Microeconomics
Dali Laxton
LECTURE
5
The Costs of
Production
Chapter 13

ACTIVE LEARNING   1
Brainstorming costs
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§You run Ford Motor Company.
§List three different costs you have.
§List three different
business decisions
that are affected
by your costs.
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Lecture Today
•What is a production function?  What is marginal product?  How are they related?
•What are the various costs?  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”?
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Total Revenue, Total Cost, Profit
§We assume that the firm’s goal is to maximize profit.
Profit  =  Total revenue  –  Total cost
the amount a firm receives from the sale of its output
the market value of the inputs a firm uses in production
[USEMAP]
0

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Costs:  Explicit vs. Implicit
§Explicit costs require an outlay of money,
e.g., paying wages to workers.
§Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
§Remember one of the Ten Principles:
     The cost of something is
     what you give up to get it.
§This is true whether the costs are implicit or explicit.  Both matter for firms’ decisions.
[USEMAP]
0

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Explicit vs. Implicit Costs:  An Example
§You need $100,000 to start your business.
The interest rate is 5%.
§Case 1:  borrow $100,000
§explicit cost = $5000 interest on loan
§Case 2:  use $40,000 of your savings,
borrow the other $60,000
§explicit cost = $3000 (5%) interest on the loan
§implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.
[USEMAP]
0
In both cases, total (exp + imp) costs are $5000.

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Economic Profit  vs. Accounting Profit
§Accounting profit
§= total revenue minus total explicit costs
§Economic profit
§= total revenue minus total costs (including explicit and implicit costs)
§Accounting profit ignores implicit costs,
so it’s higher than economic profit.
[USEMAP]
0

ACTIVE LEARNING   2
Economic profit vs. accounting profit
§The equilibrium rent on office space has just increased by $500/month.
§Determine the effects on accounting profit and economic profit if:
§a. you rent your office space
§b. you own your office space
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ACTIVE LEARNING   2
Answers
§The rent on office space increases $500/month.
§a. You rent your office space.
§ Explicit costs increase $500/month.
Accounting profit & economic profit each fall $500/month.
§b. You own your office space.
§ Explicit costs do not change,
so accounting profit does not change.
Implicit costs increase $500/month (opp. cost
of using your space instead of renting it)
so economic profit falls by $500/month.
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The Production Function
§A production function shows the relationship between the quantity of inputs used to produce a good
and the quantity of output of that good.
§It can be represented by a table, equation, or graph.
§Example 1:
§Farmer Slavko grows wheat.
§He has 5 acres of land.
§He can hire as many workers as he wants.
[USEMAP]
0

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0
500
1,000
1,500
2,000
2,500
3,000
0
1
2
3
4
5
No. of workers
EXAMPLE 1:  Farmer Slavko’s Production Function
3000
5
2800
4
2400
3
1800
2
1000
1
0
0
Q (bushels
of wheat)
L
(no. of workers)
[USEMAP]
0

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or in part, except for use as permitted in a license distributed with a certain product or service
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Marginal Product
§If Slavko hires one more worker, his output rises by the marginal product of labor.
§The marginal product of any input is the increase in output arising from an additional unit of
that input, holding all other inputs constant.
§Notation:
   ∆ (delta) = “change in…”
§ Examples:
∆Q = change in output, ∆L = change in labor
§Marginal product of labor (MPL) =
[USEMAP]
0
∆Q
∆L

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3000
5
2800
4
2400
3
1800
2
1000
1
0
0
Q  (bushels
of wheat)
L
(no. of workers)
EXAMPLE 1:  Total & Marginal Product
200
400
600
800
1000
MPL
[USEMAP]
0
∆Q = 1000
∆L = 1
∆Q = 800
∆L = 1
∆Q = 600
∆L = 1
∆Q = 400
∆L = 1
∆Q = 200
∆L = 1

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MPL equals the
slope of the production function.
Notice that
MPL diminishes
as L increases.
This explains why the production function gets flatter
as L increases.
0
500
1,000
1,500
2,000
2,500
3,000
0
1
2
3
4
5
No. of workers
EXAMPLE 1:  MPL = Slope of Prod Function
3000
5
200
2800
4
400
2400
3
600
1800
2
800
1000
1
1000
0
0
MPL
Q
(bushels
of wheat)
L
(no. of workers)
[USEMAP]
0

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Why MPL Is Important
§Recall one of the Ten Principles:
    Rational people think at the margin.
§When Farmer Slavko hires an extra worker,
§his costs rise by the wage he pays the worker
§his output rises by MPL
§Comparing them helps Slavko decide whether he should hire the worker.

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Why MPL Diminishes
§Farmer Slavko’s output rises by a smaller and smaller amount for each additional worker. Why?
§As he adds workers, the average worker has less land to work with and will be less productive.
§In general, MPL diminishes as L rises
whether the fixed input is land or capital  (equipment, machines, etc.).
§Diminishing marginal product:
The marginal product of an input declines as the quantity of the input increases (other things
equal).

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EXAMPLE 1:  Farmer Slavko’s Costs
§Farmer must pay $1000 per month for the land, regardless of how much wheat he grows.
§The market wage for a farm worker is $2000 per month.
§So Slavko’s costs are related to how much wheat he produces….

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EXAMPLE 1:  Farmer Slavko’s Costs
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total
cost
3000
5
2800
4
2400
3
1800
2
1000
1
$10,000
$8,000
$6,000
$4,000
$2,000
$0
$1,000
$1,000
$1,000
$1,000
$1,000
$1,000
0
0
Cost of labor
Cost of land
Q
(bushels
of wheat)
L
(no. of workers)
[USEMAP]
0

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EXAMPLE 1:  Slavko’s Total Cost Curve
Q (bushels
of wheat)
Total
Cost
0
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
3000
$11,000

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Marginal Cost
§Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
§
∆TC
∆Q
MC =

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EXAMPLE 1:  Total and Marginal Cost
$10.00
$5.00
$3.33
$2.50
$2.00
Marginal Cost (MC)
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
Total
Cost
3000
2800
2400
1800
1000
0
Q
(bushels
of wheat)
∆Q = 1000
∆TC = $2000
∆Q = 800
∆TC = $2000
∆Q = 600
∆TC = $2000
∆Q = 400
∆TC = $2000
∆Q = 200
∆TC = $2000

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MC usually rises
as Q rises,
as in this example.
EXAMPLE 1:  The Marginal Cost Curve
$11,000
$9,000
$7,000
$5,000
$3,000
$1,000
TC
$10.00
$5.00
$3.33
$2.50
$2.00
MC
3000
2800
2400
1800
1000
0
Q
(bushels
of wheat)

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Why MC Is Important
§Farmer Slavko is rational and wants to maximize his profit.  To increase profit, should he produce
more or less wheat?
§To find the answer, he needs to “think at the margin.”
§If the cost of an additional wheat (MC) is less than
the revenue he would get from selling it,
then Alejandro’s profits rise if he produces more.

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Fixed and Variable Costs
§Fixed costs (FC) do not vary with the quantity of output produced.
§For Farmer Slavko, FC = $1000 for his land
§Other examples:
cost of equipment, loan payments, rent
§Variable costs (VC) vary with the quantity produced.
§For Farmer Slavko, VC = wages he pays workers
§Other example:  cost of materials
§Total cost (TC)  =  FC  +  VC
[USEMAP]
0

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EXAMPLE 2
§Our second example is more general,
applies to any type of firm
producing any good with any types of inputs.

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EXAMPLE 2:  Costs
7
6
5
4
3
2
1
620
480
380
310
260
220
170
$100
520
380
280
210
160
120
70
$0
100
100
100
100
100
100
100
$100
0
TC
VC
FC
Q
$0
$100
$200
$300
$400
$500
$600
$700
$800
0
1
2
3
4
5
6
7
Q
FC
VC
TC
[USEMAP]
0

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Recall, Marginal Cost (MC)
is the change in total cost from producing one more unit:
Usually, MC rises as Q rises, due to diminishing marginal product.
Sometimes (as here), MC falls before rising.
(In other examples, MC may be constant.)
EXAMPLE 2:  Marginal Cost
620
7
480
6
380
5
310
4
260
3
220
2
170
1
$100
0
MC
TC
Q
140
100
70
50
40
50
$70
∆TC
∆Q
MC =

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EXAMPLE 2:  Average Fixed Cost
100
7
100
6
100
5
100
4
100
3
100
2
100
1
14.29
16.67
20
25
33.33
50
$100
n/a
$100
0
AFC
FC
Q
Average fixed cost (AFC)
is fixed cost divided by the quantity of output:
   AFC = FC/Q
Notice that AFC falls as Q rises:  The firm is spreading its fixed costs over a larger and larger
number of units.
[USEMAP]
0

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EXAMPLE 2:  Average Variable Cost
520
7
380
6
280
5
210
4
160
3
120
2
70
1
74.29
63.33
56.00
52.50
53.33
60
$70
n/a
$0
0
AVC
VC
Q
Average variable cost (AVC)
is variable cost divided by the quantity of output:
   AVC = VC/Q
As Q rises, AVC may fall initially.  In most cases, AVC will eventually rise as output rises.
[USEMAP]
0

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EXAMPLE 2:  Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
620
7
480
6
380
5
310
4
260
3
220
2
170
1
$100
0
74.29
14.29
63.33
16.67
56.00
20
52.50
25
53.33
33.33
60
50
$70
$100
n/a
n/a
AVC
AFC
TC
Q
[USEMAP]
0
Average total cost (ATC)/cost per unit/unit cost equals total cost divided by the quantity of
output:
   ATC = TC/Q
Also,
   ATC = AFC + AVC

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Usually, as in this example, the ATC curve is U-shaped.
$0
$25
$50
$75
$100
$125
$150
$175
$200
0
1
2
3
4
5
6
7
Q
EXAMPLE 2:  Average Total Cost
88.57
80
76
77.50
86.67
110
$170
n/a
ATC
620
7
480
6
380
5
310
4
260
3
220
2
170
1
$100
0
TC
Q
[USEMAP]
0

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‹#›
EXAMPLE 2:  The Various Cost Curves Together
[USEMAP]
0
AFC
AVC
ATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0
1
2
3
4
5
6
7
Q

ACTIVE LEARNING   3
Calculating costs
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Fill in the blank spaces of this table.
210
150
100
30
10
VC
43.33
35
8.33
260
6
30
5
37.50
12.50
150
4
36.67
20
16.67
3
80
2
$60.00
$10
1
n/a
n/a
n/a
$50
0
MC
ATC
AVC
AFC
TC
Q
60
30
$10

ACTIVE LEARNING   3
Answers
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Use  AFC = FC/Q
Use  AVC = VC/Q
Use relationship between MC and TC
Use  ATC = TC/Q
First, deduce FC = $50 and use FC + VC = TC.
210
150
100
60
30
10
$0
VC
43.33
35
8.33
260
6
40.00
30
10.00
200
5
37.50
25
12.50
150
4
36.67
20
16.67
110
3
40.00
15
25.00
80
2
$60.00
$10
$50.00
60
1
n/a
n/a
n/a
$50
0
MC
ATC
AVC
AFC
TC
Q
60
50
40
30
20
$10

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‹#›
$0
$25
$50
$75
$100
$125
$150
$175
$200
0
1
2
3
4
5
6
7
Q
EXAMPLE 2:  Why ATC Is Usually U-Shaped
[USEMAP]
0
As Q rises:
Initially,
falling AFC
pulls ATC down.
Eventually,
rising AVC
pulls ATC up.
Efficient scale:
The quantity that minimizes ATC.

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‹#›
EXAMPLE 2:  ATC and MC
[USEMAP]
0
ATC
MC
$0
$25
$50
$75
$100
$125
$150
$175
$200
0
1
2
3
4
5
6
7
Q
When MC < ATC,
ATC is falling.
When MC > ATC,
ATC is rising.
The MC curve crosses the
ATC curve at
the ATC curve’s minimum.

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‹#›
Costs in the Short Run & Long Run
§Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
§Long run:
All inputs are variable
(e.g., firms can build more factories
or sell existing ones).
§In the long run, ATC at any Q is cost per unit using the most efficient mix of inputs for that Q
(e.g., the factory size with the lowest ATC).

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‹#›
EXAMPLE 3:  LRATC with 3 factory sizes
ATCS
ATCM
ATCL
Q
Avg
Total
Cost
Firm can choose from three factory sizes:  S, M, L.
Each size has its own SRATC curve.
The firm can change to a different factory size in the long run, but not in the short run.

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‹#›
EXAMPLE 3:  LRATC with 3 factory sizes
ATCS
ATCM
ATCL
Q
Avg
Total
Cost
QA
QB
LRATC
To produce less than QA, firm will choose size S
in the long run.
To produce between QA
and QB, firm will choose size M
in the long run.
To produce more than QB, firm will choose size L
in the long run.

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‹#›
A Typical LRATC Curve
Q
ATC
In the real world, factories come in many sizes,
each with its own SRATC curve.
So a typical LRATC curve
looks like this:
LRATC

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‹#›
How ATC Changes as
the Scale of Production Changes
Economies of scale:  ATC falls
as Q increases.
Constant returns to scale:  ATC stays the same
as Q increases.
Diseconomies of scale:  ATC rises
as Q increases.
LRATC
Q
ATC

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How ATC Changes as
the Scale of Production Changes
§Economies of scale occur when increasing production allows greater specialization:
workers are more efficient when focusing on a narrow task.
§More common when Q is low.
§Diseconomies of scale are due to coordination problems in large organizations.
E.g., management becomes stretched, can’t control costs.
§More common when Q is high.

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CONCLUSION
§Costs are critically important to many business decisions including production, pricing, and
hiring.
§This chapter has introduced the various cost concepts.
§The following chapters will show how firms use these concepts to maximize profits in various
market structures.

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.
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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
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Summary
•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.
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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
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Summary
•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.
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or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
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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.
© 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole
or in part, except for use as permitted in a license distributed with a certain product or service
or otherwise on a password-protected website for classroom use.
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