CHAPTER

11

Production and Cost

Analysis I

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 Chapter Goals
• Explain the role of the firm in economic
analysis.
• Describe the production process in the short
run.
• Calculate fixed costs, variable costs, marginal
costs, total costs, average fixed costs, average
variable costs, and average total costs.
• Distinguish the various cost curves and
describe the relationships among them.
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 The Role of the Firm
• Firms transform the factors into goods and
services to consumers.
• In the supply process, people offer their
factors of production, such as land, labor, and
capital, to the market.
• Production is the transformation of factors
into goods.
• Ultimately, all supply comes from individuals
because they control the factors of
production.
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 The Role of the Firm
A firm is an economic institution that transforms factors of
production into goods and services.
Firms:
1. Organize factors of production and/or
2. Produce goods and services and/or
3. Sell produced goods and services
Some firms don’t have a physical location and don’t
“produce” anything; they simply subcontract out all
production.
Actual production is more and more being done by contract
manufacturing and contract fulfillment companies such as
Amazon. © 2020 McGraw-Hill Education 4
 Firms Maximize Profit
The goal of a firm is to maximize profits.

Profit = Total revenue – Total cost

For economists, total cost is explicit payments to

the factors of production plus the opportunity cost
of the factors provided by the owners of the firm.

For economists, total revenue is the amount a firm

receives for selling its product or service plus any
increase in the value of the assets owned by the
firm.
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 Firms Maximize Profit
Economists and accountants measure profit
differently.
Accountants focus on explicit costs and revenues.
Accounting profit = Explicit revenue – Explicit cost
Economists focus on both explicit and implicit costs
and revenue.
Economic profit =
(Explicit + Implicit revenue) – (Explicit + Implicit
cost)

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 The Production Process
The production process can be divided into the
long run and the short run.
The terms long run and short run do not
necessarily refer to specific periods of time, but
to the flexibility the firm has in changing its
inputs.

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 Short Run versus Long Run
Short Run Long Run
•A firm is constrained in •A firm chooses from all
regard to what production possible production
decisions it can make. techniques.
•Some inputs are fixed. •All inputs are variable.

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Production Tables and Production Functions
Firms combine factors of production to produce
goods and services.
A production table is a table showing the output
resulting from various combinations of factors of
production or inputs.
Real-world production tables are complicated.
This analysis will concentrate on short-run
production in which one of the factors is fixed.

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 A Production Table

# of Total Marginal Average

workers Output Product Product
0 0 --- Average product is the
1 4 4 4 output per worker.
2 10 6 5
7
Marginal product is
3 17 5.7
6 output per worker the
4 23 5.8
5 additional output that
5 28 5.6
3 will be forthcoming
6 31 5.2
1 from an additional
7 32 4.6
0 worker, other inputs
8 32 -2 4.0
constant.
9 30 -5 3.3
10 25 2.5
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 A Production Function
A production function is the relationship
between the inputs (factors of production) and
outputs.
It tells the maximum amount of output that can
be derived from a given number of inputs.
A production function can be seen in the next
few slides.

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 Graphing a Production Function
Q

32 A production
function is the
26
relationship
TP between the
20
inputs and the
14 outputs.

2 Number
of workers
1 2 3 4 5 6 7 8 9 10
Increasing Diminishing Diminishing
marginal marginal productivity Absolute
productivity productivity
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Graphing Marginal and Average Productivity
Marginal productivity
first increases.
Q
8 Then marginal
productivity declines.
6
Eventually marginal
4 productivity is
negative.
2 AP
0 Number of workers
1 2 3 4 5 6 7 8 9 10
-2
-4
MP
-6
Increasing Diminishing Diminishing
marginal marginal productivity Absolute
productivity productivity
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Law of Diminishing Marginal Productivity

# of Total Marginal Average Law of diminishing marginal

workers Output Product Product productivity states as more
of a variable input is added
0 0 ---
to an existing fixed input,
1 4 4 4 after some point the
2 10 6 5 additional output from the
7 additional input will fall.
3 17 5.7
6
4 23 5.8
5 Increasing
5 28 5.6
3 marginal productivity
6 31 5.2
1 Diminishing
7 32 0 4.6
marginal productivity
8 32 -2 4.0
9 30 -5 3.3 Diminishing
10 25 2.5 Absolute productivity
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 Fixed Costs
Fixed costs (FC) are those that are spent and cannot be
changed in the period of time under consideration.
In the short run, a number of inputs and their costs will
be fixed.
In the long run, there are no fixed costs since all inputs
(and therefore their costs) are variable.
Examples of fixed costs are buildings and machinery.

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 Variable Costs
Variable costs (VC) are costs that change as
output changes.
Examples of variable costs (VC) are labor, utility
bills, and the materials for producing your
product.

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 Total Costs
The sum of the variable and fixed costs are total
costs (TC).
TC = FC + VC

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 Average Costs
Average fixed costs (AFC) equal fixed cost divided by
quantity produced:
AFC = FC/Q
Average variable costs (AVC) equal variable cost
divided by quantity produced:
AVC = VC/Q
Average total costs (ATC) equal total cost divided by
quantity produced:
ATC = TC/Q or ATC = AFC + AVC

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 Marginal Cost
Marginal cost (MC) is the increase in total cost
when output increases by one unit.
MC = ΔTC/ΔQ

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 Costs of Production Table

Output FC ($) VC ($) TC ($) MC ($) AFC ($) AVC ($) ATC ($)
3 50 38 88 16.67 12.66 29.33
12
4 50 50 100 12.50 12.50 25.00
9 50 100 150 5.56 11.11 16.67
8
10 50 108 158 5.00 10.80 15.80
16 50 150 200 3.12 9.38 12.50
7
17 50 157 207 2.94 9.24 12.18
22 50 200 250 2.27 9.09 11.36
10
23 50 210 260 2.17 9.13 11.30
27 50 255 305 1.85 9.44 11.29
15
28 50 270 320 1.79 9.64 11.43
32 50 400 450 1.56 12.50 14.06

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 Graphing Total Cost Curves

Total Cost
(TC = FC + VC) TC
$450
• VC TC and VC
400
• curves
increase as
Q increases.
L
FC curve is
158 •O constant.
108 •M
50 • FC
Q
10 32

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 Graphing Per Unit Output Cost Curves

Cost

30 MC

MC, ATC,
20 and AVC
ATC curves are
AVC U-shaped.
10
AFC curve
AFC
decreases.
0
Q
10 20 30

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 The Shapes of Cost Curves
• The variable and total cost (VC and TC) curves are
upward sloping. Increasing output increases VC
and TC.
• The fixed cost (FC) curve is always constant.
Increasing output does not change FC.
• The average fixed cost (AFC) curve is downward
sloping. Increasing output decreases AFC.
• The marginal cost (MC), average variable cost
(AVC), and average total cost (ATC) curves are U-
shaped. Increasing output initially leads to a
decrease in MC, AVC, and ATC but eventually they
increase. © 2020 McGraw-Hill Education 23
The Shapes of the Average Cost Curves
The U-shape of ATC and AVC curves is due to:
• When output is increased in the short run, it
can only be done by increasing the variable
input.
• The law of diminishing productivity causes
marginal and average productivities to fall.
• As average and marginal productivities fall,
average and marginal costs rise.
The marginal cost curve goes through the minimum
points of the ATC and AVC curves.
© 2020 McGraw-Hill Education 24
 The Relationship Between
Marginal Productivity and Marginal Costs
Costs
per unit
MC
AVC
If marginal productivity is
rising, marginal costs are
falling.
Q
Output
If average productivity is
per worker falling, average costs are
rising.
AP of workers
MP of workers
Q
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 The Relationship Between
Marginal Cost and Average Cost
If MC > ATC, then ATC is rising.

If MC > AVC, then AVC is rising.

If MC < ATC, then ATC is falling.

If MC < AVC, then AVC is falling.

If MC = AVC and MC = ATC, then AVC and ATC are

at their minimum points.
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 The Relationship Between
Marginal Cost and Average Cost
The marginal cost curve
Costs
per unit goes through the
minimum point of both
MC
the ATC and AVC curves.
ATC

AVC

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 Chapter Summary
Accounting profit is explicit revenue less explicit cost.

Economists include implicit revenue and cost in

determining economic profit.

Implicit revenue includes the increases in the value of

assets owned by the firm. Implicit costs include the
opportunity cost of time and capital provided by owners
of the firm.

In the long run a firm can choose among all possible

production techniques. In the short run it is constrained
in its choices because at least one input is fixed.
© 2020 McGraw-Hill Education 28
 Chapter Summary
The law of diminishing marginal productivity states that as
more of a variable input is added to a fixed input, the
additional output will eventually be decreasing

Costs are generally divided into fixed costs, variable costs,

and total costs.

TC = FC + VC

MC = ΔTC/ΔQ

AFC = FC/Q

AVC = VC/Q

ATC = AFC + AVC © 2020 McGraw-Hill Education 29

 Chapter Summary
The average variable cost curve and marginal cost curve
are mirror images of the average product curve and the
marginal product curve, respectively.
The law of diminishing marginal productivity causes
marginal and average costs to rise.

If MC > ATC, then ATC is rising.

If MC = ATC, then ATC is constant.

If MC < ATC, then ATC is falling.

MC curve goes through the minimum points of the AVC

curve and ATC curve. © 2020 McGraw-Hill Education30