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What Are Costs?: - The Firm's Objective

Micro

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90 views42 pages

What Are Costs?: - The Firm's Objective

Micro

Uploaded by

chittran313
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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WHAT ARE COSTS?

The Firms 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.

Total Revenue, Total Cost, and Profit


Profit is the firms total revenue minus its

total cost.
Profit = Total revenue - Total cost

Costs as Opportunity
Costs
A firms cost of production includes all the

opportunity costs of making its output of


goods and services.
Explicit and Implicit Costs
A firms 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.

Economic Profit versus Accounting


Profit
Economists measure a firms economic profit

as total revenue minus total cost, including


both explicit and implicit costs.
Accountants measure the accounting profit as
the firms total revenue minus only the firms
explicit costs.

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.

Figure 1 Economists versus Accountants


How an Economist
Views a Firm

How an Accountant
Views a Firm

Economic
profit
Accounting
profit
Revenue

Implicit
costs

Explicit
costs

Revenue
Total
opportunity
costs

Explicit
costs

2007 Thomson South-Western

PRODUCTION AND COSTS


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.

2007 Thomson South-Western

The Production Function


Marginal Product
The marginal product of any input in the
production process is the increase in output
that arises from an additional unit of that input.

Table 1 A Production Function and Total Cost: Hungry


Helens Cookie Factory

2007 Thomson South-Western

The
Production
Function
Diminishing
marginal product is the property
whereby the marginal product of an input
declines as the quantity of the input
increases.
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.

Figure 2 Hungry Helens Production Function


Quantity of output

Number of Workers Hired


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.

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.

Table 1 A Production Function and Total Cost: Hungry


Helens Cookie Factory

2007 Thomson South-Western

Figure 2 Hungry Helens Total-Cost Curve

Total
Cost

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

Table 2 The Various Measures of Cost: Thirsty Thelmas


Lemonade Stand

2007 Thomson South-Western

Fixed and Variable Costs


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

Fixed and Variable Costs


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

Average and Marginal


Costs
AFC

AVC

Fixed cost FC

Quantity
Q

Variable cost VC

Quantity
Q

Total cost TC
ATC

Quantity
Q

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?

Average and Marginal


Cost
(change in total cost) TC
MC

(change in quantity)
Q

Note how Thelmas


Marginal Cost changes
with each change in Quantity.
Thirsty
Lemonade
Stand

Quantity

0
1
2
3
4
5

Total
Cost

Marginal
Cost

$3.00

3.30 $0.30
3.80
0.50
4.50
0.70
5.40
0.90
6.50
1.10

Quantity

6
7
8
9
10

Total
Cost

$7.80
9.30
11.00
12.90
15.00

Marginal
Cost

$1.30
1.50
1.70
1.90
2.10

Figure 3 Thirsty Thelmas Total-Cost Curves


Total Cost
Total-cost curve

$15.00
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

Quantity
of Output
(glasses of lemonade per hour)
8

10

2007 Thomson South-Western

Figure 4 Thirsty Thelmas 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

Quantity
of Output
(glasses of lemonade per hour)
9

10

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.

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.

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.

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.

Typical Cost Curves


It is now time to examine the relationships

that exist between the different measures of


cost.

Figure 5 Cost Curves for a Typical Firm


Note how
MCdeclines
hits both
Marginal
Cost
at ATC
first and
and AVC
thenat their
minimum
points.
increases
due
to diminishing marginal product.

Costs

AFC, a short-run concept, declines throughout.

$3.00
2.50

MC
2.00
1.50

ATC
AVC

1.00
0.50

AFC
0

10

12

14
Quantity of Output
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 averagetotal-cost curve at the minimum of average
total cost.

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 firms 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.

Figure 6 Average Total Cost in the Short and Long Run


Average
Total
Cost

ATC in short
run with
small factory

ATC in short ATC in short


run with
run with
medium factory large factory

ATC in long run

$12,000
10,000
Economies
of
scale

Constant
returns to
scale

1,000 1,200

Diseconomies
of
scale
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 firms 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 firms costs reflect its production process.
A typical firms production function gets flatter as
the quantity of input increases, displaying the
property of diminishing marginal product.
A firms 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 firms 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

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