Slide 1Knowledge RecapCosts and ProfitCosts and ProfitCosts and ProfitProduction and CostsProduction and CostsProduction and CostsTypes of CostsTypes of CostsTypes of CostsTypes of CostsTypes of CostsProperties of Typical Cost CurvesECON 203: Principles of MicroeconomicsClass 13: Costs of Production1Knowledge Recap•According to the law of supply, firms increase quantity supplied in response to an increase in price.–Describes general behavior of all firms in a market.•In the next two classes, we turn to the study of decisions made by individual firms. –Revenue, costs, and profit (generic for all types of markets).–Firms’ decision in competitive markets.2Costs and Profit•Total Revenue: the amount a firm receives for the sale of its output.Total Revenue = Price per unit * Quantity sold•Total Cost: the value of the inputs a firm uses in production.•Profit: the amount a firm keeps as a result of production.Profit = Total Revenue – Total Cost•Firm’s objective: to maximize profit.3Costs and Profit•Types of costs:–Explicit costs: require an outlay of money by the firm.•Examples: employee’s wages, electricity bills.–Implicit costs: do not require an outlay of money by the firm.•Typically represent revenue from alternative uses of inputs.•Examples: wage of owner at alternative job, interest rates on investment.4Costs and Profit•Types of profit:–Economic profit: considers both implicit and explicit costs.Economic Profit = Total Revenue – Total Cost–Accounting profit: only considers explicit costs.Accounting Profit = Total Revenue – Explicit Cost–Economic profit is always smaller or equal to accounting profit.5Production and Costs•Production Function: –The relationship between the quantity of inputs used in production and the quantity of output produced.–Marginal Product: •The increase in output from an additional unit of input.–Diminishing Marginal Product: •The property whereby the marginal product of an additional input declines as the quantity of input increases. 6Production and Costs•Total Cost Curve:–The relationship between quantity of output and total cost.•Derived from combining information from the production function with prices of inputs. –Because of diminishing marginal product, costs increase quicker as quantity produced increases. 7Production and Costs•Example:8Q Input (Analysts)Q Output (Sales Projections)Marginal ProductTotal Cost0 0 $01 5 5 $3002 9 4 $6003 12 3 $9004 14 2 $1,2005 15 1 $1,500Types of Costs•Fixed Costs: do not vary with quantity of output produced.–Examples office space, computers, software license.•Variable Costs: vary with the quantity of output produced.– Example: Analysts’ wages.•Total Cost = Fixed Costs + Variable Costs9Types of Costs•Average Costs: the cost of producing a typical unit of output.Average Total Cost = Total Cost / Quantity Average Fixed Cost = Fixed Cost / QuantityAverage Variable Cost = Variable Cost / Quantity•Marginal Cost: the cost of producing one additional unit of input.Change in Total Cost / Change in Quantity10Types of Costs•Example11Q Fixed CostVariable CostTotal CostMarginal CostAverage Fixed CostAverage Variable CostAverage Total Cost0 $1,000 $05 $1,000 $3009 $1,000 $60012 $1,000 $90014 $1,000 $1,20015 $1,000 $1,500Types of Costs•Example12Q Fixed CostVariable CostTotal CostMarginal CostAverage Fixed CostAverage Variable CostAverage Total Cost0 $1,000 $0 $1,0005 $1,000 $300 $1,300 $609 $1,000 $600 $1,600 $7512 $1,000 $900 $1,900 $10014 $1,000 $1,200 $2,200 $15015 $1,000 $1,500 $2,500 $300Types of Costs•Example13Q Fixed CostVariable CostTotal CostMarginal CostAverage Fixed CostAverage Variable CostAverage Total Cost0 $1,000 $0 $1,0005 $1,000 $300 $1,300 $60 $200 $60 $2609 $1,000 $600 $1,600 $75 $111 $67 $17812 $1,000 $900 $1,900 $100 $83 $75 $15814 $1,000 $1,200 $2,200 $150 $71 $86 $15715 $1,000 $1,500 $2,500 $300 $67 $100 $167Properties of Typical Cost Curves•Marginal Cost (MC) curve eventually rises with the quantity of output (J-shape).•Average Fixed Cost (AFC) curve is decreasing.•Average Variable Cost (AVC) approaches ATC.•Average Total Cost (ATC) curve is U-shaped.– Efficient scale: the quantity of output that minimizes ATC.•MC curve crosses the ATC curve at the minimum of the ATC curve. –When MC < ATC, ATC is falling.–When MC > ATC, ATC is