CH 13 Student Handout 8e PDF

N.
GREGORY MANKIW
PRINCIPLES OF
ECONOMICS
Eight Edition
CHAPTER
The Costs
13 of Production
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V. Andreea CHIRITESCU
Eastern Illinois University
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1
management system for classroom use.
Active Learning 1 Brainstorming costs

You run Ford Motor Company.
• List three different costs you have.
• List three different
business decisions
that are affected
by your costs
as permitted in a license distributed with a certain product or service or otherwise on a password-protected website or school-approved learning 2
Total Revenue, Total Cost, Profit

• We assume that the firm’s goal is …
Profit = Total revenue – Total cost
TR = P×Q
1
Costs: Explicit vs. Implicit
• ‘The cost of something is what you give
up to get it.’
• Explicit costs
–…
• E.g., paying wages to workers.
• Implicit costs
–…
• E.g., the opportunity cost of the owner’s time.
• Total cost = Explicit + Implicit costs
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 = …
• Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = …
– implicit cost = ...
In both cases, …
Economic Profit vs. Accounting Profit

• Accounting profit
=…
• Economic profit
=…
• Accounting profit ignores implicit costs,

so ...
2
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
Production Function
• Production function
– Relationship between
•…
– Gets flatter as production rises
EXAMPLE 1: Farmer Jack

Example 1:
• Farmer Jack grows wheat.
• He has 5 acres of land (fixed resource).
• He can hire as many workers as he wants.
– The quantity of output produced varies with the
number of workers hired
3
EXAMPLE 1: Farmer Jack’s Production Function
L Q 3,000
(no. of (bushels
workers) of wheat) 2,500
Quantity of output
0 0 2,000
1 1000 1,500
2 1800 1,000
3 2400 500
4 2800 0
0 1 2 3 4 5
5 3000
No. of workers
10
10
Marginal Product
• Marginal product
–…
• Other inputs constant

– Slope of the production function
• Marginal product of labor, MPL
– MPL = …
– If Jack hires one more worker, his output
rises by the marginal product of labor.
EXAMPLE 1: Total & Marginal Product

L Q
(no. of (bushels
MPL
workers) of wheat)
0 0
∆L = 1 ∆Q = 1000 1000
1 1000
2 1800
3 2400
4 2800
5 3000
4
Diminishing MPL
• Diminishing marginal product
–…
– Production function gets flatter as more

inputs are being used:
• The slope of the production function …
EXAMPLE 1: MPL = Slope of Prod Function
L Q MPL
3,000 equals the
(no. of (bushels MPL slope of the
workers) of wheat) 2,500
Quantity of output
production function.
0 0 2,000
1000
Notice that
1 1000 MPL
1,500diminishes
800 as L increases.
2 1800 1,000
600 This explains why
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
14
14
Why MPL Is Important

• ‘Rational people think at the margin’
• When Farmer Jack hires an extra worker
–…
– Comparing them helps Jack decide

whether he should hire the worker.
5
Why MPL Diminishes
• Farmer Jack’s output rises by a smaller
and smaller amount for each additional
worker. Why?
–…
– In general, MPL diminishes as L rises

whether the fixed input is land or capital
(equipment, machines, etc.).
EXAMPLE 1: Farmer Jack’s Costs
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 Jack’s costs are related to how
much wheat he produces….
EXAMPLE 1: Farmer Jack’s Costs
L Q
Cost of Cost of Total
(no. of (bushels
land labor cost
workers) of wheat)
0 0 $1,000 $0 $1,000
1 1000 $1,000 $2,000 $3,000
2 1800 $1,000 $4,000 $5,000
3 2400 $1,000 $6,000 $7,000
4 2800 $1,000 $8,000 $9,000

5 3000 $1,000 $10,000 $11,000
6
EXAMPLE 1: Farmer Jack’s Total Cost Curve
Q $12,000
Total
(bushels
Cost $10,000
of wheat)
$8,000
Total cost
0 $1,000
$6,000
1000 $3,000
$4,000
1800 $5,000
$2,000
2400 $7,000
$0
2800 $9,000
0 1000 2000 3000
3000 $11,000 Quantity of wheat
19
19
Marginal Cost
• Marginal cost, MC
–…
– Marginal cost = …
– MC = …
– Increase in total cost
• From producing an additional unit of output
EXAMPLE 1: Total and Marginal Cost

Q
Total Marginal
(bushels
Cost Cost (MC)
of wheat)
0 $1,000
∆Q = 1000 ∆TC = $2000 $2.00
1000 $3,000
1800 $5,000
2400 $7,000
2800 $9,000
3000 $11,000
7
EXAMPLE 1: The Marginal Cost Curve
$12
Q
(bushels TC MC $10 MC usually rises
of wheat) as Q rises,
Marginal Cost ($)

$8 as in this example.
0 $1,000
$2.00 $6
1000 $3,000
$2.50 $4
1800 $5,000
$3.33 $2
2400 $7,000
$5.00
$0
2800 $9,000
0 1,000 2,000 3,000
$10.00
3000 $11,000 Q
Why MC Is Important
• Farmer Jack is rational and wants to
maximize his profit
– To increase profit, should he produce
more or less wheat?
• Farmer Jack needs to “think at the margin”
–…
Fixed and Variable Costs

• Fixed costs, FC, …
– For Farmer Jack, FC = …

– Other examples: cost of equipment, loan
payments, rent
• Variable costs, VC, …
• For Farmer Jack, VC = …

• Other example: cost of materials
• Total cost = …
8
EXAMPLE 2: Production Costs
• Our second example is more general,
applies to any type of firm producing any
good with any types of inputs.
– Calculate and graph TC knowing FC and VC
– Calculate and graph marginal and average
costs
– Understand the relationship between marginal
cost and average cost
EXAMPLE 2: Costs: TC = FC + VC
$800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $100 $600
1 100 70 170 $500
Costs
2 100 120 220

$400
3 100 160 260
$300
4 100 210 310
$200
5 100 280 380
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
EXAMPLE 2: Marginal Cost
$200 Marginal Cost (MC)

Recall,
Q TC MC is the change in total cost from
$175
producing one more unit:
0 $100 $150 ∆TC
$70 MC =
1 170 $125 ∆Q
Costs
50
2 220 $100
40 $75
3 260 Usually, MC rises as Q rises, due to
50 diminishing
$50 marginal product.
4 310
70 Sometimes
$25 (as here), MC falls
5 380 before
100 $0 rising.
6 480 (In other
0 examples,
1 2 3 MC 4 may
5 be
6 7
140
7 620 constant.) Q
9
EXAMPLE 2: Average Fixed Cost, AFC
Q FC AFC Average
$200 fixed cost (AFC)
is$175
fixed cost divided by the
0 $100 n/a
quantity
$150 of output:
1 100 $100 $125
AFC = FC/Q
Costs
2 100 50 $100
3 100 33.33 $75
4 100 25 Notice
$50 that AFC falls as Q
5 100 20
rises:
$25 The firm is spreading its
fixed
$0 costs over a larger and
6 100 16.67 0 1 2 of 3 units.
4 5 6 7
larger number
7 100 14.29 Q
EXAMPLE 2: Average Variable Cost, AVC
Q VC AVC Average
$200 variable cost
(AVC)
$175
0 $0 n/a
is variable
$150 cost divided by
1 70 $70 the
$125 quantity of output:
Costs
2 120 60 $100AVC = VC/Q

3 160 53.33 $75
As Q rises, AVC may fall
4 210 52.50 $50
initially. In most cases,
5 280 56.00 $25
AVC will eventually rise as
6 380 63.33 output
$0 rises.
0 1 2 3 4 5 6 7
7 520 74.29 Q
EXAMPLE 2: Average Total Cost
Q TC ATC AFC AVC Average total cost

(ATC) equals …
0 $100 n/a n/a n/a
1 170 $170 $100 $70
2 220 110 50 60
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
5 380 76 20 56.00 ATC = …
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29
10
EXAMPLE 2: Average Total Cost, usually U-shaped
Usually,
$200 as in this example, the
Q TC ATC
ATC curve is U-shaped.
$175
0 $100 n/a
$150
1 170 $170 $125
Costs
2 220 110 $100

3 260 86.67 $75
As Q rises: Eventually,
4 310 77.50 $50
Efficient
$25 scale:
5 380 76
The quantity that minimizes ATC.
$0
6 480 80
0 1 2 3 4 5 6 7
7 620 88.57 Q Efficient scale
EXAMPLE 2: The Various Cost Curves Together
$200
$175
$150
ATC
$125
Costs
AVC
$100
AFC
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
EXAMPLE 2: ATC and MC
When MC < ATC, $200 ATC

ATC …. MC
$175
$150
When MC > ATC,
$125
Costs
ATC ….
$100
The MC curve $75
crosses the ATC $50

curve $25
at …. $0
0 1 2 3 4 5 6 7
Q
© 2018 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part, except for use 33
11
Active Learning 3 Calculating costs
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 $50 n/a n/a n/a
$10
1 10 $10 $60.00
2 30 80
30
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30
60
6 210 260 8.33 35 43.33
Costs in the Short Run & Long Run

• Short run:
–…
• Long run:
–…
• In the long run

• ATC at any Q is cost per unit using …
EXAMPLE 3: LRATC with 3 factory sizes
Firm can choose

Avg
from three factory
Total
sizes: S, M, L. Cost
Each size has its

own SRATC curve.
12
EXAMPLE 3: LRATC with 3 factory sizes
To produce less than
QA , … Avg
Total
Cost ATCS ATCM
ATCL
To produce between
QA and QB, …
To produce more Q
than QB, … QA QB
A Typical LRATC Curve
In the real world,

factories come in ATC
many sizes, each
with its own
SRATC curve.
So a typical
LRATC curve
looks like this:
Q
How ATC Changes as

the Scale of Production Changes
Economies of scale:
ATC
LRATC
Constant returns to
scale:
Diseconomies of Q
scale:
13
Costs in Short and Long Run
• Economies of scale
–…
• Constant returns to scale

–…
Costs in Short and Long Run

• Diseconomies of scale
–…
• E.g., management becomes stretched, can’t

control costs.
• More common when Q is high.
14

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N.

Active Learning 1 Brainstorming costs

Total Revenue, Total Cost, Profit

Profit = Total revenue – Total cost

Explicit vs. Implicit Costs: An Example

Economic Profit vs. Accounting Profit

• Accounting profit ignores implicit costs,

– Gets flatter as production rises

EXAMPLE 1: Farmer Jack

• Other inputs constant

EXAMPLE 1: Total & Marginal Product

– Production function gets flatter as more

EXAMPLE 1: MPL = Slope of Prod Function

Why MPL Is Important

– Comparing them helps Jack decide

– In general, MPL diminishes as L rises

EXAMPLE 1: Farmer Jack’s Costs

Farmer Jack must pay $1000 per month for

EXAMPLE 1: Farmer Jack’s Costs

1 1000 $1,000 $2,000 $3,000

2 1800 $1,000 $4,000 $5,000

3 2400 $1,000 $6,000 $7,000

4 2800 $1,000 $8,000 $9,000

EXAMPLE 1: Total and Marginal Cost

Marginal Cost ($)

Fixed and Variable Costs

– For Farmer Jack, FC = …

• For Farmer Jack, VC = …

2 100 120 220

EXAMPLE 2: Marginal Cost

$200 Marginal Cost (MC)

EXAMPLE 2: Average Variable Cost, AVC

2 120 60 $100AVC = VC/Q

EXAMPLE 2: Average Total Cost

Q TC ATC AFC AVC Average total cost

2 220 110 $100

EXAMPLE 2: The Various Cost Curves Together

EXAMPLE 2: ATC and MC

When MC < ATC, $200 ATC

The MC curve $75

crosses the ATC $50

Costs in the Short Run & Long Run

• In the long run

EXAMPLE 3: LRATC with 3 factory sizes

Firm can choose

Each size has its

A Typical LRATC Curve

In the real world,

How ATC Changes as

• Constant returns to scale

Costs in Short and Long Run

• E.g., management becomes stretched, can’t

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