Chapter 13 The Costs of Production What Are Costs Total Revenue Total Cost and Profit o Ex Caroline s Cookie Factory o Total revenue The amount a firm receives for the sale of its output cookies o Total cost The market value of the inputs a firm uses in production flour sugar workers ovens etc o Profit Total revenue minus total cost o Caroline s objective make firm s profit as large as possible aka maximize profit Costs as Opportunity Costs o Recall Cost of something is what you give up to get it Opportunity cost of an item refers to all things that must be forgone to acquire that item o Explicit costs input costs that require an outlay of money by the firm Ex Wages the firm pays its workers o Implicit costs input costs that do not require an outlay of money by the firm Ex Wages the firm owner gives up by working in the firm rather than taking another job o When analyzing a firm s behavior it is important to include both kinds of costs of production The Cost of Capital as an Opportunity Cost o An important implicit cost of almost every business is opportunity cost of financial capital that has been invested in the business o Ex Suppose Caroline used 350 000 of her savings to buy her cookie factory from its previous owner If Caroline had instead left this money deposited in a savings account that pays an interest rate of 5 percent she would have earned 15 000 a year in interest income This forgone 15 000 is one of the implicit opportunity costs of Caroline s business Economic Profit versus Accounting Profit o Economic profit total revenue minus total cost including both explicit and implicit costs o Accounting profit total revenue minus explicit cost Production and Costs The Production Function o The relationship between quantity of inputs used to make a good and the quantity of output of that good Number of Workers Output quantity of cookies produced per hour Marginal Product of Labor Cost of Factory Cost of Workers 0 1 2 3 4 5 0 50 90 120 140 155 50 40 30 20 10 30 30 30 30 30 30 0 10 20 30 50 60 Total Cost of Inputs cost of factory cost of workers 30 40 50 60 80 90 produced rises The Various Measures of Cost Fixed and Variable Costs o Marginal product the increase in output that arises from an additional unit of input o Diminishing marginal product the property whereby the marginal product of an input declines as the quantity of the input increases From the Production Function to the Total Cost Curve o 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 property of diminishing marginal product o As a result a firm s total cost curve gets steeper as the quantity o Fixed costs costs that do not vary with the quantity of output produced Ex Salary o Variable costs Costs that vary with the quantity of output produced Ex Cost of supplies needed Average and Marginal Cost o Average total cost total cost divided by the quantity of output o Average fixed cost fixed cost divided by the quantity of output o Average variable cost variable cost divided by the quantity of output o Marginal cost the increase in total cost that arises from an extra unit of production o Average cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced o Marginal cost tells us the increase in total cost that arises from producing an additional unit of output Cost Curves and Their Shapes o Rising Marginal Cost If marginal cost rises with quantity of output produced reflects property of diminishing marginal product When quantity of an item being produced is already high the marginal product of an extra worker is low and the marginal cost of an extra of that item is large o U Shaped Average Total Cost Reflects shapes of both average fixed cost and average variable cost Average fixed cost always declines as output rises because fixed cost is spread over large of units Average variable cost typically rises as output increases because of diminishing marginal product Bottom of U shape occurs quantity that maximizes average total cost aka the efficient scale o Relationship between Marginal Cost and Average Total Cost Whenever marginal cost is less than average total cost Whenever marginal cost is greater than average cost average total cost is falling average total cost is rising Marginal cost curve crosses average total cost curve at Relationship between Short Run and Long Run Average Total Cost o Because many decisions are fixed in the short run but variable in the long run a firm s long run cost curve differs from its short run cost curves o Long run average total cost curve is a much flatter U shape than the short run average total cost curve o All short run curves lie on or above the long run curve Economies and Diseconomies of Scale o Economies of scale the property whereby long run average total cost falls as the quantity of output increases o Diseconomies of scale the property whereby long run average total cost rises as the quantity of output increases o Constant returns to scale the property whereby long run average total cost stays the same as the quantity of output changes o Cause of economies of scale Costs in the Short Run and in the Long Run its minimum Specialization specialization among workers permits each worker to become better at a specific task o Cause of diseconomies of scale Coordination problems happens in large organizations
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