Production ,cost and returns

 Factors of production
 Division of labour
 Mobility of the factors of production
 Combining the factors of production
 The laws of returns
 Cost of production
 The firm’s revenue .

CHAPTER 13 THE COSTS OF PRODUCTION 1

GETTING STARTED
– Production is defined as any economic activity
which satisfies human wants .
– The chain of production is complete when a good or
service is sold to the consumer .
– the volume of productions depends on many
factors including the quantity and quality of
available resources ,the extent to which they are
utilized the efficiency with which they are
combined .

© 2007 Thomson South-Western

Getting started

• - productivity a certain level of inputs yields

higher output . It is usually measured as
average product per worker. Thus productivity
rises when the average product per worker
rises.

© 2007 Thomson South-Western

Getting started
• Short run and long run
- the short run exist when there is at least one
fixed factor of production .
Note – any factor of production can fixed in the
short run .
- The long run is the time period required to
bring about a change in the input of all the
factors of production in the long run

© 2007 Thomson South-Western

Getting started

• Marginal product , is the rate at which total product

changes as an additional unit of the variable factor
is employed .

• Marginal cost is the rate at which total cost changes

as output changes .however , at this level it is
measured as the change in total cost of production
when output is increase by one more unit .

© 2007 Thomson South-Western

Getting started

• Economic efficiency - firms are producing at

their most economically efficient level when ,
given their current scale of operations, they
are maximizing profits.
• Technical efficiency - firms are producing on
their most technical efficient level when ,
given their current scale of production
,average cost per unit is minimized .
© 2007 Thomson South-Western
Getting started

• The Firm’s Objective

– The economic goal of
the firm is to
maximize profits.

© 2007 Thomson South-Western

Total Revenue, Total Cost, and Profit

• Total Revenue
• The amount a firm receives for the sale of its
output.
• Total Cost
• The market value of the inputs a firm uses in
production.

© 2007 Thomson South-Western

Total Revenue, Total Cost, and Profit

• Profit is the firm’s total revenue minus its total

cost.

• Profit = Total revenue - Total cost

© 2007 Thomson South-Western

Costs as Opportunity Costs

• A firm’s cost of production includes all the

opportunity costs of making its output of goods
and services.
• Explicit and Implicit Costs
• A firm’s cost of production include explicit costs
and implicit costs.
• Explicit costs are input costs that require a direct outlay
of money by the firm.
• Implicit costs are input costs that do not require an outlay
of money by the firm.

© 2007 Thomson South-Western

Economic Profit versus Accounting Profit

• Economists measure a firm’s economic profit as

total revenue minus total cost, including both
explicit and implicit costs.
• Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit costs.

© 2007 Thomson South-Western

Economic Profit versus Accounting Profit

• When total revenue exceeds both explicit and

implicit costs, the firm earns economic profit.
• Economic profit is smaller than accounting
profit.

© 2007 Thomson South-Western

 Figure 1 Economists versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

© 2007 Thomson South-Western

Factors of production

Land - all free gift of nature . Includes surface area of the

planet as well as minerals and ore deposits . As a factor of
production it is fixed in supply ie cannot be reproduced and
cannot be moved from one place to another.
Labour - the physical and mental human effort used to
create goods and services .
Capital – man made assets which is used in the production of
further goods and services .
Enterprise – most commonly knows as entrepreneur . The
entrepreneur performs two important roles :
The hiring and combining the other factors of production
;and
Risk taking by producing goods and services in anticipation
© 2007 Thomson South-Western
Division of labour

© 2007 Thomson South-Western

Mobility of the factors of production

© 2007 Thomson South-Western

Combining the factors of production

• The Production Function

– The production function shows the relationship
between quantity of inputs used to make a good
and the quantity of output of that good.
– Profit maximizing firms will combine the factors
of production so as to minimize the cost of
producing a single output.

© 2007 Thomson South-Western

The Production Function

• Total product (TP ) – the total out a firm

produces within a given period of time.
• Average Product (AP) –usally measures in
relation to a particular factor of production such
a labour or capital .eg average product of labour
= TP/L
• Marginal Product

• The marginal product(MP) of any input in the

© 2007 Thomson South-Western
Table 1 A Production Function and Total Cost: Hungry
Helen’s Cookie Factory

© 2007 Thomson South-Western

The Laws of returns

The laws of returns explain the relationship between changes

in the input of variable factors and changes in the level of
output . The general relationship is summarized in two laws
which are sometimes combined into a single law known as
THE LAW OF VARIABLE PORPORTIONS.

The law of increasing returns - in the early stage of

production , as successive units of a variable factor are
combined with a fixed factor , initially , both marginal and
average product will rise. In other words TP rise more than in
proportion to the rise in input

© 2007 Thomson South-Western

The laws of return

• Diminishing marginal returns . The law simply

states that as successive units of a variable
factor are combined with a fixed factor ,after a
certain point both marginal product and average
product will fall .
• Example: As more and more workers are hired at a
firm, each additional worker contributes less and
less to production because the firm has a limited
amount of equipment.

© 2007 Thomson South-Western

 Figure 2 Hungry Helen’s Production Function
Quantity of output
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
0 1 2 3 4 5 6 7
Number of Workers Hired
© 2007 Thomson South-Western
#of workers TP AV MP
       
1 4 4 4
2 10 10 6
3 20 6.7 10
4 35 8.8 15
5 50 10 15
6 60 10 10
7 65 9.3 5
8 65 8.1 0
9 55 6.1 -10
       

© 2007 Thomson South-Western

The Production Function

• Diminishing Marginal Product

• The slope of the production function measures the
marginal product of an input, such as a worker.
• When the marginal product declines, the production
function becomes flatter.

© 2007 Thomson South-Western

Returns to scale

• In the long run ,there are no fixed factors and

firms can vary the input of all factors of
production .when this happens there have been
a change in the scale of production.
• If a change in the scale of production leads to a
more than proportional change in output, firms
are subject to increasing returns to scale . The
se are more generally referred to as economies
of scale .

© 2007 Thomson South-Western

Returns to scale (cont.)

• Constant returns to scale - when a change in all

factor inputs results in an equi-proportional
change in output .
• Diseconomies of scale or decreasing returns to
scale- a change in input of all factors of
production leads to a less than proportional
change in output .

© 2007 Thomson South-Western

Returns to scale (cont.)

• Firms are interested in changes in return

because as we shall see, a change in returns
implies a change in a firm’s costs. For this
reason economies of scale are sometime defines
as those aspect of increasing size which leads to
falling average cost i.e cost per unit produced.
Diseconomies of scale are those aspect of
increasing size which leads to increasing
average cost .

© 2007 Thomson South-Western

Sources of economies of scale

• Technical economies – common in

manufacturing . Eg
a) greater scope for division of labour
b) Indivisibilities – certain items of capital
expenditure are relatively expensive and cannot be
purchase in smaller or cheaper units ,yet they may
help raise output substantially .
c) Economies of linked processes – where machines
works at different speed large firms are often able
to operate more efficiently tha nsmall firms.
© 2007 Thomson South-Western
Sources of economies of scale (cont)

• Marketing Economies – the main economies of

scale in marketing arise from bulk purchasing
and bulk distribution.

• Financial economies – large firms are able to

obtain fiancé more easily and on a more
favorable term than smaller firms.
• Managerial economies – large firms are able to
attract and reward the most capable staff whose
ability and expertise may well lead to lower
© 2007 Thomson South-Western
Sources of Diseconomies of scale

• Managerial difficulties –
• Low Morale
• Higher input prices
• Marketing diseconomies

© 2007 Thomson South-Western

From the Production Function to the
Total-Cost Curve
• The relationship between the quantity a firm
can produce and its costs determines pricing
decisions.
• The total-cost curve shows this relationship
graphically.

© 2007 Thomson South-Western

Table 1 A Production Function and Total Cost: Hungry
Helen’s Cookie Factory

© 2007 Thomson South-Western

 Figure 2 Hungry Helen’s Total-Cost Curve
Total
Cost
100
90
80
70
60
50
40
30
20
10
0
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 160
Quantity
of Output
(cookies per hour)
© 2007 Thomson South-Western
THE VARIOUS MEASURES OF
COST
• Costs of production may be divided into fixed
costs and variable costs.
– Fixed costs are those costs that do not vary with
the quantity of output produced.
– Variable costs are those costs that do vary with
the quantity of output produced.

© 2007 Thomson South-Western

Fixed and Variable Costs

• Total Costs
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• TC = TFC + TVC

© 2007 Thomson South-Western

Table 2 The Various Measures of Cost: Thirsty Thelma’s
Lemonade Stand

© 2007 Thomson South-Western

Fixed and Variable Costs

• Average Costs
• Average costs can be determined by dividing the
firm’s costs by the quantity of output it produces.
• The average cost is the cost of each typical unit of
product.

© 2007 Thomson South-Western

Fixed and Variable Costs

• Average Costs
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• ATC = AFC + AVC

© 2007 Thomson South-Western

Average and Marginal Costs

Fixed cost FC
AFC  
Quantity Q

Variable cost VC
AVC  
Quantity Q

Total cost TC
ATC  
Quantity Q

© 2007 Thomson South-Western

Average and Marginal Costs

• Marginal Cost
• Marginal cost (MC) measures the increase in total
cost that arises from an extra unit of production.
• Marginal cost helps answer the following question:
• How much does it cost to produce an additional unit of
output?

© 2007 Thomson South-Western

Average and Marginal Cost

(change in total cost) TC

MC  
(change in quantity) Q

© 2007 Thomson South-Western

The relationship between MC and VC
(short run)
• MC is the change in total cost when one more
unit is produced and is therefore entirely a
VC .because in the SR only the input of
variabkle factors can be changed it is clear that
the sum of margial cost of producing each unit
equals the total variable cost of production.
• Though VC vary directly with output ,they are
unlikely to vary proportionately because of the
effect of increasing and diminishing returns .

© 2007 Thomson South-Western

• TVC at first rise less than proportionately as
output expands and the firm experiences
increasing returns .subsequently as the firm
experiences diminishing returns TVC rise more
than proportionately as output expands .
• The change in Total Variable Costs brought
about by increasing and diminishing returns
alos imply changes in average variable cost .

© 2007 Thomson South-Western

• When the firm experiences increasing marginal
returns ,marginal product rises and marginal cost
falls. Conversely ,when the firm experiences
diminishing marginal returns ,marginal product
falls and marginal cost rises .
• However , when marginal cost is below average
variable cost (AVC) ,the latter is falling and when
MC is above AVC the latter is rising .this is
because in the short run Mc is the addition to
AVC.
© 2007 Thomson South-Western
• When the last unit adds less to the total than the
current average ,then the average must fall .AVC
rises,howver when MC curev lies above it .The
implication is that the margibnal cost curve cuts
the AVC curve at its minimum point .
• Similar reasoning explains why the AP rises
when MP is above it and falls wghen MP is
below it ,and why the MP cus the AP at is
maximum point .

© 2007 Thomson South-Western

© 2007 Thomson South-Western
Thirsty Thelma’s Lemonade Stand
Note how Marginal Cost changes with each change in Quantity.

Quantity Total Marginal Quantity Total Marginal

Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10

© 2007 Thomson South-Western

Figure 3 Thirsty Thelma’s Total-Cost Curves
Total Cost
$15.00 Total-cost curve
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
© 2007 Thomson South-Western
Figure 4 Thirsty Thelma’s Average-Cost and Marginal-Cost
Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
© 2007 Thomson South-Western
Cost Curves and Their Shapes

• Marginal cost rises with the amount of output

produced.
• This reflects the property of diminishing marginal
product.

© 2007 Thomson South-Western

Cost Curves and Their Shapes

• The average total-cost curve is U-shaped.

• At very low levels of output average total cost
is high because fixed cost is spread over only a
few units.
• Average total cost declines as output increases.
• Average total cost starts rising because average
variable cost rises substantially.

© 2007 Thomson South-Western

Cost Curves and Their Shapes

• The bottom of the U-shaped ATC curve occurs

at the quantity that minimizes average total
cost. This quantity is sometimes called the
efficient scale of the firm.

© 2007 Thomson South-Western

Cost Curves and Their Shapes

• Relationship between Marginal Cost and

Average Total Cost
• Whenever marginal cost is less than average total
cost, average total cost is falling.
• Whenever marginal cost is greater than average
total cost, average total cost is rising.

© 2007 Thomson South-Western

Cost Curves and Their Shapes

• Relationship between Marginal Cost and

Average Total Cost
• The marginal-cost curve crosses the average-total-
cost curve at the efficient scale.
• Efficient scale is the quantity that minimizes average
total cost.

© 2007 Thomson South-Western

Typical Cost Curves

• It is now time to examine the relationships that

exist between the different measures of cost.

© 2007 Thomson South-Western

Figure 5 Cost Curves for a Typical Firm

Note how MC hits both ATC and AVC at their

minimum points.
Marginal Cost declines at first and then
Costs increases due to diminishing marginal product.

$3.00 AFC, a short-run concept, declines throughout.

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output
© 2007 Thomson South-Western
Average total cost ( ATC) of production ( short run)

AFC falls continuously as output expands and that initially ,

because of increasing average returns, average variable costa
fall . It follows that average total cost ( ATC or AC) will fall
initially .However beyond a certain point AVC will begins to
rise because of diminishing average returns ,and oncethe rise
in AVC offsets the fall in AFC , ATC will rise.

The MC curve cuts the ATC curve at the minimum point for
exactly the same reason that it cuts the AVC curve t the
minimum point .

© 2007 Thomson South-Western

Typical Cost Curves

• Three Important Properties of Cost Curves

• Marginal cost eventually rises with the quantity of
output.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve crosses the average-total-
cost curve at the minimum of average total cost.

© 2007 Thomson South-Western

COSTS IN THE SHORT RUN AND
IN THE LONG RUN
• For many firms, the division of total costs between
fixed and variable costs depends on the time horizon
being considered.
– In the short run, some costs are fixed.
– In the long run, all fixed costs become variable costs.
• Because many costs are fixed in the short run but
variable in the long run, a firm’s long-run cost curves
differ from its short-run cost curves.

© 2007 Thomson South-Western

Economies and Diseconomies of Scale

• Economies of scale refer to the property

whereby long-run average total cost falls as the
quantity of output increases.
• Diseconomies of scale refer to the property
whereby long-run average total cost rises as the
quantity of output increases.
• Constant returns to scale refers to the property
whereby long-run average total cost stays the
same as the quantity of output increases.

© 2007 Thomson South-Western

 Figure 6 Average Total Cost in the Short and Long Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
© 2007 Thomson South-Western
 Summary

• The goal of firms is to maximize profit, which

equals total revenue minus total cost.
• When analyzing a firm’s behavior, it is
important to include all the opportunity costs
of production.
• Some opportunity costs are explicit while
other opportunity costs are implicit.

© 2007 Thomson South-Western

 Summary

• A firm’s costs reflect its production process.

– A typical firm’s production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
– A firm’s total costs are divided between fixed and
variable costs. Fixed costs do not change when the
firm alters the quantity of output produced;
variable costs do change as the firm alters quantity
of output produced.

© 2007 Thomson South-Western

 Summary
• Average total cost is total cost divided by the
quantity of output.
• Marginal cost is the amount by which total
cost would rise if output were increased by one
unit.
• The marginal cost always rises with the
quantity of output.
• Average cost first falls as output increases and
then rises.

© 2007 Thomson South-Western

 Summary

• The average-total-cost curve is U-shaped.

• The marginal-cost curve always crosses the
average-total-cost curve at the minimum of
ATC.
• A firm’s costs often depend on the time
horizon being considered.
• In particular, many costs are fixed in the short
run but variable in the long run.

© 2007 Thomson South-Western