The Tax System

Taxes and Equity

• benefits principle
• the idea that people should pay taxes based on the benefits they receive from government services
• ability-to-pay principle
• the idea that taxes should be levied on a person according to how well that person can shoulder the burden
• vertical equity
• the idea that taxpayers with a greater ability to pay taxes should pay larger amounts
• horizontal equity
• the idea that taxpayers with similar abilities to pay taxes should pay the same amount
• proportional
• a tax for which high-income and low-income taxpayers pay the same fraction of income
• regressive
• a tax for which high-income taxpayers pay a smaller fraction of their income than do low-income taxpayers
• progressive
• a tax for which high-income taxpayers pay a larger fraction of their income than do low-income taxpayers
The Costs of Production
Total Revenue, Total Cost, and Profit
• Total revenue
• Amount a firm receives for the sale of its output
• Total cost
• Market value of the inputs a firm uses in production
• Profit
• Total revenue minus total cost
Costs: Explicit vs. Implicit
• Explicit costs require an outlay of money,
e.g., paying wages to workers.
• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
• Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
• This is true whether the costs are implicit or explicit. Both matter for
firms’ decisions.

5
What are Costs?

• Economic profit
• Total revenue minus total cost
• Including both explicit and implicit costs
• Accounting profit
• Total revenue minus total explicit cost

6
The Production Function
• production function
• the relationship between the quantity of
inputs used to make a good and the
quantity of output of that good

• We assume that the size of Chloe’s

factory is fixed and that Chloe can vary
the quantity of cookies produced only by
changing the number of workers she
employs. This assumption is realistic in
the short run but not in the long run.
• marginal product
• the increase in output that arises from an additional unit of input

• Notice that as the number of workers increases, the marginal product declines. The second worker has a
marginal product of 40 cookies, the third worker has a marginal product of 30 cookies, and the fourth worker
has a marginal product of 20 cookies. This property is called diminishing marginal product. At first, when
only a few workers are hired, they have easy access to Chloe’s kitchen equipment. As the number of workers
increases, additional workers have to share equipment and work in more crowded conditions.

• The slope of the production function measures the marginal product. As the number of workers increases, the
marginal product declines, and the production function becomes flatter.

• diminishing marginal product

• the property whereby the marginal product of an input declines as the quantity of the input increases
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.
Marginal Cost
• Marginal Cost (MC)
is the increase in Total Cost from producing one more unit:

∆TC
MC =
∆Q

THE COSTS OF
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PRODUCTION
Fixed and Variable 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?
• fixed costs
• costs that do not vary with the quantity of output produced
• variable costs
• costs that vary with the quantity of output produced
average total cost (ATC)
• total cost divided by the quantity of output
• average fixed cost
• fixed cost divided by the quantity of output
• average variable cost
• variable cost divided by the quantity of output
• marginal cost
• the increase in total cost that arises from an extra unit of production
Fixed and Variable Costs

• Average Costs
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• ATC = AFC + AVC
Average Costs
Why Marginal Cost Is Important
• Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce more
or less wheat?
• To find the answer, Farmer Jack needs to
“think at the margin.”
• If the cost of additional wheat (MC) is less than
the revenue he would get from selling it,
then Jack’s profits rise if he produces more.

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Cost Curves and Their Shapes
• We will find graphs of average
and marginal cost useful when
analyzing the behavior of firms

• Rising Marginal Cost

• U-Shaped Average Total Cost

• The bottom of the U-shape
occurs at the quantity that
minimizes average total cost.
This quantity is sometimes
called the efficient scale of the
firm.
Cost Curves and Their Shapes

• Marginal cost rises with the amount of output produced.

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

• This relationship between average total cost and marginal cost has an important corollary: The marginal-cost
curve crosses the average-total-cost curve at its minimum. Why? At low levels of output, marginal cost is
below average total cost, so average total cost is falling. But after the two curves cross, marginal cost rises
above average total cost. As a result, average total cost must start to rise at this level of output. Hence, this
point of intersection is the minimum of average total cost.
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.
Figure 5 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
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
Typical Cost Curves
• The cost curves in Figure 5 share the three
properties that are most important to
remember:
• 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.
Costs in the Short Run & Long Run
• Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
• Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones).
• In the long run, ATC at any Q is cost per unit using the most efficient
mix of inputs for that Q (e.g., the factory size with the lowest ATC).
EXAMPLE 1: LRATC (Long Run Average Total Cost) with 3 factory
Sizes
Firm can choose
from 3 factory Avg
sizes: S, M, L. Total
Cost ATCS ATCM
Each size has its ATCL
own SRATC curve.
The firm can
change to a
different factory
size in the long
run, but not in the Q
short run.

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EXAMPLE 1: LRATC with 3 factory Sizes
To produce less
than QA, firm will Avg
choose size S Total
in the long run. Cost ATCS ATCM
ATCL
To produce
between QA
and QB, firm will LRATC
choose size M
in the long run.
To produce more Q
than QB, firm will QA QB
choose size L
in the long run.
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A Typical LRATC Curve
In the real world,
factories come in ATC
many sizes,
each with its own LRATC
SRATC curve.
So a typical
LRATC curve
looks like this:

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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
How ATC Changes as
the Scale of Production Changes
Economies of ATC
scale: ATC falls
as Q increases.
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises Q
as Q increases.

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How ATC Changes as
the Scale of Production Changes
• Economies of scale occur when increasing production
allows greater specialization:
workers more efficient when focusing on a narrow
task.
• More common when Q is low.
• Diseconomies of scale are due to coordination
problems in large organizations.
E.g., management becomes stretched, can’t control
costs.
• More common when Q is high.

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The Relationship between Short-Run and
Long-Run Average Total Cost
• Because many decisions 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.
• This graph shows how short-run and long-run costs
are related. The long-run average-total-cost curve
has a much flatter U-shape than the short-run
averagetotal-cost curve. In addition, all the short-run
curves lie on or above the long-run curve. These
properties arise because firms have greater flexibility
in the long run.
• How long does it take a firm to get to the long run?
The answer depends on the firm. It can take a year or
more for a major manufacturing firm, such as a car
company, to build a larger factory. By contrast, a
person running a coffee shop can buy another coffee
maker within a few days.
Economies and Diseconomies of Scale
• When long-run average total cost declines as output increases, there are said to be economies of scale.
• When long-run average total cost rises as output increases, there are said to be diseconomies of scale.
• When long-run average total cost does not vary with the level of output, there are said to be constant returns
to scale.
• Economies of scale often arise because higher production levels allow specialization among workers, which
permits each worker to become better at a specific task. For instance, if Ford hires a large number of workers
and produces a large number of cars, it can reduce costs using modern assembly-line production.
• Diseconomies of scale can arise because of coordination problems that often occur in large organizations.