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

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CALCULATING PROFIT AND LOSS

• 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.
o When does the firm earn a profit? A loss?

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BUSINESS DECISION-MAKING

If you are a manager of a fast food restaurant, what are some of the
important operational decisions do you need to make?
o How much to produce (output)
o How many workers to be employed (input – labour)
o What equipment are needed (input - capital)
o Other inputs (electricity, water etc.)
• Concepts:
o Output—The product or service that the firm creates.

o Inputs - Factors of production —resources used in the production process.

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EXPLICIT AND IMPLICIT COSTS - 1

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
o Opportunity cost of capital.
o Opportunity cost of owner’s time.

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EXPLICIT AND IMPLICIT COSTS - 2

• 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

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 ACCOUNTING VERSUS ECONOMIC PROFIT - 1

• 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.

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ACCOUNTING VERSUS ECONOMIC PROFIT - 2

$8,000 – $7,500 = $500

$8,000 – $8,200 = –$200

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 The relationship between the inputs
PRODUCTION FUNCTION employed by the firm and the output
it can produce with those inputs

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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.
o What happens to output as the manager hires more workers?

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 Number of Total Output (Number of Meals Marginal Product of
Workers Served per Hour) Labor
0 0
5
1 5
10
2 15
15
3 30
12
4 42
10
5 52
8
6 60
5
7 65
2
8 67
-4
9 63
-8
10 55
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PRODUCTION FUNCTION - TOTAL AND MARGINAL PRODUCT - 1

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 Is the concept whereby the marginal
DIMINISHING
MARGINAL PRODUCT product of an input declines as the
quantity of the input increases

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 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.

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COSTS IN THE SHORT RUN - 1

• 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.

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COSTS IN THE SHORT RUN - 2

• Variable costs (VC):

o Costs that change with the rate of output.

• Fixed costs (FC):

o Costs that do not vary with output.

• Total cost (TC):

o The sum of variable and fixed costs.
o TC = TVC + TFC.

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COSTS IN THE SHORT RUN - 3

• 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.

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 ATC
TC AVC AFC MC
Q TVC TFC TC ÷ Q or
TVC + TFC TVC ÷ Q TFC ÷ Q Δ TVC÷ΔQ
AVC + AFC

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

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THE TOTAL COST CURVE

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AVERAGE COST CURVES AND MARGINAL COST

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U-SHAPE COST CURVE

• 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

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MARGIN AND AVERAGE RELATIONSHIP - 1

• Think about two examples:

o Class 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.
o What happens to the class average?
• Lazy joins the class and gets 34 percent on the exam.
o What happens to the class average?

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MARGIN AND AVERAGE RELATIONSHIP - 2

• 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.

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CALCULATING COSTS

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COSTS IN THE LONG-RUN - 1

• 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

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COSTS IN THE LONG-RUN - 2

• 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.

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COSTS IN THE LONG-RUN - 3

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COSTS IN THE LONG-RUN - 4

• 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.

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