7 Production and Cost in the Firm

 How do economists calculate profit?

 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”?
 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
 Costs: Explicit vs. Implicit
 Explicit costs – actual cash payments for
resources, such as paying wages to workers
 Implicit costs – opportunity cost of using
owner-supplied resources, such as the
opportunity cost of the owner’s time
 Remember: The cost of something is the value
of the next best alternative.
 This is true whether the costs are implicit or
explicit. Both matter for a firm’s decisions.
Explicit vs. Implicit Costs: An Example
Fred currently works for a corporate law firm. He is
considering opening his own legal practice, where
he expects to earn P200,000 per year once he gets
established. To run his own firm, he would need an
office and a law clerk. He has found the perfect
office, which rents for P50,000 per year. A law
clerk could be hired for P35,000 per year. But to
open his own practice, Fred would have to quit his
current job, where he is earning an annual salary of
P125,000.
Explicit vs. Implicit Costs: An Example
Step 1. First you have to calculate the explicit and
implicit costs.
 Explicit Costs = P85,000
1. Office rental P50,000
2. Clerk’s salary P35,000

 Implicit cost
1. Fred’s salary P125,000
Economic Profit vs. Accounting Profit
 Accounting profit
= total revenue minus total explicit costs
 Economic profit
= total revenue minus total costs (including
BOTH explicit and implicit costs)
 Accounting profit ignores implicit costs,
so it will be greater than economic profit.
 Economic Profit vs. Accounting Profit: Sample

 Step 2. Subtracting the explicit costs from the revenue

gives you the accounting profit.
1. Revenue = P200,000
2. Explicit costs = (P85,000)
3. Accounting profit = P115,000
Step 3. You need to subtract both the explicit and implicit
costs to determine the true economic profit:
4. Revenue = P200,000
5. Explicit and implicit costs = (P85,000+P125,000)
6. Economic Profit = (P10,000)
 Conclusion
 Fred would be losing P10,000 per year. That does not
mean he would not want to open his own business,
but it does mean he would be earning P10,000 less
than if he worked for the corporate firm.
Implicit costs can include other things as well. Maybe
Fred values his leisure time, and starting his own firm
would require him to put in more hours than at the
corporate firm. In this case, the lost leisure would
also be an implicit cost that would subtract from
economic profits.
 Production in the Short Run

 Some resources are considered to be variable

and some are considered to be fixed.
• It depends on how quickly the level can be
altered to change the rate of output.
 In the short run, at least one resource is fixed.
 In the long run, all resources are variable.
 The Structure of Costs in the Short Run
 Fixed costs are expenditures that do not change regardless of
the level of production, at least not in the short term. Whether
you produce a lot or a little, the fixed costs are the same. One
example is the rent on a factory or a retail space. Once you
sign the lease, the rent is the same regardless of how much you
produce, at least until the lease runs out.
 Variable costs, on the other hand, are incurred in the act of
producing—the more you produce, the greater the variable
cost. Labor is treated as a variable cost, since producing a
greater quantity of a good or service typically requires more
workers or more work hours. Variable costs would also
include raw materials.
 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.
EXAMPLE 1: Farmer Jack’s Production Function

L Q 3,000
(# of (bushels
workers) of wheat) 2,500

Quantity of output
0 0 2,000

1 1,000 1,500

2 1,800 1,000

3 2,400 500

4 2,800 0
0 1 2 3 4 5
5 3,000
# of workers
 Marginal Product

 The marginal product of any input is the

increase in output arising from an additional unit
of that input, holding all other inputs constant.
 If Farmer Jack hires one more worker, his output
rises by the marginal product of labor.
 Marginal product of labor (MPL) = ∆Q
∆L
 EXAMPLE 1: Total & Marginal Product

L Q
(# of (bushels
MPL
workers) of wheat)

0 0
∆L = 1 ∆Q = 1,000
1 1,000
∆L = 1 ∆Q = 800
2 1,800
∆L = 1 ∆Q = 600
3 2,400
∆L = 1 ∆Q = 400
4 2,800
∆L = 1 ∆Q = 200
5 3,000
EXAMPLE 1: MPL = Slope of Prod. Function

L Q MPL
3,000 equals the
(# of (bushels MPL
slope of the
workers) of wheat) 2,500

Quantity of output
production function.
0 0 2,000
Notice that
1,000
1 1,000 MPL diminishes
1,500
800 as L increases.
2 1,800 1,000
600 This explains why
3 2,400 the
500 production
400 function gets flatter
4 2,800 0
200 as L0increases.
1 2 3 4 5
5 3,000
No. of workers
 Why MPL Is Important

 Recall from Chapter 1: Rational people choose

actions for which the expected marginal benefit
exceeds the expected marginal cost.
 When Farmer Jack hires an extra worker,
• his costs rise by the wage he pays the worker
• his output rises by MPL
 Comparing the wage and the change in his output
helps Jack decide whether he would benefit from
hiring the worker.
 EXAMPLE 2: A “Fold-It” Factory

We are going to create

a factory that produces
a product known as a
“fold-it”

Resources:
• factory
• paper
• stapler
• staples
• labor
 Why MPL Diminishes
 The Law of Diminishing Marginal Returns:
the marginal product of a variable resource
eventually falls as the quantity of the resource
used increases (other things equal)
 If we increases the # of workers but not the # of
staplers or the desk area, each add’l worker has
less to work with and will be less productive.
 In general, MPL diminishes as L rises
whether the fixed resource is land (as would be
the case with Jack the wheat farmer) or capital
(our desk and stapler).
 EXAMPLE 1: Farmer Jack’s Costs

 Farmer Jack must pay $1,000 per month for the

land, regardless of how much wheat he grows.
 The market wage for a farm worker is $2,000 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
(# of (bushels
land labor Cost
workers) of wheat)

0 0

1 1,000

2 1,800

3 2,400
4 2,800
5 3,000
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
1,000 $3,000
$4,000
1,800 $5,000
$2,000
2,400 $7,000
$0
2,800 $9,000
0 1000 2000 3000
3,000 $11,000 Quantity of wheat
 Marginal Cost
 Marginal Cost (MC)
is the increase in Total Cost from producing one
more unit:
∆TC
MC =
∆Q
 EXAMPLE 1: Total and Marginal Cost

Q
Total Marginal
(bushels
Cost Cost (MC)
of wheat)

0 $1,000
∆Q = 1000 ∆TC = $2000 $2.00
1,000 $3,000
∆Q = 800 ∆TC = $2000 $2.50
1,800 $5,000
∆Q = 600 ∆TC = $2000 $3.33
2,400 $7,000
∆Q = 400 ∆TC = $2000 $5.00
2,800 $9,000
∆Q = 200 ∆TC = $2000 $10.00
3,000 $11,000
 EXAMPLE 1: The Marginal Cost Curve
$12
Q
(bushels TC MC $10 MC usually rises
of wheat) as Q rises,

Marginal Cost ($)

$8
0 $1,000 as in this example.
$2.00
$6
1,000 $3,000
$2.50
1,800 $5,000 $4
$3.33
2,400 $7,000 $2
$5.00
2,800 $9,000 $0
$10.00 0 1,000 2,000 3,000
3,000 $11,000 Q
 Why MC Is Important
 Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce
more wheat or less?
 To find the answer, Farmer Jack needs to “think at
the margin.”
 If the cost of an additional bushel of wheat (MC) is
less than the revenue he would get from selling it,
Jack’s profits rise if he produces more.
(In the next chapter, we will learn more about
how firms choose Q to maximize their profits.)
 EXAMPLE 3
 Our third example is more general, and applies
to any type of firm producing any good with any
types of resources.
EXAMPLE 3: Costs
$800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $600
1 100 70 $500

Costs
2 100 120 $400
3 100 160
$300
4 100 210
$200
5 100 280
$100
6 100 380
$0
7 100 520 0 1 2 3 4 5 6 7
Q
EXAMPLE 3: Marginal Cost
$200
Q TC MC Recall, Marginal Cost (MC)
is $175
the change in total cost from
0 $100
$70 producing
$150 one more unit:
1 170
50 $125 ∆TC
MC =
Costs
2 220 $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
EXAMPLE 3: Average Fixed Cost

Q FC AFC $200
Average fixed cost (AFC)
0 $100 ---- is$175
fixed cost divided by the
quantity
$150 of output:
1 100
AFC
$125 = FC/Q

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

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

Costs
2 120
$100
3 160 As$75
Q rises, AVC may fall initially.
4 210 In most cases, AVC will
$50
eventually rise as output rises.
5 280 $25
6 380 $0
7 520 0 1 2 3 4 5 6 7
Q
EXAMPLE 3: Average Total Cost

Q TC ATC AFC AVC Average total cost

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

Q TC ATC $200
Usually,
$175 as in this example,
0 $100 ----
the ATC curve is U-shaped.
$150
1 170 $170
$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
EXAMPLE 3: The 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
A C T I V E L E A R N I N G 3:
Costs
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 $50 ---- ---- ----
$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
34
EXAMPLE 3: Why ATC Is Usually U-shaped

As Q rises: $200

Initially, $175
falling AFC $150
pulls ATC down. $125

Costs
Eventually, $100
rising AVC $75
pulls ATC up.
$50
$25
$0
0 1 2 3 4 5 6 7
Q
 EXAMPLE 3: ATC and MC
When MC < ATC, $200 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
 Lessons from Alternative Measures of Costs
 Breaking down total costs into fixed cost, marginal cost,
average total cost, and average variable cost is useful because
each statistic offers its own insights for the firm.
 Whatever the firm’s quantity of production, total revenue must
exceed total costs if it is to earn a profit. As explored in the
chapter Choice in a World of Scarcity, fixed costs are often
sunk costs that cannot be recouped. In thinking about what to
do next, sunk costs should typically be ignored, since this
spending has already been made and cannot be changed.
However, variable costs can be changed, so they convey
information about the firm’s ability to cut costs in the present
and the extent to which costs will increase if production rises.
 Average cost tells a firm whether it can earn profits given the current price in the market. If we
divide profit by the quantity of output produced we get average profit, also known as the
firm’s profit margin. Expanding the equation for profit gives:

 But note that:

 Thus:
 This is the firm’s profit margin. This definition implies that if the market price is above
average cost, average profit, and thus total profit, will be positive; if price is below average
cost, then profits will be negative.

 The marginal cost of producing an additional unit can be compared with the marginal revenue
gained by selling that additional unit to reveal whether the additional unit is adding to total
profit—or not. Thus, marginal cost helps producers understand how profits would be affected
by increasing or decreasing production.
 Costs in the Long Run
 Short run:
Some inputs are fixed
 Long run:
All inputs are variable (firms can build new
factories, or remodel 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
(the factory size with the lowest ATC).
 EXAMPLE 4: LRAC with 3 Factory Sizes
Firm can choose
from 3 factory Cost
sizes: S, M, L. ($)
ATCS ATCM
Each size has its ATCL
own SRATC curve.

The firm can

change to a
different factory
size in the long Q
run, but not in the
short run.
EXAMPLE 4: LRAC with 3 Factory Sizes

Cost
($)
ATCS ATCM
ATCL

LRATC

Q
QA QB
 A Typical LRAC Curve
In the real world,
factories come in Cost
many sizes,
each with its own LRAC
SRATC curve.
So a typical LRAC
curve
looks like this:

Q
 How LRAC Changes as
the Scale of Production Changes
Economies of Cost
scale: LRAC falls
as Q increases.
LRAC
Constant returns
to scale: LRAC
stays the same
as Q increases.
Diseconomies of
Q
scale: LRAC rises

as Q increases.