Slide 0The Costs of ProductionWHAT ARE COSTS?Slide 4Total Revenue, Total Cost, and ProfitSlide 6Costs as Opportunity CostsEconomic Profit versus Accounting ProfitSlide 9Figure 1 Economists versus AccountantsPRODUCTION AND COSTSThe Production FunctionTable 1 A Production Function and Total Cost: Hungry Helen’s Cookie FactorySlide 14Figure 2 Hungry Helen’s Production FunctionSlide 16From the Production Function to the Total-Cost CurveSlide 18Figure 2 Hungry Helen’s Total-Cost CurveTHE VARIOUS MEASURES OF COSTFixed and Variable CostsTable 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade StandSlide 23Slide 24Average and Marginal CostsSlide 26Average and Marginal CostThirsty Thelma’s Lemonade StandFigure 3 Thirsty Thelma’s Total-Cost CurvesFigure 4 Thirsty Thelma’s Average-Cost and Marginal-Cost CurvesCost Curves and Their ShapesSlide 32Slide 33Cost Curves and Their ShapesSlide 35Typical Cost CurvesFigure 5 Cost Curves for a Typical FirmTypical Cost CurvesCOSTS IN THE SHORT RUN AND IN THE LONG RUNEconomies and Diseconomies of ScaleFigure 6 Average Total Cost in the Short and Long RunSlide 41Slide 42Slide 43Slide 44© 2007 Thomson South-Western© 2007 Thomson South-WesternThe Costs of Production•The Market Forces of Supply and Demand– Supply and demand are the two words that economists use most often.–Supply and demand are the forces that make market economies work.–Modern microeconomics is about supply, demand, and market equilibrium.© 2007 Thomson South-WesternWHAT ARE COSTS?•According to the Law of Supply:–Firms are willing to produce and sell a greater quantity of a good when the price of the good is high.–This results in a supply curve that slopes upward.© 2007 Thomson South-WesternWHAT ARE COSTS?•The Firm’s Objective–The economic goal of the firm is to maximize profits.© 2007 Thomson South-WesternTotal 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.© 2007 Thomson South-WesternTotal Revenue, Total Cost, and Profit•Profit is the firm’s total revenue minus its total cost.•Profit = Total revenue - Total cost© 2007 Thomson South-WesternCosts as Opportunity Costs•A firm’s cost of production includes all the opportunity costs of making its output of goods and services.•Explicit and Implicit Costs•A firm’s cost of production include explicit costs and implicit costs.•Explicit costs are input costs that require a direct outlay of money by the firm. •Implicit costs are input costs that do not require an outlay of money by the firm.© 2007 Thomson South-WesternEconomic Profit versus Accounting Profit•Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs.•Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs.© 2007 Thomson South-WesternEconomic Profit versus Accounting Profit•When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.•Economic profit is smaller than accounting profit.© 2007 Thomson South-WesternFigure 1 Economists versus AccountantsRevenueTotalopportunitycostsHow an EconomistViews a FirmHow an AccountantViews a FirmRevenueEconomicprofitImplicitcostsExplicitcostsExplicitcostsAccountingprofit© 2007 Thomson South-WesternPRODUCTION AND COSTS•The Production Function–The production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.© 2007 Thomson South-WesternThe Production Function •Marginal Product•The marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.© 2007 Thomson South-WesternTable 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory© 2007 Thomson South-WesternThe Production Function •Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. •Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.© 2007 Thomson South-WesternFigure 2 Hungry Helen’s Production FunctionNumber of Workers HiredQuantity of output© 2007 Thomson South-WesternThe Production Function •Diminishing Marginal Product •The slope of the production function measures the marginal product of an input, such as a worker.•When the marginal product declines, the production function becomes flatter.© 2007 Thomson South-WesternFrom the Production Function to the Total-Cost Curve•The relationship between the quantity a firm can produce and its costs determines pricing decisions.•The total-cost curve shows this relationship graphically.© 2007 Thomson South-WesternTable 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory© 2007 Thomson South-WesternFigure 2 Hungry Helen’s Total-Cost CurveTotalCostQuantityof Output(cookies per hour)© 2007 Thomson South-WesternTHE VARIOUS MEASURES OF COST•Costs of production may be divided into fixed costs and variable costs.–Fixed costs are those costs that do not vary with the quantity of output produced.–Variable costs are those costs that do vary with the quantity of output produced.© 2007 Thomson South-WesternFixed and Variable Costs•Total Costs•Total Fixed Costs (TFC)•Total Variable Costs (TVC)•Total Costs (TC) •TC = TFC + TVC© 2007 Thomson South-WesternTable 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand© 2007 Thomson South-WesternFixed and Variable Costs•Average Costs•Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. •The average cost is the cost of each typical unit of product.© 2007 Thomson South-WesternFixed and Variable Costs•Average Costs•Average Fixed Costs (AFC)•Average Variable Costs (AVC)•Average Total Costs (ATC)•ATC = AFC + AVC© 2007 Thomson South-WesternAverage and Marginal CostsFixed costQuantityFCAFCQ= =Variable costQuantityVCAVCQ= =Total costQuantityTCATCQ= =© 2007 Thomson South-WesternAverage and Marginal Costs•Marginal Cost•Marginal cost (MC) measures the increase in total cost that arises from an extra unit of production.•Marginal cost helps answer the following