Chapter 13 The Costs of Production 1 What are Costs a Total Revenue Total Cost and Profit Assumed goal of all firms is to maximize profit Profit total revenue total cost o Total revenue the amount a firm receives for the sale of its output o Total cost the market value of the inputs a firm uses in production b Costs as Opportunity Costs Economists consider opportunity costs to include explicit and implicit costs o Explicit input costs that require an outlay of money by the firm o Implicit ex wages money to buy an input etc input costs that do not require an outlay of money by the firms ex money someone could be making at a different job Total cost explicit costs implicit costs c The Cost of Capital as an Opportunity Cost An important implicit cost of almost any business is the opportunity cost of the financial capital that has been invested in the business o ex If you invest 300 000 into a business but could have put that money in savings and gotten 15 000 in interest this amount is considered an implicit cost d Economic Profit vs Accounting Profit Economic profit Accounting profit total revenue explicit cost total revenue total cost explicit implicit costs Revenue Implicit Costs Revenue Economic Profit Accounting Profit Total Opportunity Costs Explicit Costs Explicit Costs 2 Production and Costs a The Production Function Production Function quantity of output of that good Marginal Product Diminishing Marginal Product quantity of the input increases the relationship between the quantity of inputs used to make a good and the the increase in output that arises from an additional unit of input o As the number of workers increase marginal product decreases the property whereby the marginal product of an input declines as the o Graph gets flatter as the number of inputs workers increase o In terms of slope as the number of workers increases the marginal product declines and the production function becomes flatter curve starts out with steep slopes but as more workers are added the slope becomes flatter and flatter as it increases b From the Production Function to the Total Cost Curve Production function relatively flat because as the number of workers increases it becomes crowded less is produced diminish marginal produced Total cost curve when the quantity produced is large total cost curve is relatively steep o Gets steeper as the amount produced rises 3 The Various Measures of Cost a Fixed and Variable Costs Fixed Cost costs that do not vary with the quantity of output produced o ex rent bookkeeper not affected by quantity sold Variable Cost costs that vary with the quantity of output produced o ex cost of inputs more coffee sold more coffee beans needed to be bought Total cost Fixed costs Variable Costs b Average and Marginal Cost Average Total Cost total cost divided by quantity of output o Total cost sum of fixed cost and variable cost o Average fixed cost fixed cost quantity of output o Average variable cost variable cost quantity of output o ATC Tells us the cost of the typical unit but it does not tell us how much total cost will change as the firm alters its level of production Marginal Cost the increase in total cost that arises from an extra unity of production o MC TC Q Average total cost tells us the cost of a typical unit of output if total cost id divided evenly over all the units produced Marginal cost tells us the increase in total cost that arises from producing an additional unit of output Efficient scale the quantity of output that minimizes average total cost U shaped curve Whenever marginal cost is less than average total cost average total cost is falling Whenever marginal cost is greater than average total cost average total cost is rising The marginal cost curve crosses the average total cost curve at its minimum because at low levels of output marginal cost is below average total cost so average total cost is falling But after the two curves cross marginal cost rises above average total cost c Typical Cost Curves Marginal cost eventually rises with the quantity of output 4 Costs in the Short Run and in the Long Run a The Relationship between Short Run and Long Run Average Total Cost Because many decisions are fixed in the short run but variable in the long run a firm s long run cost curves differ from its short run cost curves LR ATC curve is much flatter U shaped that the SR ATC curve o Due to the greater flexibility firms have in the long run b Economies and Diseconomies of Scale Economies of Scale increases the property whereby long run average total cost falls as the quantity of output o Often arise because higher production levels allow specialization among workers which permits each worker to become better at a specific task Diseconomies of Scale the property whereby long run average total cost rises as the quantity of output increases o Often arise because of coordination problems that are inherent in any large organization the property whereby long run average total cost stays the same as the Constant returns to scale quantity of output changes 5 Conclusion Term Explicit Costs Implicit Costs Fixed Costs Variable Costs Total Costs Average Fixed Costs Average Variable Costs Average Total Costs Marginal Costs Definition Costs that require an outlay of money by the firm Costs that do not require an outlay of money by the firm Costs that do not vary with the quantity of output produced Costs that vary with the quantity of output produced The market value of all the inputs that a firm uses in production Fixed cost divided by the quantity of output Variable cost divided by the quantity of output Total cost divided by quantity of outputs The increase in total cost that arises from an extra unit of production Mathematical Description FC VC TC FC VC AFC FC Q AVC VC Q ATC TC Q MC TC Q 6 Summary The goal of firms is to maximize profit which equals total revenue minus total cost When analyzing a firm s behavior it is important to include all the opportunity costs of production Some of the opportunity costs such as the wages a firm pays its workers are explicit Other opportunity costs such as the wages the firm owner gives up by working in the firm rather than taking another job are implicit Economic profit takes both explicit and implicit costs into account whereas accounting profits considers only explicit costs A firm s costs reflect its production process A typical firm s production function gets flatter as the quantity of an input increases displaying the