Chapter 13 Production & Costs

Look for the answers to these questions:

 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”?

0
 Total Revenue, Total Cost, Profit
 We assume that the firm’s goal is to maximize
profit.

Profit = Total revenue – Total cost

the amount a the market

firm receives value of the
from the sale inputs a firm
of its output uses in
production

THE COSTS OF PRODUCTION 1

 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.

THE COSTS OF PRODUCTION 2

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.

THE COSTS OF PRODUCTION 3

ACTIVE LEARNING 2
Economic profit vs. accounting profit
The equilibrium rent on office space has just
increased by Dhs1500/month.
Determine the effects on accounting profit and
economic profit if
a. you rent your office space
b. you own your office space

4
 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:
 Maha grows dates.
 She has 5 acres of land.
 She can hire as many workers as she wants.

THE COSTS OF PRODUCTION 5

 Example 1: Maha’s Production Function

L Q 3,000
(no. of (bushels
workers) of dates) 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
THE COSTS OF PRODUCTION 6
 Marginal Product
 If Maha hires one more worker, her 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
∆Q
 Marginal product of labor (MPL) =
∆L
THE COSTS OF PRODUCTION 7
 EXAMPLE 1: Total & Marginal Product
L Q
(no. of (bushels
MPL
workers) of dates)

0 0
∆L = 1 ∆Q = 1000 1000
1 1000
∆L = 1 ∆Q = 800 800
2 1800
∆L = 1 ∆Q = 600 600
3 2400
∆L = 1 ∆Q = 400 400
4 2800
∆L = 1 ∆Q = 200 200
5 3000

THE COSTS OF PRODUCTION 8

 EXAMPLE 1: MPL = Slope of Production
Function
L Q MPL
3,000 equals the
(no. of (bushels MPL slope of the
workers) of dates 2,500

Quantity of output
production function.
0 0 2,000
1000
Notice that
1 1000 MPL diminishes
1,500
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
THE COSTS OF PRODUCTION 9
 Why MPL Is Important
 Recall one of the Ten Principles:
Rational people think at the margin.
 When Maha hires an extra worker,
 her costs rise by the wage she pays the worker
 her output rises by MPL
 Comparing them helps Maha decide whether she
should hire the worker.

THE COSTS OF PRODUCTION 10

 Why MPL Diminishes
 Maha’s output rises by a smaller and smaller
amount for each additional worker. Why?
 As Maha 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)

THE COSTS OF PRODUCTION 11

 EXAMPLE 1: Maha’s Costs
 Maha must pay AED1000 per month for the land,
regardless of how many dates she grows.
 The market wage for a farm worker is AED2000
per month.
 So Maha’s costs are related to how much dates
she produces….

THE COSTS OF PRODUCTION 12

 EXAMPLE 1: Maha’s Costs
L Q
Cost of Cost of Total
(no. of (bushels
land labor Cost
workers) of dates)

0 0 1,000
AED 0
AED 1,000
AED

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

THE COSTS OF PRODUCTION 13

 EXAMPLE 1: Maha’s Total Cost Curve
Q 12,000
Total
(bushels
Cost 10,000
of dates)
8,000

Total cost
0 1,000
AED

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 dates

THE COSTS OF PRODUCTION 14

 Marginal Cost

 Marginal Cost (MC) is the increase in Total Cost

from producing one more unit:

∆TC
MC =
∆Q

THE COSTS OF PRODUCTION 15

 EXAMPLE 1: Total and Marginal Cost
Q
Total Marginal
(bushels
Cost Cost (MC)
of dates)

0 1,000
AED

∆Q = 1000 ∆TC = AED2000 2.00

AED

1000 3,000
∆Q = 800 ∆TC = 2000 2.50
1800 5,000
∆Q = 600 ∆TC = 2000 3.33
2400 7,000
∆Q = 400 ∆TC = 2000 5.00
2800 9,000
∆Q = 200 ∆TC = 2000 10.00
3000 11,000

THE COSTS OF PRODUCTION 16

 EXAMPLE 1: The Marginal Cost Curve
12
Q
(bushels TC MC 10 MC usually rises
of dates) as Q rises,

Marginal Cost ($)

8 as in this example.
0 1,000
AED

2.00
AED
6
1000 3,000
2.50
1800 5,000 4
3.33
2400 7,000 2
5.00
2800 9,000 0
10.00 0 1,000 2,000 3,000
3000 11,000 Q

THE COSTS OF PRODUCTION 17

 Why MC Is Important

 Maha is rational and wants to maximize her profit.

To increase profit, should she produce more or
less dates?
 To find the answer, Maha needs to “think at the
margin.”
 If the cost of additional dates (MC) is less than
the revenue she would get from selling it,
then Maha’s profits rise if she produces more.

THE COSTS OF PRODUCTION 18

 Fixed and Variable Costs
 Fixed costs (FC) do not vary with the quantity of
output produced.
 For Maha, FC = AED1000 for her land
 Other examples:
cost of equipment, loan payments, rent
 Variable costs (VC) vary with the quantity
produced.
 For Maha, VC = wages she pays workers
 Other example: cost of materials
 Total cost (TC) = FC + VC

THE COSTS OF PRODUCTION 19

A New Example:
800
AED
FC
Q FC VC TC 700 VC
TC
0 100
AED 0
AED 100
AED
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
THE COSTS OF PRODUCTION 20
EXAMPLE 2: Marginal Cost

Q TC MC 200 Marginal Cost (MC)

Recall,
is the
175change in total cost from
0 100
AED
70
AED producing
150 one more unit:
1 170
50 125 ∆TC

Costs
2 220 MC =
100 ∆Q
40
3 260 Usually,
75 MC rises as Q rises, due
50 to diminishing marginal product.
4 310 50
70 Sometimes (as here), MC falls
5 380 25
100 before rising.
6 480 0
140 (In other0 examples,
1 2 3 MC 4 may
5 6be 7
7 620 constant.) Q
THE COSTS OF PRODUCTION 21
EXAMPLE 2: Average Fixed Cost

Q FC AFC Average
200 fixed cost (AFC)
0 AED100 n/a
is 175
fixed cost divided by the
quantity
150
of output:
1 100 100
AED

AFC
125 = FC/Q

Costs
2 100 50
100
3 100 33.33
Notice
75 that AFC falls as Q rises:
4 100 25 The firm is spreading its fixed
50
5 100 20 costs over a larger and larger
25
number of units.
6 100 16.67 0
7 100 14.29 0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 22
EXAMPLE 2: Average Variable Cost

Q VC AVC Average
200 variable cost (AVC)
is variable
175 cost divided by the
0 0
AED n/a
quantity of output:
150
1 70 70
AED
AVC
125 = VC/Q

Costs
2 120 60
100
3 160 53.33 As Q rises, AVC may fall initially.
75
4 210 52.50 In most cases, AVC will
50
eventually rise as output rises.
5 280 56.00
25
6 380 63.33 0
7 520 74.29 0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 23
EXAMPLE 2: Average Total Cost

Q TC ATC AFC AVC Average total cost

(ATC) equals total
0 AED100 n/a n/a n/a
cost divided by the
1 170 170
AED 100
AED 70
AED quantity of output:
2 220 110 50 60 ATC = TC/Q
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
ATC = AFC + AVC
5 380 76 20 56.00
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29

THE COSTS OF PRODUCTION 24

EXAMPLE 2: Average Total Cost

Q TC ATC 200
AED

Usually,
175
as in this example,
0 100
AED n/a
the ATC curve is U-shaped.
150
1 170 170
AED

125

Costs
2 220 110
100
3 260 86.67
75
4 310 77.50 50
5 380 76 25
6 480 80 0
0 1 2 3 4 5 6 7
7 620 88.57
Q
THE COSTS OF PRODUCTION 25
 EXAMPLE 2: The Various Cost Curves Together

200
AED

175
150
ATC
125

Costs
AVC
100
AFC
MC 75
50
25
0
0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 26
ACTIVE LEARNING 3
Calculating costs
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 AED50 n/a n/a n/a
$10
1 10 10
AED 60.00
AED

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
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EXAMPLE 2: Why ATC Is Usually U-Shaped

As Q rises: 200
AED

Initially, 175
falling AFC 150
pulls ATC down. 125

Costs
Eventually, 100
rising AVC 75
pulls ATC up.
50
Efficient scale: 25
The quantity that
0
minimizes ATC. 0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 28
 EXAMPLE 2: ATC and MC
When MC < ATC, 200
AED ATC
ATC is falling. MC
175
When MC > ATC, 150
ATC is rising. 125

Costs
The MC curve 100
crosses the 75
ATC curve at 50
the ATC curve’s
25
minimum.
0
0 1 2 3 4 5 6 7
Q
THE COSTS OF PRODUCTION 29
 How ATC Changes as
the Scale of Production Changes
 Economies of scale occur when increasing
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
problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
 More common when Q is high.
THE COSTS OF PRODUCTION 30
 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.

THE COSTS OF PRODUCTION 31