13
The Costs of Production
The Market Forces of Supply
and Demand
Supply and demand are the two words that economists
use most often.
Supply and demand are the forces that make market
economies work.
Modern microeconomics is about supply, demand, and
market equilibrium.
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 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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WHAT ARE COSTS?
According to the Law of Supply:
Supply
Firms are willing to produce and sell a greater quantity of
a good when the price of the good is high.
This results in a supply curve that slopes upward.
WHAT ARE COSTS?
The Firm’s Objective
The economic goal of the firm is to maximize profits.
Total Revenue, Total Cost, and
Profit
Total Revenue
The amount a firm receives for the sale of its output.
TR = P * Q
Total Cost
The market value of the inputs a firm uses in production.
TC=TFC+TVC
Total Revenue, Total Cost, and
Profit
Profit is the firm’s total revenue minus its total cost.
Profit = Total revenue -
Total cost
Costs as Opportunity Costs
A firm’s cost of production includes all the opportunity
costs of making its output of goods and services.
Explicit and Implicit Costs
A firm’s 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 firm’s economic profit as total
revenue minus total cost, including both explicit and
implicit costs.
Accountants measure the accounting profit as the firm’s
total revenue minus only the firm’s 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 Economic versus Accountants
How an Economist How an Accountant
Views a Firm Views a Firm
Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs
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Table 1 A Production Function and Total Cost:
Cookie Factory
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.
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.
The Production Function
Diminishing Marginal Product
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.
The Production Function
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:
Cookie Factory
Total-Cost Curve
Total
Cost
$80 Total-cost
curve
70
60
50
40
30
20
10
0 10 20 30 40 50 60 70 80 90 100 110 120 130 140 150 Quantity
of Output
(cookies per hour)
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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 vary with the
quantity of output produced.
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: Lemonade Stand
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Fixed and Variable Costs
Average Costs
Average costs can be determined by dividing the firm’s
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 Costs
F ix ed co st F C
AFC
Q u an tity Q
V ariab le co st V C
AVC
Q u an tity Q
T o tal co st T C
ATC
Q u an tity Q
The Various Measures of Cost
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?
Marginal Cost
(chan g e in to tal co st) T C
MC
(chan g e in q u an tity ) Q
Marginal Cost
Quantity Total Marginal Quantity Total Marginal
Cost Cost Cost Cost
0 $3.00 —
1 3.30 $0.30 6 $7.80 $1.30
2 3.80 0.50 7 9.30 1.50
3 4.50 0.70 8 11.00 1.70
4 5.40 0.90 9 12.90 1.90
5 6.50 1.10 10 15.00 2.10
Total-Cost Curves
Total Cost
$15.00 Total-cost curve
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 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
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