Microeconomics: The Costs of Production

ACTIVE LEARNING
13
Brainstorming
The Costs of Production
1:
You run General Motors.
List 3 different costs you have.
PRINCIPLES OF
List 3 different
MICROECONOMICS
business decisions
that are affected
by your costs.
FOURTH EDITION
N. G R E G O R Y M A N K I W
Premium PowerPoint Slides
by Ron Cronovich
2007 update
2008 Thomson South-Western, all rights reserved
Total Revenue, Total Cost, Profit
In this chapter, look for the answers to

these questions:
What is a production function? What is marginal
We assume that the firms goal is to maximize

profit.
product? How are they related?
Profit = Total revenue Total cost
What are the various costs, and how are they

related to each other and to output?
the amount a
firm receives
from the sale
of its output
How are costs different in the short run vs. the

long run?
What are economies of scale?
CHAPTER 13
THE COSTS OF PRODUCTION
CHAPTER 13
the market
value of the
inputs a firm
uses in
production
Explicit vs. Implicit Costs: An Example
Costs: Explicit vs. Implicit
You need $100,000 to start your business.

The interest rate is 5%.
Explicit costs require an outlay of money,

e.g. paying wages to workers
Case 1: borrow $100,000

explicit cost = $5000 interest on loan
Implicit costs do not require a cash outlay,

e.g. the opportunity cost of the owners time
Case 2: use $40,000 of your savings,
Remember one of the Ten Principles:
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.
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.
In both cases, total (exp + imp) costs are $5000.

CHAPTER 13
CHAPTER 13
Economic Profit vs. Accounting Profit
Accounting profit
The equilibrium rent on office space has just

increased by $500/month.
= total revenue minus total explicit costs
Economic profit
Compare the effects on accounting profit and

economic profit if
a. you rent your office space
= total revenue minus total costs (including

explicit and implicit costs)
Accounting profit ignores implicit costs,
b. you own your office space
so its higher than economic profit.
Example 1: Farmer Jacks Production Function
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 Jack grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.
CHAPTER 13
Marginal Product
If Jack hires one more worker, his output rises
1000
1800
2400
500
2800
3000
CHAPTER 13
2,000
1,500
1,000
No. of workers
9
EXAMPLE 1: Total & Marginal Product

Q
(no. of (bushels
workers) of wheat)
increase in output arising from an additional unit

of that input, holding all other inputs constant.
L = 1
Notation:
1000
1800
2400
2800
3000
L = 1
(delta) = change in
L = 1
Examples:
Q = change in output, L = change in labor
Q
Marginal product of labor (MPL) =
L
2,500
The marginal product of any input is the
CHAPTER 13
3,000
by the marginal product of labor.
(no. of (bushels
workers) of wheat)
Quantity of output
CHAPTER 13
A C T I V E L E A R N I N G 2:
Economic profit vs. accounting profit
L = 1
L = 1
10
CHAPTER 13
MPL
Q = 1000
1000
Q = 800
800
Q = 600
600
Q = 400
400
Q = 200
200
11
EXAMPLE 1: MPL = Slope of Prod Function

Q
0
1000
1000
1800
800
3,000
MPL
Quantity of output
(no. of (bushels MPL

workers) of wheat)
600
3
2400
2800
3000
CHAPTER 13
400
200
equals the
slope of the
2,500
production function.
Rational people think at the margin.
When Farmer Jack hires an extra worker,
his costs rise by the wage he pays the worker

his output rises by MPL
2,000
Notice that
MPL diminishes
1,500
as L increases.
Comparing them helps Jack decide whether he
1,000
This explains why

500
the
production
function
gets flatter
0
as L0 increases.
1
2
3
4
Why MPL Is Important

Recall one of the Ten Principles:
would benefit from hiring the worker.
No. of workers
12
CHAPTER 13
Why MPL Diminishes
13
EXAMPLE 1: Farmer Jacks Costs
Farmer Jacks output rises by a smaller and

smaller amount for each additional worker. Why?
As Jack adds workers, the average worker has

less land to work with and will be less productive.
In general, MPL diminishes as L rises
Farmer Jack 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 Farmer Jacks costs are related to how much
whether the fixed input is land or capital

(equipment, machines, etc.).
wheat he produces.
Diminishing marginal product:

the marginal product of an input declines as the
quantity of the input increases (other things equal)
14
EXAMPLE 1: Farmer Jacks Costs

L
Q
(no. of (bushels
workers) of wheat)
cost of
land
cost of
labor
CHAPTER 13
EXAMPLE 1: Farmer Jacks Total Cost Curve

$12,000
Q
(bushels
of wheat)
Total
Cost
Total
Cost
$1,000
$0
$1,000
$1,000
1000
$1,000
$2,000
$3,000
1000
$3,000
1800
$1,000
$4,000
$5,000
1800
$5,000
2400
$1,000
$6,000
$7,000
2400
$7,000
2800
$1,000
$8,000
$9,000
2800
$9,000
3000
$1,000 $10,000
$11,000
3000
$11,000
CHAPTER 13
15
16
CHAPTER 13
$10,000
Total cost
CHAPTER 13
$8,000
$6,000
$4,000
$2,000
$0
1000
2000
3000
Quantity of wheat
17
Marginal Cost
EXAMPLE 1: Total and Marginal Cost
Marginal Cost (MC)
Q
(bushels
of wheat)
is the increase in Total Cost from

producing one more unit:
MC =
TC
Q
Q = 1000
Q = 800
Q = 600
Q = 400
Q = 200
Total
Cost
$1,000
1000
$3,000
1800
$5,000
2400
$7,000
2800
$9,000
Marginal
Cost (MC)
TC = $2000
$2.00
TC = $2000
$2.50
TC = $2000
$3.33
TC = $2000
$5.00
TC = $2000
$10.00
3000 $11,000
CHAPTER 13
18
CHAPTER 13
EXAMPLE 1: The Marginal Cost Curve
MC
$1,000
$2.00
1000
$3,000
$2.50
1800
$5,000
$3.33
2400
$7,000
2800
$9,000
$10
Marginal Cost ($)
TC
$8
19
Why MC Is Important
Farmer Jack is rational and wants to maximize
$12
Q
(bushels
of wheat)
his profit. To increase profit, should he produce

more wheat, or less?
MC usually rises
as Q rises,
as in this example.
To find the answer, Farmer Jack

needs to think at the margin.
$6
If the cost of additional wheat (MC) is less than
$4
the revenue he would get from selling it,

then Jacks profits rise if he produces more.
$2
$5.00
3000 $11,000
CHAPTER 13
$10.00
$0
0
1,000
2,000
3,000
20
CHAPTER 13
Fixed and Variable Costs
21
EXAMPLE 2
Fixed costs (FC) do not vary with the quantity of

output produced.
For Farmer Jack, FC = $1000 for his land
Other examples:
cost of equipment, loan payments, rent
Our second example is more general,

applies to any type of firm,
producing any good with any types of inputs.
Variable costs (VC) vary with the quantity

produced.
For Farmer Jack, VC = wages he pays workers
Other example: cost of materials
Total cost (TC) = FC + VC

CHAPTER 13
22
CHAPTER 13
23
EXAMPLE 2: Costs
$700
VC
$0 $100
$600
0 $100
70
170
$500
170
100 120
220
$400
220
$300
260
$200
310
$100
380
100
2
3
100 160
260
100 210
310
100 280
380
100 380
480
100 520
620
$0
0
Q
CHAPTER 13
24
EXAMPLE 2: Average Fixed Cost

FC
0 $100
n.a.
100
$100
100
50
100 33.33
100
25
100
20
100 16.67
100 14.29
AFC
$125
= FC/Q
$100
Notice
$75 that AFC falls as Q rises:
The
$50firm is spreading its fixed
costs over a larger and larger
$25
number of units.
$0
0
7
26
EXAMPLE 2: Average Total Cost

Q
TC
ATC
AFC
AVC
n.a.
n.a.
n.a.
170
$170
$100
$70
220
110
50
60
260 86.67 33.33
53.33
310 77.50
25
52.50
380
76
20
56.00
480
80 16.67
620 88.57 14.29
0 $100
CHAPTER 13
480
620
CHAPTER 13
Q
CHAPTER 13
MC
$70
50
40
50
70
100
140
$200
Recall,
Marginal Cost (MC)
is $175
the change in total cost from
producing
one more unit:
$150
TC
Q
Usually,
$75 MC rises as Q rises, due
to diminishing marginal product.
$50
$125
Sometimes
(as here), MC falls
$25
before rising.
$0
(In other0 examples,

1 2 3 MC
4 may
5 6be 7
constant.)
Q
25
VC
AVC
$0
n.a.
70
$70
120
60
160 53.33
210 52.50
280 56.00
380 63.33
520 74.29
CHAPTER 13
$200
Average
variable cost (AVC)
is$175
variable cost divided by the
quantity
of output:
$150
AVC
$125
= VC/Q
$100
As$75
Q rises, AVC may fall initially.
In most cases, AVC will
$50
eventually rise as output rises.
$25
$0
0
4
Q
7
27
EXAMPLE 2: Average Total Cost
Average total cost

(ATC) equals total
cost divided by the
quantity of output:
TC
0 $100
$200
ATC
Usually,
as in this example,
$175
the ATC curve is U-shaped.
n.a.
$150
170
$170
220
110
260 86.67
310 77.50
$50
380
76
$25
63.33
480
80
$0
74.29
620 88.57
MC =
$100
EXAMPLE 2: Average Variable Cost
$200
Average
fixed cost (AFC)
is$175
fixed cost divided by the
quantity
of output:
$150
AFC
Costs
TC
TC
Costs
TC
Costs
0 $100
VC
FC
ATC = TC/Q
Also,
ATC = AFC + AVC
28
CHAPTER 13
Costs
FC
Costs
EXAMPLE 2: Marginal Cost
$800
$125
$100
$75
Q
29
EXAMPLE 2: The Various Cost Curves Together
ACTIVE LEARNING
Costs
$200
3:
Fill in the blank spaces of this table.
$150
$125
$100
10
$75
30
$50
$25
100
150
210
$0
0
Q
CHAPTER 13
Eventually,
rising AVC
pulls ATC up.
Costs
Initially,
falling AFC
pulls ATC down.
$175
AFC
AVC
ATC
n.a.
n.a.
n.a.
$10
$60.00
20
36.67
16.67
150
12.50
260
8.33
37.50
35
$175
When MC > ATC,
$150
ATC is rising.
$125
$100
The MC curve
crosses the
ATC curve at
the ATC curves
minimum.
$75
$50
ATC
MC
$200
$125
$0
$100
$75
$50
$25
$0
Q
32
CHAPTER 13
7
33
EXAMPLE 3: LRATC with 3 factory Sizes

Firm can choose
from 3 factory
sizes: S, M, L.
Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
Avg
Total
Cost
Each size has its

own SRATC curve.
Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones)
The firm can

change to a
different factory
size in the long
run, but not in the
short run.
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).
4
Q
Costs in the Short Run & Long Run
CHAPTER 13
60
43.33
EXAMPLE 2: ATC and MC
$150
$25
CHAPTER 13
30
30
ATC is falling.
$10
80
When MC < ATC,
MC
31
EXAMPLE 2: Why ATC Is Usually U-Shaped

$200
TC
$50
30
As Q rises:
VC
Costs
ATC
AVC
AFC
MC
Costs
$175
34
CHAPTER 13
ATCS
ATCM
ATCL
35
EXAMPLE 3: LRATC with 3 factory Sizes

To produce less
than QA, firm will
choose size S
in the long run.
Avg
Total
Cost
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.
CHAPTER 13
ATCS
ATCM
A Typical LRATC Curve
ATCL
LRATC
QA
36
How ATC Changes As

the Scale of Production Changes
So a typical
LRATC curve
looks like this:
Q
CHAPTER 13
37
Economies of scale occur when increasing
ATC
LRATC
production allows greater specialization:

workers more efficient when focusing on a
narrow task.
More common when Q is low.
Diseconomies of scale are due to coordination
Diseconomies of
scale: ATC rises
as Q increases.
38
CONCLUSION
decisions, including production, pricing, and
hiring.
CHAPTER 13
39
yet are just as important as explicit costs

to firms decisions.
This chapter has introduced the various cost
Accounting profit is revenue minus explicit costs.
concepts.
Economic profit is revenue minus total (explicit +

implicit) costs.
The following chapters will show how firms use

these concepts to maximize profits in various
market structures.
problems in large organizations.

E.g., management becomes stretched, cant
control costs.
More common when Q is high.
CHAPTER SUMMARY
Implicit costs do not involve a cash outlay,
Costs are critically important to many business
CHAPTER 13
LRATC
How ATC Changes As

the Scale of Production Changes
Constant returns
to scale: ATC
stays the same
as Q increases.
CHAPTER 13
ATC
QB
Economies of
scale: ATC falls
as Q increases.
In the real world,

factories come in
many sizes,
each with its own
SRATC curve.
The production function shows the relationship

between output and inputs.
40
CHAPTER 13
41
CHAPTER SUMMARY
The marginal product of labor is the increase in
CHAPTER SUMMARY
Marginal cost is the increase in total cost from an
extra unit of production. The MC curve is usually
upward-sloping.
output from a one-unit increase in labor, holding

other inputs constant. The marginal products of
other inputs are defined similarly.
Average variable cost is variable cost divided by
Marginal product usually diminishes as the input
output.
increases. Thus, as output rises, the production

function becomes flatter, and the total cost curve
becomes steeper.
Average fixed cost is fixed cost divided by output.

AFC always falls as output increases.
Average total cost (sometimes called cost per
Variable costs vary with output; fixed costs do not.

CHAPTER 13
unit) is total cost divided by the quantity of output.

The ATC curve is usually U-shaped.
42
CHAPTER 13
43
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.
CHAPTER 13
44

Microeconomics: The Costs of Production

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ACTIVE LEARNING

The Costs of Production

You run General Motors.

List 3 different costs you have.

2008 Thomson South-Western, all rights reserved

Total Revenue, Total Cost, Profit

In this chapter, look for the answers to

We assume that the firms goal is to maximize

product? How are they related?

Profit = Total revenue Total cost

What are the various costs, and how are they

How are costs different in the short run vs. the

What are economies of scale?

THE COSTS OF PRODUCTION

THE COSTS OF PRODUCTION

Explicit vs. Implicit Costs: An Example

Costs: Explicit vs. Implicit

You need $100,000 to start your business.

Explicit costs require an outlay of money,

Case 1: borrow $100,000

Implicit costs do not require a cash outlay,

Case 2: use $40,000 of your savings,

Remember one of the Ten Principles:

borrow the other $60,000

The cost of something is

This is true whether the costs are implicit or

In both cases, total (exp + imp) costs are $5000.

THE COSTS OF PRODUCTION

THE COSTS OF PRODUCTION

Economic Profit vs. Accounting Profit

The equilibrium rent on office space has just

= total revenue minus total explicit costs

Compare the effects on accounting profit and

= total revenue minus total costs (including

Accounting profit ignores implicit costs,

b. you own your office space

so its higher than economic profit.

THE COSTS OF PRODUCTION

Example 1: Farmer Jacks Production Function

The Production Function

It can be represented by a table, equation, or

THE COSTS OF PRODUCTION

THE COSTS OF PRODUCTION

EXAMPLE 1: Total & Marginal Product

increase in output arising from an additional unit

The marginal product of any input is the

by the marginal product of labor.

THE COSTS OF PRODUCTION

EXAMPLE 1: MPL = Slope of Prod Function

(no. of (bushels MPL

Rational people think at the margin.

When Farmer Jack hires an extra worker,

his costs rise by the wage he pays the worker

Comparing them helps Jack decide whether he

This explains why

Why MPL Is Important

would benefit from hiring the worker.

THE COSTS OF PRODUCTION

Why MPL Diminishes

THE COSTS OF PRODUCTION

EXAMPLE 1: Farmer Jacks Costs

Farmer Jacks output rises by a smaller and

As Jack adds workers, the average worker has