Cost of Production

Questions for Review

1. The relationship between a firm's total revenue, profit, and total cost is profit equals total
revenue minus total costs.
2. An accountant would not count the owner’s opportunity cost of alternative employment
as an accounting cost. An example is given in the text in which Helen runs a cookie
business, but she could instead work as a computer programmer. Because she's working
in her cookie factory, she gives up the opportunity to earn $100 per hour as a computer
programmer. The accountant ignores this opportunity cost because money does not flow
into or out of the firm. But the cost is relevant to Helen's decision to run the cookie
factory.
3. Marginal product is the increase in output that arises from an additional unit of input.
Diminishing marginal product means that the marginal product of an input declines as the
quantity of the input increases.
4. Figure 4 shows a production function that exhibits diminishing marginal product of labor.
Figure 5 shows the associated total-cost curve. The production function is concave
because of diminishing marginal product, while the total-cost curve is convex for the
same reason.

Figure 4 Figure 5
5. Total cost consists of the costs of all inputs needed to produce a given quantity of output.
It includes fixed costs and variable costs. Average total cost is the cost of a typical unit of
output and is equal to total cost divided by the quantity produced. Marginal cost is the
cost of producing an additional unit of output and is equal to the change in total cost
divided by the change in quantity. An additional relation between average total cost and
marginal cost is that whenever marginal cost is less than average total cost, average total
cost is declining; whenever marginal cost is greater than average total cost, average total
cost is rising.
 Figure 6
6. Figure 6 shows the marginal-cost curve and the average-total-cost curve for a typical
firm. It has three main features: (1) marginal cost is rising; (2) average total cost is U-
shaped; and (3) whenever marginal cost is less than average total cost, average total cost
is declining; whenever marginal cost is greater than average total cost, average total cost
is rising. Marginal cost is rising for output greater than a certain quantity because of
diminishing returns. The average-total-cost curve is U-shaped because the firm initially is
able to spread out fixed costs over additional units, but as quantity increases, it costs
more to increase quantity further because an important input is limited. Whenever
marginal cost is less than average total cost, average total cost is declining; whenever
marginal cost is greater than average total cost, average total cost is rising. The marginal
cost and average total cost curves intersect at the minimum of average total cost; that
quantity is the efficient scale.
7. In the long run, a firm can adjust the factors of production that are fixed in the short run;
for example, it can increase the size of its factory. As a result, the long-run average-total-
cost curve has a much flatter U-shape than the short-run average-total-cost curve. In
addition, the long-run curve lies along the lower envelope of the short-run curves.
8. Economies of scale exist when long-run average total cost falls as the quantity of output
increases, which occurs because of specialization among workers. Diseconomies of scale
exist when long-run average total cost rises as the quantity of output increases, which
occurs because of coordination problems inherent in a large organization.
Problems and Applications

1. (a) opportunity cost; (b) average total cost; (c) fixed cost; (d) variable cost; (e). total cost;
(f). marginal cost.
2. a. The opportunity cost of something is what must be given up to acquire it.
b. The opportunity cost of running the hardware store is $550,000, consisting of
$500,000 to rent the store and buy the stock and a $50,000 opportunity cost,
because your aunt would quit her job as an accountant to run the store. Because
the total opportunity cost of $550,000 exceeds revenue of $510,000, your aunt
should not open the store, as her profit would be negative.
3. a. Because you would have to pay for room and board whether you went to college
or not, that portion of your college payment is not an opportunity cost.
 b. The explicit opportunity cost of attending college is the cost of tuition and books.
c. An implicit opportunity cost of attending college is the cost of your time. You
could work at a job for pay rather than attend college. The wages you give up
represent an opportunity cost of attending college.
4. a. The following table shows the marginal product of each hour spent fishing:

Hours Fish Fixed Cost Variable Total Marginal

Cost Cost Product
0 0 $10 $0 $10 ---
1 10 10 5 15 10
2 18 10 10 20 8
3 24 10 15 25 6
4 28 10 20 30 4
5 30 10 25 25 2
b. Figure 7 graphs the fisherman's production function. The production function
becomes flatter as the number of hours spent fishing increases, illustrating
diminishing marginal product.

Figure 7
c. The table shows the fixed cost, variable cost, and total cost of fishing. Figure 8
shows the fisherman's total-cost curve. It has an upward slope because catching
additional fish takes additional time. The curve is convex because there are
diminishing returns to fishing time because each additional hour spent fishing
yields fewer additional fish.
 Figure 8
5. Here is the table of costs:

Worker Output Marginal Total Average Marginal

s Product Cost Total Cost
Cost
0 0 --- $200 --- ---
1 20 20 300 $15.00 $5.00
2 50 30 400 8.00 3.33
3 90 40 500 5.56 2.50
4 120 30 600 5.00 3.33
5 140 20 700 5.00 5.00
6 150 10 800 5.33 10.00
7 155 5 900 5.81 20.00

a. See the table for marginal product. Marginal product rises at first, then declines
because of diminishing marginal product.
b. See the table for total cost.
c. See the table for average total cost. Average total cost is U-shaped. When quantity
is low, average total cost declines as quantity rises; when quantity is high, average
total cost rises as quantity rises.
d. See the table for marginal cost. Marginal cost is also U-shaped, but rises steeply
as output increases. This is due to diminishing marginal product.
e. When marginal product is rising, marginal cost is falling, and vice versa.
f. When marginal cost is less than average total cost, average total cost is falling; the
cost of the last unit produced pulls the average down. When marginal cost is
greater than average total cost, average total cost is rising; the cost of the last unit
produced pushes the average up.
6. a. The fixed cost is $300, because fixed cost equals total cost minus variable cost.
b.
Quantity Total Variabl Marginal Cost Marginal Cost
Cost e Cost (using total cost) (using variable cost)
0 $300 $0 --- ---
 1 350 50 $50 $50
2 390 90 40 40
3 420 120 30 30
4 450 150 30 30
5 490 190 40 40
6 540 240 50 50
Marginal cost equals the change in total cost for each additional unit of output. It
is also equal to the change in variable cost for each additional unit of output. This
occurs because total cost equals the sum of variable cost and fixed cost and fixed
cost does not change as the quantity changes. Thus, as quantity increases, the
increase in total cost equals the increase in variable cost.
7. a. The fixed cost of setting up the lemonade stand is $200. The variable cost per cup
is $0.50.

Figure 9

b. The following table shows total cost, average total cost, and marginal cost. These
are plotted in Figure 9.
Quantity Total Average Total Marginal
(gallons) Cost Cost Cost
0 $200 --- ---
1 208 $208 $8
2 216 108 8
3 224 74.7 8
4 232 58 8
5 240 48 8
6 248 41.3 8
7 256 36.6 8
8 264 33 8
9 272 30.2 8
10 280 28 8
8. The following table illustrates average fixed cost (AFC), average variable cost (AVC),
and average total cost (ATC) for each quantity. The efficient scale is four houses per month,
because that minimizes average total cost.
Quantity Variabl Fixed Total Average Average Average
e Cost Cost Cost Fixed Cost Variable Total Cost
Cost
0 $0 $200 $200 --- --- ---
1 10 200 210 $200 $10 $210
2 20 200 220 100 10 110
3 40 200 240 66.7 13.3 80
4 80 200 280 50 20 70
5 160 200 360 40 32 72
6 320 200 520 33.3 53.3 86.7
7 640 200 840 28.6 91.4 120
9 a. The following table shows average variable cost (AVC), average total cost (ATC),
and marginal cost (MC) for each quantity.
Quantity Variabl Total Average Average Marginal
e Cost Cost Variable Total Cost Cost
Cost
0 $0 $30 --- --- ---
1 10 40 $10 $40 $10
2 25 55 12.5 27.5 15
3 45 75 15 25 20
4 70 100 17.5 25 25
5 100 130 20 26 30
6 135 165 22.5 27.5 35
b. Figure 10 shows the three curves. The marginal-cost curve is below the average-
total-cost curve when output is less than four and average total cost is declining.
The marginal-cost curve is above the average-total-cost curve when output is
above four and average total cost is rising. The marginal-cost curve lies above the
average-variable-cost curve.

Figure 10
10. a. The following table shows the firm’s fixed cost (FC), variable cost (VC), and total
 cost (TC):
Quantity Fixed Cost Variable Cost Total Cost
0 $100 $0 $100
1 100 5 105
2 100 10 110
3 100 15 115
4 100 20 120
5 100 25 125
6 100 30 130
7 100 35 135
8 100 40 140
9 100 45 145
10 100 50 150
b. The following table shows the firm’s marginal cost (MC) and average total cost
(ATC):
Quantity Marginal Cost Average Total Cost
0 ---- ----
1 5 105
2 5 55
3 5 38.33
4 5 30
5 5 25
6 5 21.67
7 5 19.29
8 5 17.50
9 5 16.11
10 5 15
The marginal-cost and average-total-cost curves are shown in Figure 11.

Figure 11

c. The firm’s marginal cost is $5 for every unit produced. This implies that the
 production function does not face diminishing marginal returns.
11. The following table shows quantity (Q), total cost (TC), and average total cost (ATC) for
the three firms:
Firm A Firm B Firm C
Quantity TC AT TC AT TC AT
C C C
1 60 60 11 11 21 21
2 70 35 24 12 34 17
3 80 26.7 39 13 49 16.3
4 90 22.5 56 14 66 16.5
5 100 20 75 15 85 17
6 110 18.3 96 16 106 17.7
7 120 17.1 119 17 129 18.4
Firm A has economies of scale because average total cost declines as output increases.
Firm B has diseconomies of scale because average total cost rises as output rises. Firm C
has economies of scale for output from one to three and diseconomies of scale for levels
of output beyond three units.