12.90
$3.00
$9.90
$0.33
$1.10
$1.43
$1.90
10
$15.00
$3.00
$12.00
$0.30
$1.20
$1.50
$2.10
Average and Marginal Cost
Average Total Cost (ATC):
ATC = Total Cost / Quantity of Output.
Average Fixed Cost (AFC):
AFC = Fixed Cost / Quantity of Output.
Average Variable Cost (AVC):
AVC = Variable Cost / Quantity of Output.
Marginal Cost (MC):
MC = Change in Total Cost / Change in Quantity.
Cost Curves and Their Shapes
Rising Marginal Cost:
Marginal cost rises with the quantity of output produced due to diminishing marginal product.
Common Features of Cost Curves
Marginal cost rises with output.
The average-total-cost curve is U-shaped.
The marginal-cost curve intersects the average-total-cost curve at its minimum.
U-Shaped Average Total Cost
The bottom of the U-shape occurs at the quantity that minimizes average total cost, known as efficient scale.
When Marginal Cost (MC) < Average Total Cost (ATC):
Average total cost is falling.
When Marginal Cost (MC) > Average Total Cost (ATC):
Average total cost is rising.
Typical Cost Curves
Marginal cost eventually increases as the quantity of output rises.
The average-total-cost curve is U-shaped, and the marginal-cost curve intersects it at the lowest point of average total cost.
Example: Cost Curves for a Typical Firm
Many firms experience increasing marginal product before reaching diminishing marginal product, leading to the characteristic shapes of cost curves discussed.
Everyday Application: Cost Calculations
Active Learning 3:
Q
TC
VC
AFC
AVC
ATC
MC
0
$50
n/a
n/a
n/a
n/a
n/a
1
10
$10
$60.00
$10
10.00
2
30
80
3
16.67
20.00
36.67
3
100
150
12.50
37.50
30.00
60
Short-Run vs Long-Run Average Total Cost
Many decisions are fixed in the short run and variable in the long run.
Firms have greater flexibility in the long run.
Long-run cost curves differ from short-run cost curves, typically being much flatter.
Short-run cost curves lie on or above the long-run cost curves.
Figure: Average Total Cost in the Short and Long Runs
The difference arises because fixed costs are variable in the long run, impacting the shape of the average-total-cost curve.
Economies and Diseconomies of Scale
Economies of Scale:
Long-run average total cost falls as the quantity of output increases.
Constant Returns to Scale:
Long-run average total cost stays constant as the quantity of output changes.
Diseconomies of Scale:
Long-run average total cost rises as the quantity of output increases.
Summary of Cost Types
Types of Costs:
Term
Definition
Mathematical Description
Explicit Costs
Costs that require an outlay of money by the firm
-
Implicit Costs
Costs that do not require an outlay of money by the firm
-
Fixed Costs
Costs that do not vary with the quantity of output produced
FC
Variable Costs
Costs that vary with the quantity of output produced
VC
Total Cost
The market value of all the inputs that a firm uses in production
TC = FC + VC
Average Fixed Cost
Fixed cost divided by the quantity of output
AFC = FC/Q
Average Variable Cost
Variable cost divided by the quantity of output
AVC = VC/Q
Average Total Cost
Total cost divided by the quantity of output
ATC = TC/Q
Marginal Cost
The increase in total cost that arises from an extra unit of production
MC = ΔTC/ΔQ
Think-Pair-Share Activity
Scenario: Your neighbor grows fruits and vegetables for market sales with hired help.
A. Explain the production increase when a helper is hired.
B. Forecast if hiring several more helpers will lead to proportional production increases.
Self-Assessment Question
Why is it important to include all opportunity costs when analyzing a firm’s behavior?