The Economics of Production

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founder
 The Economics of Production
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•Week 8
•Read Chapter 13 (and Chapter 18 pages 382 to 388 8th Edition )

Behind the Supply Curve - Costs

Summary
1.What items are included in a firm’s cost of
production.

2.Difference between economic and

accounting profit

3. The link between a firm’s production

process and its total costs.

4. Learn the meaning of ATC, MC and how

they are related.

5.Learn the shape of a typical firm’s cost

curves.

6.Examine the relationship between short-

run and long-run costs.

7.Economies of Scale

8.Decide the optimum number of workers in

a competitive firm.
 Total revenue, total cost,
and profit
Profit = total revenue − total cost
•
Costs as opportunity costs:
Economic profit versus
accounting profit
 Economists versus accountants
How an economist How an accountant
views a firm views a firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Copyright © 2004 South-Western

Economic Profits Guide Decisions
• McDonald's decision: keep farming or quit?
Implicit cost - if quits farming could earn $11,000
per year working in retail sector (opportunity cost
of McDonald’s time)
Explicit farm costs are $10,000
Total revenue is $22,000
Accounting Profit Economic Profit Normal Profit
$12,000 $1,000 $11,000

– McDonald should stick with farming

• If revenue fell below $21,000, McDonald should quit
 Owned Inputs
• Rent for the farm land is $6,000 of the $10,000
in explicit costs
– What changes if McDonald inherits the land?
• His rent payments become an implicit cost
Total Revenue Explicit Costs Implicit Costs
$22,000 $4,000 $17,000

Accounting Profit Economic Profit Normal Profit

$18,000 $1,000 $17,000

• McDonald should stick with farming

Production
 Production
(Services of) FACTOR
INTERMEDIATE INPUTS
INPUTS

TECHNOLOGY

OUTPUT
Production and costs
 Production Example Output:
https://www.luxify.com/blog/hermes-birkin-bags-expensive/

Hermes Birkin bags ($70 000) kiva

The Production Function
 The Production Function

Diminishing Marginal Product

 The production function
• Marginal product: The marginal product
of any input in the production process is
the increase in output that arises
from using an additional unit of that
input.
• Diminishing marginal product is the
property whereby (eventually) the
marginal product of an input
declines as the quantity of the input
increases.
Production Example – cake
factory
 Example: Ray’s Cake Factory
Total cost
Output of inputs
(quantity of Cost of (cost of
cakes Marginal factory factory +
Number of produced per product of + Cost of cost of
workers hour) labour Equipm’t workers workers)

0 0 0
1 50 50
2 90 40
3 120 30
4 140 20

5 150 10
The production
function
Diminishing marginal
product

The slope of this

production function
measures the
marginal product of
the input (workers).
When the marginal
product declines, the
production function
becomes flatter.
 Now moving on to drawing
cost curves
• Just as drawing a production function
reflects a firm’s technology, drawing
cost curves also reflects (or
represents) a firm’s technology.
 Ray’s cake factory
Total cost
Output of inputs
(quantity of (cost of
Number cakes Marginal (rental) Cost of factory +
of produced product of Cost of workers cost of
workers per hour) labour factory ($10/worker) workers)
0 0 0 $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
 Total Cost Curve
Rises as output rises reflects positive
marginal cost

Increasing slope reflects rising marginal

cost which in turn reflects diminishing
marginal product of labour
 Ray’s total-cost curve
Total
cost

$80 Total-cost
curve

70

60

50

40

30

20

10

0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity

of output
(cookies per hour)
Copyright © 2004 South-Western
 Fixed and variable costs mothers day

• Total costs:
Total fixed costs (TFC)
Total variable costs (TVC) (Long-run all costs variable)

Total costs (TC)

• TC = TFC + TVC
 OJ’s Juice Stand
Quantity
of Juice Average Average Average
(bottles Total Fixed Variable fixed variable total Marginal
per hour) cost cost cost cost cost cost cost
0 $3.00 $3.00 $ 0.00
1 3.30 3.00 0.30
2 3.80 3.00 0.80
3 4.50 3.00 1.50
4 5.40 3.00 2.40
5 6.50 3.00 3.50
6 7.80 3.00 4.80
7 9.30 3.00 6.30
8 11.00 3.00 8.00
9 12.90 3.00 9.90
10 15.00 3.00 12.00
 Average costs
•Average costs (3)
Average fixed costs (AFC)
Average variable costs (AVC)
Average total costs (ATC)

•ATC = AFC + AVC

 Average costs work

F ix ed co st F C
AFC  
Q u an tity Q

V a riab le co st V C
AV C  
Q u an tity Q

To tal co st T C
AT C  
Q u an tity Q
 OJ’s Juice Stand
Quantity
of Juice Average Average Average
(bottles Total Fixed Variable fixed variable total Marginal
per hour) cost cost cost cost cost cost cost
0 $3.00 $3.00 $ 0.00 — — —
1 3.30 3.00 0.30 $3.00 $0.30 $3.30
2 3.80 3.00 0.80 1.50 0.40 1.90
3 4.50 3.00 1.50 1.00 0.50 1.50
4 5.40 3.00 2.40 0.75 0.60 1.35
5 6.50 3.00 3.50 0.60 0.70 1.30
6 7.80 3.00 4.80 0.50 0.80 1.30
7 9.30 3.00 6.30 0.43 0.90 1.33
8 11.00 3.00 8.00 0.38 1.00 1.38
9 12.90 3.00 9.90 0.33 1.10 1.43
10 15.00 3.00 12.00 0.30 1.20 1.50
 Marginal cost
• Marginal cost (MC) measures the
increase in total cost that arises from
an extra unit of production.
• Marginal cost helps answer the following
question:
– How much does it cost to produce an
additional unit of output?
 Marginal cost

(ch ang e in to tal co st) T C

MC  
(ch an g e in q u an tity) Q
 OJ’s Juice Stand
Quantity
of Juice Average Average Average
(bottles Total Fixed Variable fixed variable total Marginal
per hour) cost cost cost cost cost cost cost
0 $3.00 $3.00 $ 0.00 — — — —
1 3.30 3.00 0.30 $3.00 $0.30 $3.30 $0.30
2 3.80 3.00 0.80 1.50 0.40 1.90 0.50
3 4.50 3.00 1.50 1.00 0.50 1.50 0.70
4 5.40 3.00 2.40 0.75 0.60 1.35 0.90
5 6.50 3.00 3.50 0.60 0.70 1.30 1.10
6 7.80 3.00 4.80 0.50 0.80 1.30 1.30
7 9.30 3.00 6.30 0.43 0.90 1.33 1.50
8 11.00 3.00 8.00 0.38 1.00 1.38 1.70
9 12.90 3.00 9.90 0.33 1.10 1.43 1.90
10 15.00 3.00 12.00 0.30 1.20 1.50 2.10
 OJ’s cost curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of output
(glasses of juice per hour)
Copyright © 2004 South-Western
Cost curves and their shapes
• The relationship between marginal cost
and average total cost
– 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.
 OJ’s cost curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC
1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of output
(glasses of juice per hour)
Costs in the short
run and in the long
run
In the short
run, many
costs are fixed
(well, at least
one input
cannot be
varied).

In the
long run, fixed
costs become
variable costs.
Costs in the short
run and in the long
run daily

Because many costs

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.

Suppose
factory size can only
be varied in the long
run
 Average total cost in the
short and long run kfc

Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory

A*

ATC in long run

0 Quantity of
Cars per Day
Copyright © 2004 South-Western
Economies and
diseconomies of
scale
Economies of scale refer to
the property whereby
long-run average total
cost falls as the quantity
of output increases.

Diseconomies of scale refer

to the property whereby
long-run average total cost
rises as the quantity of
output increases.

Constant returns to scale

refers to the property
whereby long-run average
total cost stays the same
as the quantity of output
changes.
 Average total cost in the short and long run
https://www.youtube.com/watch?v=KL2HZBJ37m0&feature=youtu.be

Average
total ATC in short ATC in short ATC in short
cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

cars per day
Copyright © 2004 South-Western
 For the exam
1.What items are included in a firm’s cost of
production.

2.Difference between economic and accounting

profit

3. The link between a firm’s production process

and its total costs.

4. Learn the meaning of ATC, MC and how they are

related.

5.Learn the shape of a typical firm’s cost curves.

6.Examine the relationship between short-run and

long-run costs.

7.Economies of Scale

8.Decide the optimum number of workers in a

competitive firm.