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5

FIRM BEHAVIOR AND THE �ORGANIZATION OF INDUSTRY

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13

The Costs of Production

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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.

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WHAT ARE COSTS?

According to the Law of 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.

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WHAT ARE COSTS?

The Firm’s Objective

The economic goal of the firm is to maximize profits.

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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.

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Total Revenue, Total Cost, and Profit

Profit is the firm’s total revenue minus its total cost.

Profit = Total revenue - Total cost

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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.

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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.

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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.

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Figure 1 Economic versus Accountants

Revenue

Total

opportunity

costs

How an Economist

Views a Firm

How an Accountant

Views a Firm

Revenue

Economic

profit

Implicit

costs

Explicit

costs

Explicit

costs

Accounting

profit

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Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory

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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.

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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.

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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.

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Figure 2 Hungry Helen’s Production Function

Quantity of

Output

(cookies

per hour)

150

140

130

120

110

100

90

80

70

60

50

40

30

20

10

Number of Workers Hired

0

1

2

3

4

5

Production function

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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.

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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.

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Table 1 A Production Function and Total Cost: Hungry Helen’s Cookie Factory

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Figure 3 Hungry Helen’s Total-Cost Curve

Total

Cost

$80

70

60

50

40

30

20

10

Quantity

of Output

(cookies per hour)

0

10

20

30

150

130

110

90

70

50

40

140

120

100

80

60

Total-cost

curve

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THE VARIOUS MEASURES OF COST

Costs of production may be divided into fixed costs and variable costs.

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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.

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Fixed and Variable Costs

Total Costs

Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC

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Table 2 The Various Measures of Cost: Thirsty Thelma’s 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.

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Fixed and Variable Costs

Average Costs

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

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Average Costs

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Table 2 The Various Measures of Cost: Thirsty Thelma’s Lemonade Stand

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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?

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Marginal Cost

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Marginal Cost� Thirsty Thelma’s Lemonade Stand

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Figure 4 Thirsty Thelma’s Total-Cost Curves

Total Cost

$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

Quantity

of Output

(glasses of lemonade per hour)

0

1

4

3

2

7

6

5

9

8

10

Total-cost curve

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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0

1

4

3

2

7

6

5

9

8

10

MC

ATC

AVC

AFC

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Cost Curves and Their Shapes

Marginal cost rises with the amount of output produced.

This reflects the property of diminishing marginal product.

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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0

1

4

3

2

7

6

5

9

8

10

MC

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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.

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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.

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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0

1

4

3

2

7

6

5

9

8

10

ATC

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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.

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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.

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Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs

$3.50

3.25

3.00

2.75

2.50

2.25

2.00

1.75

1.50

1.25

1.00

0.75

0.50

0.25

Quantity

of Output

(glasses of lemonade per hour)

0

1

4

3

2

7

6

5

9

8

10

ATC

MC

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Typical Cost Curves

It is now time to examine the relationships that exist between the different measures of cost.

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Big Bob’s Cost Curves

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Figure 6 Big Bob’s Cost Curves

(a) Total-Cost Curve

$18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

Quantity of Output (bagels per hour)

TC

4

2

6

8

14

12

10

2.00

Total

Cost

0

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Figure 6 Big Bob’s Cost Curves

(b) Marginal- and Average-Cost Curves

Quantity of Output (bagels per hour)

Costs

$3.00

2.50

2.00

1.50

1.00

0.50

0

4

2

6

8

14

12

10

MC

ATC

AVC

AFC

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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 average-total-cost curve at the minimum of average total cost.

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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, fixed costs become variable costs.

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COSTS IN THE SHORT RUN AND IN THE LONG RUN

Because many costs 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.

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Figure 7 Average Total Cost in the Short and Long Run

Quantity of

Cars per Day

0

Average

Total

Cost

1,200

$12,000

ATC

in short

run with

small factory

ATC

in short

run with

medium factory

ATC

in short

run with

large factory

ATC

in long run

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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

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Figure 7 Average Total Cost in the Short and Long Run

Quantity of

Cars per Day

0

Average

Total

Cost

1,200

$12,000

1,000

10,000

Economies

of

scale

ATC

in short

run with

small factory

ATC

in short

run with

medium factory

ATC

in short

run with

large factory

ATC

in long run

Diseconomies

of

scale

Constant

returns to

scale

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Summary

The goal of firms is to maximize profit, which equals total revenue minus total cost.
When analyzing a firm’s behavior, it is important to include all the opportunity costs of production.
Some opportunity costs are explicit while other opportunity costs are implicit.

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Summary

A firm’s costs reflect its production process.
A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product.
A firm’s 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.

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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.

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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 firm’s 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.