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1 The Costs of Production PowerPoint Slides prepared by: Andreea CHIRITESCU Eastern Illinois University 1 What are Costs? Total revenue = amount a firm receives for the sale of its output Total cost = market value of the inputs a firm uses in production Profit = total revenue total cost Costs (as opportunity costs) = the cost of something is what you give up to get it Firm s (total) cost of production = include all the opportunity costs of making its output of goods and services = explicit costs + implicit costs 2 1

2 What are Costs? Explicit costs = input costs that require an outlay of money by the firm (e.g., wages, costs of raw materials; interest on a loan; e.g., to operate your business you borrowed \$50,000 from a bank at a yearly interest rate of 3 %; then the Loan, not from savings interest (cost) = (0.03)(\$50,000) = \$1,500 is an explicit cost Implicit costs = input costs that do not require an outlay of money by the firm (this cost is ignored by accountants); e.g., foregone salary/income; for an engineer who could have earned a salary of 80,000 pesos/month but decided to start and run a business instead (the given up or foregone salary of 80,000 pesos/month is an implicit cost of running a business); e.g., foregone interest income (see next page); 3 What are Costs? The cost of (financial) capital as an opportunity cost: It s an implicit cost; e.g., interest income not earned (given up) on financial capital, say, owned as savings then invested in a business (this is not shown as cost by an accountant); e.g., if you took out your bank savings of \$100,000 to invest in a business but which (if you had not) would have earned you 5 % a year in interest, then the interest income (foregone) = (0.05)(\$100,000) = \$5,000 is an implicit cost. Explicit + Implicit costs from savings, not a loan Economic profit = total revenue total cost Acctg. profit = total revenue total explicit cost 2

3 Figure 1 Economists versus Accountants Economists include all opportunity costs when analyzing a firm, whereas accountants measure only explicit costs. Therefore, economic profit is smaller than accounting profit. 5 Production and Costs Production function = It captures the relationship between the quantity of inputs (such as labor) used to make a good and the quantity of output of that good; it gets flatter as production (qty. produced) rises Marginal product = an increase in output that arises from an additional unit of input; it is measured as the slope (rise over run) of the production function Diminishing marginal product: the marginal product of an input (like labor) declines as the quantity of the input increases Total-cost curve = the relationship between quantity produced (Q) and total costs; it gets steeper as the amount produced rises 6 3

4 Table 1 A Production Function and Total Cost: Caroline s Cookie Factory 7 Figure 2 Caroline s Production Function and Total-Cost Curve Quantity of Output (cookies per hour) (a) Production function Production function Total Cost Number of Quantity Workers Hired of Output The production function in panel (a) shows the relationship between the number of workers hired and the quantity of output produced. Here the number of workers hired (on the horizontal axis) is from the first column in Table 1, and the quantity of output produced (on the vertical axis) is from the second column. The production function gets flatter as the number of workers increases, which reflects diminishing marginal product. The total-cost curve in panel (b) shows the relationship between the quantity of output produced and total cost of production. Here the quantity of output produced (on the horizontal axis) is from the second column in Table 1, and the total cost (on the vertical axis) is from the sixth column. The total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product. \$ (b) Total-cost curve Total-cost curve 8 4

5 Various Measures of Cost Fixed costs (FC) = costs that do not vary with the quantity of output produced (e.g., ) Variable costs (VC) = costs that vary with the quantity of output produced (e.g., ) Total cost (TC) = Fixed cost + Variable cost Average fixed cost (AFC) = fixed costs (FC) divided by the quantity of output (Q) Average variable cost (AVC) = variable costs (VC) divided by the quantity of output (Q) 9 Table 2 The Various Measures of Cost: Conrad s Coffee Shop AVC ATC TC FC VC MC Q = 1 TC = TC = 1 Q Q = 1 TC = min VC = Q TC = Q 10 5

6 Figure 3 Conrad s Total-Cost Curve Total Cost \$ Total-cost curve Here the quantity of output produced (on the horizontal axis) is from the first column in Table 2, and the total cost (on the vertical axis) is from the second column. As in Figure 2, the total-cost curve gets steeper as the quantity of output increases because of diminishing marginal product Quantity of Output (cups of coffee per hour) 11 Various Measures of Cost Average total cost (ATC) = total cost (TC) divided by the quantity of output (Q) ATC = TC / Q i.e., the cost of a typical unit of output (if total cost is divided evenly over all the units produced) Marginal cost (MC) = the increase in total cost arising from producing an extra (additional) unit of output (Q); e.g. one more seat in an airline flight or, Marginal cost = Change in total cost / Change in quantity MC = ΔTC / ΔQ 12 6

7 Various Measures of Cost The marginal cost (MC) curve is rising because of diminishing marginal product the average total cost curve is U-shaped ATC = AFC + AVC AFC = always declines as output (Q) rises AVC = typically rises as output (Q) increases because of diminishing marginal product The bottom (lowest or minimum pt.) of the U-shaped ATC curve is the output (Q) that minimizes ATC. Efficient scale = qty. of output that minimizes ATC Relationship between MC and ATC: (e.g., GPA) When MC < ATC: average total cost is falling When MC > ATC: average total cost is rising The MC curve crosses the ATC curve at its min. pt. Figure 4 Conrad s Average-Cost and Marginal-Cost Curves Costs \$ MC Quantity of Output (cups of coffee per hour) This figure shows the average total cost (ATC), average fixed cost (AFC), average variable cost (AVC), and marginal cost (MC) for Conrad s Coffee Shop. All of these curves are obtained by graphing the data in Table 2. These cost curves show three features that are typical of many firms: (1) Marginal cost rises with the quantity of output. (2) The averagetotal-cost curve is U- shaped. (3) The marginalcost curve crosses the average-total-cost curve at the minimum of average total cost. ATC AVC AFC 14 7

8 Figure 5 Cost Curves for a Typical Firm Costs \$ MC ATC AVC AFC Quantity of Output (Q) Many firms experience increasing marginal product before diminishing marginal product. As a result, they have cost curves shaped like those in this figure. Notice that marginal cost and average variable cost fall for a while before starting to rise. 15 Costs in Short and Long Run Many decisions (like factory size) are fixed in the short run, variable in the long run; firms have greater flexibility in the long-run Long-run (l.r.) cost curves differ from short-run (s.r.) cost curves; they are much flatter than s.r. cost curves; and they lie on or above the l.r. cost curves Economies of scale: when long-run ATC falls as Q increases (due in part to increasing specialization among workers; many overcoming the learning curve) Constant returns to scale: when long-run ATC stays the same as Q changes Diseconomies of scale: when long-run ATC rises as Q increases due in part to increasing coordination problems 16 8

9 Figure 6 Average Total Cost (ATC) in the Short and Long Runs ATC ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run \$12,000 10,000 Economies of scale (increasing returns to scale, i.e., decreasing unit costs) Constant returns to scale Diseconomies of scale (decreasing returns to scale, i.e., increasing unit costs) 0 1,000 1,200 Quantity of Cars per Day (Q) Because fixed costs are variable in the long run, the average-total-cost (ATC) curve in the short run differs from the average-total-cost curve in the long run. Increasing returns to scale means that as you enlarge/expand production (scale), your unit costs are coming down. Decreasing returns to scale means that as you expand production (scale), your unit costs are going up. 17 Table 3 The Many Types of Cost: A Summary 18 9

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