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Production Costs

©2006 South-Western College Publishing

The Firm’s ObjectiveThe economic goal of the firm is

to maximize profits.

A Firm’s Total Revenue and Total Cost

Total Revenue The amount that the firm receives for

the sale of its output. Total Cost

The amount that the firm pays to buy inputs.

A Firm’s Profit

Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

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To understand profit, what is necessary?

To distinguish between the way economists measure costs and the way accountants measure costs

Explicit and Implicit Costs

A firm’s cost of production include explicit costs and implicit costs.

Explicit costs involve a direct money outlay for factors of production. (Labor and Raw Materials)Implicit costs do not involve a direct money outlay.

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What are implicit costs?

The opportunity costs of using resources owned by the firm

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What is an example of implicit costs?

When you invest your nest egg in your own enterprise, you give up earning interest on that money

Economic Profit versus Accounting Profit

RevenueTotalopportunitycosts

How an EconomistViews a Firm

Explicitcosts

Economicprofit

Implicitcosts

Explicitcosts

Accountingprofit

How an AccountantViews a Firm

Revenue

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What are total opportunity costs?

Explicit costs + Implicit costs

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What is economic profit?

Total revenue minus total opportunity costs

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What is normal profit?The minimum profit necessary to keep a firm in operation

The Various Measures of Cost

Costs of production may be divided into fixed costs and variable costs.

Fixed 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 change as the firm alters the quantity of output produced.

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What is the short run?A period of time so short that there is at least one fixed input

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What is the long run?A period of time so long that all inputs are variable

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What istotal fixed cost?

Costs that do not vary as output varies and that must be paid even if output is zero

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What istotal variable cost?

Costs that are zero when output is zero and vary as output varies

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What is total cost?The sum of total fixed cost and total variable cost at each level of output

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TC = TFC + TVC

Average Costs

Average costs can be determined by dividing the firm’s costs by the quantity of output produced.

The average cost is the cost of each typical unit of product.

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AFC = TFC / Q

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AVC = TVC / Q

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ATC = AFC + AVC = TC/Q

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.

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What is the long-run average cost curve?The curve that traces the

lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size

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What areeconomies of scale?A situation in which the long-run average cost curve declines as the firm increases output

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What arediseconomies of scale?

A situation in which the long-run average cost curve rises as the firm increases output

Marginal Cost Marginal cost (MC) measures the

amount total cost rises when the firm increases production by one unit.

Marginal cost helps answer the following question: How much does it cost to produce an

additional unit of output?

Cost Curves and Their Shapes

Marginal cost rises with the amount of output produced.

This reflects the property of diminishing marginal product.

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.