Chapter 13.

The Cost of Production

• So far we have studied supply and demand in a market.
• In this chapter we will focus solely on the suppliers and their decisions
to produce.
• Suppliers are the ones who provide much needed goods to our
society and hence important to understand how they optimize their
decisions.
Firm’s Objective
• Firms want to maximize their profit (earnings).

• Depending on the firms, firms face/choose difference price.

• Perfectly competitive firms
• Monopolies
• Oligopolies
Perfectly Competitive Firms
• Many sellers and Many buyers
• Sellers and Buyers take price as given
Monopolies
• Monopolies take up huge (or all) of the market share;
• Have more flexibility in setting price
• Monopolies face regulations due to its potential to:
• Practice predatory pricing
• Create barriers to entry
• Buying up competitors (M & A)
Oligopolies
• A few firms dominates the market.
• The pricing strategy is perhaps the most complex (Game Theory)
Oligopolies and Game Theory
• In the example of Coke, when deciding how to price, it takes into
account the competitors’ response to its decision.
• One strategy is to mirror the competitors’ price.
• Assume both Coke and Pepsi initially set price of coke at $1/can.
• Coca-cola sets the price of a soda at $.75/can.
• Pepsi then sets the price at $.75/can.
• There is however an incentive to further deviate and lower price..
• But knowing that Pepsi will follow suit, Coke will probably not lower further and
vice versa.
• Sometimes Oligopolistic firms join hands to form cartels
Some definitions of Cost and Inputs
• In cost accounting, there are several key definitions and
categorizations we need to be aware of
Type of Costs:
• Fixed Costs: One time investments that do not change with more
output in the short run. (factory buildings, heavy machinery)
• Variable Costs: Costs that gets incurred for every extra unit of
production (electricity, oil, labor,..,etc.)
Time Horizon:
• The Short run: At least one input is fixed.
• The Long run: All inputs are variable.
Capital & Labor (two types of inputs)
• Although not in our textbook, it helps to understand yet another
distinction in the firm’s input for production: Capital and Labor

Capital includes: Labor includes:

1. Factories 1. Machine Operators
2. Machines 2. Service Workers
3. Building 3. Teachers
4. Land 4. Engineers..
5. Technologies..
Capital - Labor Trade-off
• Virtually all the products we use are some combination of capital and
labor.
• Theories about the relationship between capital and labor:
• First, the idea that capital and labor are substitutes
• Second, the idea that capital and labor are complements
• A high skilled labor was thought to complement capital but..
Firm’s Objective in competitive
markets
• Firms want to maximize their profit (earnings).

• In competitive firms, firms take market price as given.

• As an owner of the firm you observe the market price and decide:
• Shut down? or open?
• If open, produce more? Or less?
• Keep producing until producing more incurs a loss
• We need to first understand the firms cost function
Fixed cost: $30 oven
Variable cost: $10/hour of labor

# of Workers Output Marginal Fixed Cost Variable Cost Total Cost

(production) Productivity of (marginal cost)
Labor
0 0 - $30 $0 $30
1 50 50 30 10 40
2 90 40 30 20 50
3 120 30 30 30 60
4 140 20 30 40 70
5 150 10 30 50 80
6 155 5 30 60 90
Various Definition of Costs
output Fixed Costs Var. Cost Total Cost Marg. Cost AFC AVC ATC
0 $3 $0 $3 - - - -
1 3 0.3 3.3 0.3 3 0.3 3.3
2 3 0.8 3.8 0.5 1.5 0.4 1.9
3 3 1.5 4.5 0.7 1 0.5 1.5
4 3 2.4 5.4 0.9 0.75 0.6 1.35
5 3 3.5 6.5 1.1 0.6 0.7 1.3
6 3 4.8 7.8 1.3 0.5 0.8 1.3
7 3 6.3 9.3 1.5 0.43 0.9 1.33
8 3 8.0 11 1.7 0.38 1 1.38
9 3 9.9 12.9 1.9 0.33 1.1 1.43
10 3 12.0 15 2.1 0.3 1.2 1.5
Short-Run Cost Curves
output AFC AVC ATC
0 - - -
1 3 0.3 3.3
2 1.5 0.4 1.9
3 1 0.5 1.5
4 0.75 0.6 1.35
5 0.6 0.7 1.3
6 0.5 0.8 1.3
7 0.43 0.9 1.33
8 0.38 1 1.38
9 0.33 1.1 1.43
10 0.3 1.2 1.5
Long-Run Cost Curve
• In the long run firms no longer have fixed inputs and can scale up.
• However, scaling up doesn’t always decrease ATC.
Long Run ATC Segments
• Economies of Scale
• Where ATC falls due to specialization that comes with scaling up. (automobile
manufacturing, schools with different dept.)
• Constant Returns to Scale
• The company can no longer reduce ATC it has hit a plateau.
• Decreasing returns to Scale
• Once a company gets too large, it starts experiencing problems such as
• Communication problem, Coordination problem, Employee Morale falls
Chapter 14. Firms in Competitive
Markets
• In chapter 13, we merely learned about the cost structure of the firm.
This information is useful in this chapter.
• So how do firms exactly maximize their profits in a competitive
market if they don’t have any power over setting price?
• The answer is setting quantity of production instead of price.
• Since cost is not constant but exhibits an increasing marginal cost.
• In this chapter we will learn how firms set quantity to maximize profit
both in the short and the long term.
Motivation
• Suppose Fred and Jane are co-owners of an ice-cream shop. Fred is a
bit lost on how to manage the business. Jane who is an economics
major is explaining to Fred how he should best manage his business.
Here is a list of Fred’s doubts.
• How much ice cream should we produce to maximize profit?
• Will we be profitable at this quantity?
• What should we do if that output makes a loss in the long run?
• Should we keep operating in the short run?
How much ice cream should we produce to maximize profit?

• Ice cream should be produced up until the MR= MC.

• This is where the profit is maximized.
• Marginal Revenue is the extra utility, Marginal Cost is the extra cost.
• When MR>MC, you should keep going
• When MR=MC, you should stop there
• When MR<MC, you should scale back
• We are going to approach the solution both numerically and
graphically
Numerical Analysis
Output Price Total Total Cost Profit Marginal Marginal MR –MC
(Quantity) Revenue (TR-TC) Revenue (MR) Cost(MC) Or
Marginal Profit
0 $6 $0 $3 $-3 $6 - -
1 6 6 5 1 6 $2 4
2 6 12 8 4 6 3 3
3 6 18 12 6 6 4 2
4 6 24 17 7 6 5 1
5 6 30 23 7 6 6 0
6 6 36 30 6 6 7 -1
7 6 42 38 4 6 8 -2
8 6 48 47 1 6 9 -3

Output of 5 is the Profit Where P=MR=MC

Maximizing Output
Graphical Analysis
 Should we keep operating in the short run?
• So far we have assumed that the firms are always open for business. There will be
instances where firms either want to shut-down temporarily (in the short-run) or shut-
down permanently (in the long-run).
• Let’s talk about the short-run first. In the short-run, firms take into account the myriads
of variable costs they have incurred such as (raw materials, electricity, wages).
• Why not the fixed cost? -> fixed costs are sunk cost (not relevant)
• Shut down if Total Rev.(TR)<Total Variable Cost(VC)
• Dividing both sides by Q we get
•
• P > AVC  Remain Open and produce where P=MC
• P< AVC  Close temporarily until conditions become more favorable
Sunk Cost Fallacy
• A sunk cost is a cost that has already been incurred and cannot be recovered.
Because it can't be changed by any future decisions, it shouldn't factor into
current decision-making.
• The sunk cost fallacy occurs when someone continues a project or investment
based on the amount already invested, rather than on future benefits or costs.
• Example:
• Imagine you buy a non-refundable ticket to a concert for $100. Your benefit of
watching a concert is $110. On the way to the concert, you lose the ticket. Should
you buy another ticket?
• Suppose you buy a non-refundable ticket to a concert for $100. You are sick on the
day of the concert and want to resell your ticket at a black market. What should be
the lowest amount you are willing to sell it for?
Short-run decision to shut-down
 Should we keep operating in the Long Run?
• Note in the long run since fixed costs are also variable, the firm considers that total cost
(fixed cost + variable cost)
• Instead of temporarily shutting down, they exit the market if,
• Total Rev.(TR)<Total Cost(TC)
• Dividing both sides by Q we get
•
• P > ATC  Remain Open and produce where P=MC
• P< ATC  Permanently Exit the Market
Profit in the Long Run = 0
• Free entry and exit..
• The Profit is given by the area above the ATC and below price
multiplied by the profit maximizing quantity. (why?)
• Profit = TR- TC = (TR – TC) * (Q/Q) = (P-ATC) * Q
Free Entry and
Exit
• After a demand shocks, price
rises.
• Suppliers enter freely!
• Price falls as a result

• After a negative demand

shocks, price falls.
• Suppliers exit freely!
• Price rises as a result
Zero Long Run Profit
• In the long run, profit is equal to zero, because price always goes down to
where P=MC=minimum of ATC (where p=MC=ATC)
• The reason for this is because of “free-entry and exit” which is a key
characteristic of competitive market.
How can there be zero long run
profit?
• What company would want to stay in the business long-run if their
profit is zero?
• Note we are concerned with economic profit not accounting.
• Economics profit = Total Revenue – (Implicit + Explicit)cost
• Labor is included in explicit cost (CEO pay, workers pay, etc..)
• Implicit Cost = Opportunity cost (next best alternative)
• If you pursue a EV business, you are forgoing profit from pursuing a AI
business (next best alterative)