MICROECONOMICS
TOPIC 6 – COSTS OF PRODUCTION
AFTER LEARNING TOPIC 6, YOU SHOULD BE ABLE TO:
1.Explain what items are included in a firm’s costs of production
2.Understand the difference between Accounting and economic costs/profits
3. Analyse the link between a firm’s production process and its total costs
4. Understand the meaning of average total cost and marginal cost and how
they are related
5. Understand the shape of a typical firm’s cost curves and reasons behind
those shapes
6.Understand the relationship between short-run and long-run costs
MCD2020 2
CALCULATING PROFIT AND LOSS
MCD2020 3
• Profit is the difference between revenue and costs.
• Total revenue (TR):
o The amount a firm receives from the sale of goods and services.
• Total cost (TC):
o The amount a firm spends in order to produce and sell those goods and
services.
• Profit (or loss) = TR – TC.
oWhen does the firm earn a profit? A loss?
If you are a manager of a fast food restaurant, what are some of the
important operational decisions do you need to make?
oHow much to produce (output)
oHow many workers to be employed (input – labour)
oWhat equipment are needed (input - capital)
oOther inputs (electricity, water etc.)
• Concepts:
oOutput—The product or service that the firm creates.
o Inputs - Factors of production —resources used in the production process.
MCD2020 4
BUSINESS DECISION-MAKING
Some of these inputs come from outsiders (e.g. workers hired)
Some of them may be your own (e.g. your time spent at the till or the
kitchen)
• Explicit costs: When expenses are paid to outsiders Wages. Food costs
• Implicit costs: The opportunity costs of using resources owned by the firm
or its owners
oOpportunity cost of capital.
oOpportunity cost of owner’s time.
MCD2020 5
EXPLICIT AND IMPLICIT COSTS - 1
• An Economist classifies total cost as the sum of explicit costs and implicit
costs
• An Accountant only takes explicit costs as the costs of production
• For an Economist, total cost is the opportunity cost of all inputs (all
economic resources) the firm uses in the production process
MCD2020 6
EXPLICIT AND IMPLICIT COSTS - 2
• Accounting profit:
o Accounting profit = Total revenue – Explicit costs.
• Economic profit:
o Economic profit = Total revenue – (Explicit + Implicit costs).
o Economic profit = Accounting profit – Implicit costs.
MCD2020 7
ACCOUNTING VERSUS ECONOMIC PROFIT - 1
MCD2020 8
ACCOUNTING VERSUS ECONOMIC PROFIT - 2
$8,000 – $7,500 = $500
$8,000 – $8,200 = –$200
MCD2020 9
PRODUCTION FUNCTION
The relationship between the inputs
employed by the firm and the output
it can produce with those inputs
MARGINAL PRODUCT
The change in output associated with one additional unit of an input
• Production at McDonald’s:
o Assume that the size of the restaurant, capital (equipment etc.) is fixed.
oWhat happens to output as the manager hires more workers?
MCD2020 10
MCD2020 11
Number of
Workers
Total Output (Number of Meals
Served per Hour)
Marginal Product of
Labor
0 0
1 5
2 15
3 30
4 42
5 52
6 60
7 65
8 67
9 63
10 55
5
10
15
12
10
8
5
2
-4
-8
MCD2020 12
PRODUCTION FUNCTION - TOTAL AND MARGINAL PRODUCT - 1
MCD2020 13
DIMINISHING
MARGINAL PRODUCT
Is the concept whereby the marginal
product of an input declines as the
quantity of the input increases
SHORT RUN AND THE LONG RUN
• Why does the marginal product of an input diminish after successive
increases of that input?
• To answer this we need to look into short run and long run of the firm
• Short run:
o Period of production in which at least one input is fixed.
• Long run:
o Period of production in which all inputs are variable.
MCD2020 14
• With at least one input factor fixed in the short run, successive increases in
variable inputs would increase the output at a slower rate, because the
fixed capacity of the fixed input acts as a bottleneck in the production
process
• E.g. With a machine operating at a fixed capacity, additional workers will
have less and less to do or even interfere with the productivity of other
workers, so MPL starts to decrease and eventually may turn negative.
MCD2020 15
COSTS IN THE SHORT RUN - 1
COSTS IN THE SHORT RUN - 2
• Variable costs (VC):
oCosts that change with the rate of output.
• Fixed costs (FC):
oCosts that do not vary with output.
• Total cost (TC):
o The sum of variable and fixed costs.
o TC = TVC + TFC.
MCD2020 16
• Average total cost (ATC):
o Total cost divided by the number of units produced.
o ATC = TC ÷ Q.
• Average variable cost (AVC):
o Total variable cost divided by the number of units produced.
o AVC = TVC ÷ Q.
• Average fixed cost (AFC):
o Total fixed cost divided by the number of units produced.
o AFC = TFC ÷ Q.
• Marginal cost (MC):
o Increase in cost from producing one more unit of output.
o Change in total cost divided by change in output.
o MC = ΔTC ÷ ΔQ.
MCD2020 17
COSTS IN THE SHORT RUN - 3
MCD2020 18
Q TVC TFC
TC
TVC + TFC
AVC
TVC ÷ Q
AFC
TFC ÷ Q
ATC
TC ÷ Q or
AVC + AFC
MC
Δ TVC÷ΔQ
0 $0.00 $100.00 $100.00
10 30.00 100.00 130.00 $3.00 $10.00 $13.00 $3.00
20 50.00 100.00 150.00 2.50 5.00 7.50 2.00
30 65.00 100.00 165.00 2.17 3.33 5.50 1.50
40 77.00 100.00 177.00 1.93 2.50 4.43 1.20
50 87.00 100.00 187.00 1.74 2.00 3.74 1.00
60 100.00 100.00 200.00 1.67 1.67 3.34 1.30
70 120.00 100.00 220.00 1.71 1.43 3.14 2.00
80 160.00 100.00 260.00 2.00 1.25 3.25 4.00
90 220.00 100.00 320.00 2.44 1.11 3.55 6.00
100 300.00 100.00 400.00 3.00 1.00 4.00 8.00
MCD2020 19
THE TOTAL COST CURVE
MCD2020 20
AVERAGE COST CURVES AND MARGINAL COST
• The bottom of the U-shape occurs at the quantity that minimises ATC -
efficient scale
• The MC curve crosses the ATC curve at its minimum. At low levels of
output, MC is below ATC. The cost of the marginal unit reduces ATC and
therefore ATC slopes down.
• At high levels of output, MC is above ATC. The cost of the marginal unit
increases ATC and therefore ATC slopes up.
• Reason for U-shape is the diminishing marginal product
MCD2020 21
U-SHAPE COST CURVE
• Think about two examples:
oClass GPA and sports statistics.
• Suppose the class average grade on the economics exam is 85 percent.
• Smarty joins the class and gets 100 percent on the exam.
oWhat happens to the class average?
• Lazy joins the class and gets 34 percent on the exam.
oWhat happens to the class average?
MCD2020 22
MARGIN AND AVERAGE RELATIONSHIP - 1
MCD2020 23
• Suppose James has a scoring average of 30 points per game.
o If he has a game in which he scores 45 points, his average will . . .
o If he has a game in which he scores 12 points, his average will . . .
• Once again:
o The average follows the margin.
MARGIN AND AVERAGE RELATIONSHIP - 2
MCD2020 24
CALCULATING COSTS
• What are the decisions that a firm makes in the long run?
• Scale:
o Size of the production process
• Short-run costs reflect marginal product of labor.
• Long-run costs reflect scale economies.
• In the long run, the firm can adjust its capital and labor, which is a decision
about the size of the firm
MCD2020 25
COSTS IN THE LONG-RUN - 1
• Economies of scale:
o LATC falls when production expands.
• Diseconomies of scale:
o LATC rises when production expands.
• Constant returns to scale:
o LATC doesn’t change when production expands.
MCD2020 26
COSTS IN THE LONG-RUN - 2
MCD2020 27
COSTS IN THE LONG-RUN - 3
• Note that the LRAC curve is a “composite” of all the SRAC cost
curves.
• Each SRAC corresponds to a different amount of the fixed input
(different-size firm).
• For any level of output, there are multiple short-run cost curves to
pick from, but the firm would want to choose one with the lowest
average cost.
MCD2020 28
COSTS IN THE LONG-RUN - 4