Lecture 8 In this chapter, look for the answers to

these questions:
The Costs of Production What is a production function? What is marginal
product? How are they related?
What are the various costs, and how are they
related to each other and to output?
How are costs different in the short run vs. the
long run?
What are economies of scale?

Total Revenue, Total Cost, Profit Costs: Explicit vs. Implicit

We assume that the firms goal is to maximize Explicit costs require an outlay of money,
profit. e.g. paying wages to workers
Implicit costs do not require a cash outlay,
Profit = Total revenue Total cost e.g. the opportunity cost of the owners time
Remember one of the Ten Principles:
the amount a the market The cost of something is
firm receives value of the
what you give up to get it.
from the sale inputs a firm
of its output uses in This is true whether the costs are implicit or
production explicit. Both matter for firms decisions.

2 3

Economic Profit vs. Accounting Profit Figure 1 Economists versus Accountants

Accounting profit How an Economist How an Accountant
Views a Firm Views a Firm
= total revenue minus total explicit costs
Economic profit Economic
profit
= total revenue minus total costs (including Accounting
explicit and implicit costs) profit
Implicit
Accounting profit ignores implicit costs, Revenue costs Revenue
so its higher than economic profit. Total
opportunity
costs
Explicit Explicit
costs costs

4 5

1
 The Production Function Example 1: Mang Juans Production Function
A production function shows the relationship L Q
3,000
between the quantity of inputs used to produce a (no. of (cavans of
good, and the quantity of output of that good. workers) rice) 2,500

Quantity of output
It can be represented by a table, equation, or 0 0 2,000
graph.
1 1000 1,500
Example 1: 2 1800 1,000
Farmer Mang Juan grows rice.
3 2400
He has 5 hectares of land. 500

He can hire as many workers as he wants. 4 2800 0

0 1 2 3 4 5
5 3000
No. of workers
6 7

Marginal Product EXAMPLE 1: Total & Marginal Product

The marginal product of any input is the
L Q
increase in output arising from an additional unit (no. of (cavans of
of that input, holding all other inputs constant. MPL
workers) rice)

E.g., if Mang Juan hires one more worker, 0 0

his output rises by the marginal product of labor. L = 1 Q = 1000 1000
1 1000
Notation: L = 1 Q = 800 800
2 1800
(delta) = change in
L = 1 Q = 600 600
Examples: 3 2400
L = 1 Q = 400 400
Q = change in output, L = change in labor 4 2800
Q L = 1 Q = 200 200
Marginal product of labor (MPL) = 5 3000
L
8 9

EXAMPLE 1: MPL = Slope of Prod Function Why MPL Is Important

Recall one of the Ten Principles:
L Q MPL
3,000 equals the Rational people think at the margin.
(no. of (cavans of MPL
slope of the
workers) rice) 2,500 When Mang Juan hires an extra worker,
Quantity of output

production function.
0 0 2,000
his costs rise by the wage he pays the worker
Notice that
1000
MPL diminishes
his output rises by MPL
1 1000 1,500
800 as L increases. Comparing them helps Mang Juan decide whether
2 1800 1,000
This explains why he would benefit from hiring the worker.
600
3 2400 500 production
the
400
4 2800 function
0
gets flatter
200 as L0 increases.
1 2 3 4 5
5 3000
No. of workers
10 11

2
 Why MPL Diminishes
Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
E.g., Mang Juans output rises by a smaller and
smaller amount for each additional worker. Why?
If Mang Juan increases workers but not land,
the average worker has less land to work with,
so will be less productive.
In general, MPL diminishes as L rises
whether the fixed input is land or capital
(equipment, machines, etc.).
12
The Production Function and the Marginal Product
of Labor
Diminishing Marginal Product of Labor
As the number of workers increases, the marginal
product of labor declines.
As more and more workers are hired, each
additional worker contributes less to production
than the prior one.
The production function becomes flatter as the
number of workers rises.
This property is called diminishing marginal
product.
Diminishing marginal product refers to the property
whereby the marginal product of an input declines as the
quantity of the input increases.
13

EXAMPLE 1: Mang Juans Costs EXAMPLE 1: Mang Juans Costs

Farmer Mang Juan must pay P1000 per month L Q cost of cost of Total
for the land, regardless of how much rice he (no. of (cavans of land labor Cost
grows. workers) rice) (P) (P) (P)
The market wage for a farm worker is P2000 per 0 0 P1,000 P0 P1,000
month.
1 1000 1,000 2,000 3,000
So Mang Juans costs are related to how much 2 1800 1,000 4,000 5,000
rice he produces.
3 2400 1,000 6,000 7,000
4 2800 1,000 8,000 9,000
5 3000 1,000 10,000 11,000
14 15

EXAMPLE 1: Mang Juans Total Cost Curve Marginal Cost

Q Total $12,000 Marginal Cost (MC)
Cost is the increase in Total Cost from
(cavans of $10,000
rice) (P) producing one more unit:
$8,000
Total cost

0 P1,000 TC
$6,000 MC =
1000 3,000 Q
$4,000
1800 5,000
$2,000
2400 7,000
$0
2800 9,000 0 1000 2000 3000
3000 11,000 Quantity of wheat
16 17

3
 EXAMPLE 1: Total and Marginal Cost EXAMPLE 1: The Marginal Cost Curve

Total Marginal $12

Q Q TC MC
(cavans Cost Cost (MC) (cavans $10 MC usually rises
of rice) of rice) (P) (P)
(P) (P) as Q rises,

Marginal Cost ($)

$8 as in this example.
0 P1,000 0 P1,000
Q = 1000 TC = P2000 P2.00 2.00
$6
1000 3,000 1000 3,000
Q = 800 TC = 2000 2.50 2.50
1800 5,000 1800 5,000 $4
Q = 600 TC = 2000 3.33 3.33
2400 7,000 2400 7,000 $2
Q = 400 TC = 2000 5.00 5.00
2800 9,000 2800 9,000 $0
Q = 200 TC = 2000 10.00 10.00
0 1,000 2,000 3,000
3000 11,000 3000 11,000 Q
18 19

Why MC Is Important Fixed and Variable Costs

Mang Juan is rational and wants to maximize is Fixed costs (FC) do not vary with the quantity of output
produced.
profit. To increase profit, should he produce
more rice, or less? For Mang Juan, FC = $1000 for his land
Other examples:
To find the answer, Mang Juan cost of equipment, loan payments, rent
needs to think at the margin.
Variable costs (VC) vary with the quantity produced.
If the cost of additional rice (MC) is less than For Mang Juan, VC = wages he pays workers
the revenue he would get from selling it, Other example: cost of materials
then Mang Juans profits rise if he produces
Total cost (TC) = FC + VC
more.
(In the next chapter, we will learn more about
how firms choose Q to maximize their profits.) Our second example is more general, applies to any type
of firm, producing any good with any types of inputs.
20 21

EXAMPLE 2: Costs EXAMPLE 2: Marginal Cost

$800 FC
Q FC VC TC $700 VC Q TC MC $200 Marginal Cost (MC)
Recall,
TC is $175
the change in total cost from
0 P100 P0 P100 $600 0 P100
1 100 70 170 P70 producing
$150 one more unit:
$500 1 170
50 $125 TC
Costs

2 100 120 220

Costs

$400 2 220 MC =
$100 Q
3 100 160 260 40
$300 3 260 Usually,
$75 MC rises as Q rises, due
4 100 210 310 50 to diminishing marginal product.
$200 4 310 $50
5 100 280 380 70 Sometimes (as here), MC falls
$100 5 380 $25
6 100 380 480 100 before rising.
$0 6 480 $0
7 100 520 620 0 1 2 3 4 5 6 7 140 (In other0 examples,
1 2 3 MC 4 may
5 6be 7
7 620 constant.)
Q Q
22 23

4
EXAMPLE 2: Average Fixed Cost EXAMPLE 2: Average Variable Cost

Q FC AFC Average
$200 fixed cost (AFC) Q VC AVC Average
$200 variable cost (AVC)
0 P100 n.a.
is$175
fixed cost divided by the is$175
variable cost divided by the
0 P0 n.a.
quantity
$150
of output: quantity of output:
1 100 P100 $150
1 70 $70
AFC
$125 = FC/Q AVC
$125 = VC/Q
Costs

2 100 50

Costs
2 120 60
$100 $100
3 100 33.33 3 160 53.33
Notice
$75 that AFC falls as Q rises: As$75
Q rises, AVC may fall initially.
4 100 25 The firm is spreading its fixed 4 210 52.50 In most cases, AVC will
$50 $50
5 100 20 costs over a larger and larger eventually rise as output rises.
$25 5 280 56.00
number of units. $25
6 100 16.67 6 380 63.33
$0 $0
7 100 14.29 0 1 2 3 4 5 6 7 7 520 74.29 0 1 2 3 4 5 6 7
Q Q
24 25

EXAMPLE 2: Average Total Cost EXAMPLE 2: Average Total Cost

Q TC ATC AFC AVC Average total cost Q TC ATC $200

(ATC) equals total Usually,
$175
as in this example,
0 P100 n.a. n.a. n.a. 0 P100 n.a.
cost divided by the the ATC curve is U-shaped.
$150
1 170 P170 P100 P70 quantity of output: 1 170 P170
$125

Costs
2 220 110 50 60 ATC = TC/Q 2 220 110
$100
3 260 86.67 33.33 53.33 3 260 86.67
Also, $75
4 310 77.50 25 52.50 4 310 77.50
$50
ATC = AFC + AVC
5 380 76 20 56.00 5 380 76 $25
6 480 80 16.67 63.33 6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57 14.29 74.29 7 620 88.57
Q
26 27

EXAMPLE 2: The Various Cost Curves Together A C T I V E L E A R N I N G 1:

Costs
$200
Fill in the blank spaces of this table.
$175
$150
Q VC TC AFC AVC ATC MC
ATC 0 P50 n.a. n.a. n.a.
$125
P10
Costs

AVC
$100 1 10 P10 P$60.00
AFC
MC $75 2 30 80
30
$50 3 16.67 20 36.67
$25 4 100 150 12.50 37.50
$0 5 150 30
0 1 2 3 4 5 6 7 60
Q 6 210 260 8.33 35 43.33
28 29

5
A C T I V E L E A R N I N G 1: EXAMPLE 2: Why ATC Is Usually U-Shaped
Answers
As Q rises: $200
Use AFC
ATC
AVC
deduce FC/Q
= TC/Q
First,relationship
FCbetween
VC/Q MC
= $50 and and
use FCTC
+ VC = TC.
Initially, $175
Q VC TC AFC AVC ATC MC falling AFC $150
0 $0 $50 n.a. n.a. n.a. pulls ATC down. $125
$10

Costs
1 10 60 $50.00 $10 $60.00 Eventually, $100
20
2 30 80 25.00 15 40.00 rising AVC $75
30 pulls ATC up.
3 60 110 16.67 20 36.67 $50
40
4 100 150 12.50 25 37.50 $25
50
5 150 200 10.00 30 40.00 $0
60 0 1 2 3 4 5 6 7
6 210 260 8.33 35 43.33 Q
30 31

EXAMPLE 2: ATC and MC Costs in the Short Run & Long Run
When MC < ATC, $200 ATC Short run:
ATC is falling. MC Some inputs are fixed (e.g., factories, land).
$175
When MC > ATC, $150
The costs of these inputs are FC.
ATC is rising. $125 Long run:
Costs

The MC curve $100 All inputs are variable

crosses the $75 (e.g., firms can build more factories,
ATC curve at $50
or sell existing ones)
the ATC curves
$25 In the long run, ATC at any Q is cost per unit
minimum.
$0 using the most efficient mix of inputs for that Q
0 1 2 3 4 5 6 7 (e.g., the factory size with the lowest ATC).
Q
32 33

EXAMPLE 3: LRATC with 3 factory Sizes EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose To produce less
from 3 factory Avg than QA, firm will Avg
sizes: S, M, L. Total choose size S Total
Cost ATCS ATCM in the long run. Cost ATCS ATCM
Each size has its ATCL ATCL
own SRATC curve. To produce
between QA
The firm can and QB, firm will LRATC
change to a choose size M
different factory in the long run.
size in the long
Q To produce more Q
run, but not in the QA QB
than QB, firm will
short run.
choose size L
in the long run.
34 35

6
 A Typical LRATC Curve How ATC Changes As
the Scale of Production Changes
In the real world,
factories come in ATC Economies of ATC
many sizes, scale: ATC falls
each with its own as Q increases.
LRATC LRATC
SRATC curve. Constant returns
So a typical to scale: ATC
LRATC curve stays the same
looks like this: as Q increases.

Diseconomies of
Q Q
scale: ATC rises
as Q increases.

36 37

How ATC Changes As CONCLUSION

the Scale of Production Changes
Economies of scale occur when increasing Costs are critically important to many business
decisions, including production, pricing, and
production allows greater specialization:
hiring.
workers more efficient when focusing on a
narrow task. This chapter has introduced the various cost
More common when Q is low. concepts.
Diseconomies of scale are due to coordination The following chapters will show how firms use
problems in large organizations. these concepts to maximize profits in various
E.g., management becomes stretched, cant market structures.
control costs.
More common when Q is high.
38 39

CHAPTER SUMMARY CHAPTER SUMMARY

Implicit costs do not involve a cash outlay,
yet are just as important as explicit costs
to firms decisions.
Accounting profit is revenue minus explicit costs. Economic
profit is revenue minus total (explicit + implicit) costs.
The production function shows the relationship between output
and inputs.
The marginal product of labor is the increase in output from a
one-unit increase in labor, holding other inputs constant. The
marginal products of other inputs are defined similarly.
Marginal product usually diminishes as the input increases.
Thus, as output rises, the production function becomes flatter,
and the total cost curve becomes steeper.
Variable costs vary with output; fixed costs do not.
40
Marginal cost is the increase in total cost from an
extra unit of production. The MC curve is usually
upward-sloping.
Average variable cost is variable cost divided by
output.
Average fixed cost is fixed cost divided by output.
AFC always falls as output increases.
Average total cost (sometimes called cost per
unit) is total cost divided by the quantity of output.
The ATC curve is usually U-shaped.
41

7
CHAPTER SUMMARY
The MC curve intersects the ATC curve
at minimum average total cost.
When MC < ATC, ATC falls as Q rises.
When MC > ATC, ATC rises as Q rises.
In the long run, all costs are variable.
Economies of scale: ATC falls as Q rises.
Diseconomies of scale: ATC rises as Q rises.
Constant returns to scale: ATC remains constant
as Q rises.

42