Chapter 13

The Costs of Production

Ratna K. Shrestha

Supply

The Costs of Production

The Law of Supply:

Firms are willing to produce and sell a greater quantity of a good when the price of a good is high.

P

Q

Why Study Behavior of Firms?

Gain a better understanding of the decisions made by producers.

Study how the behavior of a firm depends on the structure of the market.

Purpose Facing A Firm

The economic purpose of the firm is to maximize profit!

Profit = Total Revenue - Total Cost.

Revenue: The amount that the firm receives for the sale of its product.

Revenue = Market Price x Amount Sold = PxQ Cost: The amount that the firm spends to buy inputs

such as labor, raw materials and capital (machines and tools).

Costs of Production

The firm’s costs include Explicit Costs and Implicit Costs:– Explicit Costs: costs that involve a direct money

outlay for factors of production. For example: hiring labor.

– Implicit Costs: costs that do not involve a direct money outlay (e.g. opportunity costs of the owner’s own inputs used - implicit wages, implicit rent).

When the owner works for his/her own company and does not get paid then the salary the owner could have earned by working for somebody else is the implicit costs.

Costs as Opportunity Costs

Accountants measure the explicit costs but often ignore the implicit costs.

Economists include all opportunity costs when measuring costs (such as firm’s own building for which it doesn’t pay rent).

Accounting Profit = TR - Explicit Costs Economic Profit = TR - Explicit Costs - Implicit Costs. Opportunity costs = Explicit + Implicit costs.

Costs as Opportunity Costs

A third, not so obvious cost includes sunk costs. Sunk costs are costs that have already been committed

and cannot be recovered. – So sunk costs have no alternative use and hence its

opportunity cost is zero.– It doesn’t affect the decisions about supplying a

product because its opportunity cost is zero.– Whereas opportunity cost should be taken into

consideration while making economic decisions.

Quick Quiz

“A farmer has planted corn seeds but has not yet fertilized the field.”

Is the cost of seed opportunity cost or a sunk cost? Is the cost of fertilizer an opportunity cost or a sunk

cost? Which of these two costs is more likely to affect the

decision to continue farming?

A Production Function and Total Cost

Number ofWorkers

Output MarginalProduct of

Labor

Cost ofFactory

Cost ofWorkers

Total Cost ofInputs

0 0 $30 $0 $30

1 50 50 30 10 40

2 90 40 30 20 50

3 120 30 30 30 60

4 140 20 30 40 70

5 150 10 30 50 80

The Production Function

The production function shows the relationship between quantity of inputs used to make a good and the quantity of output that can be produced from the use of those inputs.

Production function also reflects the technology of production.

For example out of the two production functions (a) Q = K L2 and (b) Q = KL, which one reflects better technology?

A Production Function...Quantity

(cookies

per hour)

150140130120110100

908070605040302010

Number of Workers Hired0 1 2 3 4 5

Production function

Marginal Product (MP)

The slope of the production function = Marginal Product (MP) of an input, such as a worker. When the MP declines, the production function becomes flatter. As long as MP of a worker is positive, you can add to your output by hiring more workers. Once MP = 0, an extra worker adds to no extra output. That means at that point when MP = 0, you have maximized your output.

Additional input

Additional output=Marginalproduct

Diminishing Marginal Product

Diminishing marginal product is the property whereby the MP of an input declines as the quantity of the input such as labor increases. Example: As more and more workers are hired at a firm, if each additional worker contributes less and less to production because the firm has a limited amount of equipment, then we have diminishing MP in the production process. If a firm has only 2 computers but hires 4 people, then 2 workers have to share a computer and thus the productivity of a worker declines. If there are only two workers, in that case productivity of each worker will be higher.

Total-Cost Curve...

TotalCost

$80

70

60

50

40

30

20

10

Quantity of Output

(cookies per hour)

0 20 40 1401201008060

Total-costcurve

Short-Run vs. Long-Run

Two different time horizons are important when analyzing costs. Short-Run: Time period over which some inputs are variable (e.g, labor, materials) and some inputs are fixed (e.g., plant size).Long-Run: Time period over which all inputs are variable, including plant size.

Short-Run CostsCosts of production may be divided into two categories in the short-run:Fixed Costs:

– Those costs that do not vary with the amount of output produced. For example, if you have rented an office for your law firm, then the rent of your office (cost) does not change with how many clients (Q) you see. So the rent in this case is a part of fixed cost.

Variable Costs:– Those costs that do vary with the amount of output

produced. In the law firm example, the cost of lawyer’s time is variable as it increases with the number of clients he/she sees

Family of Costs...

Total Fixed Costs (FC) Total Variable Costs (VC) Total Costs (C) = FC + VC

Average Costs: Cost / Output Level

Average Fixed Costs (AFC) = FC / QAverage Variable Costs (AVC) = VC/QAverage Total Costs (ATC) = C / Q

Marginal Cost

Marginal Cost (MC): is the extra cost of producing one more unit of output.” MC = C/Q

If Ford’s total cost of producing 4 cars is $225,000 and its total cost of producing 5 cars is $250,000. . . what is the ATC and MC of producing the fifth car?

Shape of Short-Run Cost Curves

Short-run cost behavior is based on the productivity of the inputs.

As the firm continues to expand output, in a fixed plant-size situation, eventually the marginal product of each successive worker hired will decrease. This is because the more workers hired have to share the limited resources (plant size).

The diminishing marginal product causes the marginal cost to increase in the short-run.

Shape of Typical Cost CurvesC

ost

($)

Quantity of output

MC

ATC

AVC

AFC

The Shape of Typical Cost Curves

U-Shaped Average Total Cost (ATC):– At low levels of output, as the firm expands

production, ATC declines.– At higher production levels, as output is increased,

ATC increases.– The bottom of the U-Shape occurs at the quantity

that minimizes average total cost.– This is called the Efficient Size of the firm.

Relationship Between MC &ATC

Why is ATC U - shaped? When MC < ATC, ATC is falling.

MC < ATC ATC When MC > ATC, ATC is rising.

MC > ATC ATC

At the point where MC = ATC, ATC is minimum. Why?

Cos

t ($

)

Quantity

MC

ATC

The MC curve always crosses the ATC

curve at the minimum ATC cost!

Relationship Between MC & ATC

Long-Run Costs

How do per unit costs behave as the firm expands all inputs, even plant size or scale of operation?

Then in this case there is no short run fixed cost as all the factors of inputs are variable.

The Long-Run Average Total Cost (LRATC) reflects the lowest possible unit cost related to different plant sizes and/or scales of operation.

For each plant size, there is one specific minimum LRAC.

The LRATC Curve is U-shaped as shown in the next slide.

Long-Run Costs

Economies of scale

Diseconomies of Scale

Constant Returns to Scale

LRATC Curve$/Unit

Scale of Operation (Q)

Short-Run ATC

Long-Run Costs

There are three typical long-run cost situations:Economies of Scale: Long run ATC decreases as the scale of operation (Q) increases. Many companies especially utilities enjoy economies of scale.

For example in the case of Shaw Cable, the cost of providing service to an additional household is very small, and so if it can expand the service, the ATC declines.

Diseconomies of Scale: LRATC increases with the scale of operation.Constant Returns to Scale: LRATC stays constant as the scale of operation increases.

Long-Run Costs

More Formally:Economies of Scale is measured as a cost-output elasticity.

EC = 1, neither economies nor diseconomies of ScaleEC > 1, diseconomies of scale.

EC < 1, economies of scale. Notice that the firm enjoys economies scale when MC < ATC.

AC

MC

QQ

CCEC

/

/

Long-Run Costs Possible causes of Economies of Scale:

– volume discounts on purchases of inputs such as raw materials.

– manufacturing, warehousing, transportation, and promotional economies.

– larger firm can borrow at lower interest rates.– The most important one is a large fixed cost. For

example if C = 10 + 5Q, then if Q = 10, ATC = $6. But if Q = 20, then ATC = $5.5. Notice that if FC = 0 (instead of $10) ATC would not change no matter how much you produce.

Possible causes of Diseconomies of Scale– management diseconomies...

The ATM and the Cost of Getting Cash

The lowest average total cost for a human teller transaction is $1.29. The lowest average total cost for an ATM transaction is 32 cents.

At Q transactions per month, both methods have the same ATC.

The ATM and the Cost of Getting Cash

For a credit union that does fewer than Q transactions per month, its least-cost method is the teller.

For a bank that does more than Q transactions per month, the least-cost method is the ATM.

The ATM and the Cost of Getting Cash

More technology and more capital is not always efficient.