5
FIRM BEHAVIOR AND THE
ORGANIZATION OF INDUSTRY
The Costs of
Production
Copyright©2004 South-Western
13
The Firm’s Objective
• … is to MAXIMIZE PROFIT
• Total Revenue = The amount a firm receives for the
sale of its output (P x Q)
• Total Cost = market value of inputs firm uses in
production
• Profit = TR - TC
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Costs as Opportunity Costs
• Cost of producing an item must include all
opportunity costs of inputs used
• Includes explicit costs and implicit costs
• Explicit costs = input costs that require a direct outlay of
money by the firm.
• Implicit costs = input costs that do not require an outlay
of money by the firm
• When TR exceeds both explicit and implicit costs, the
firm earns economic profit
• Economic profit is smaller than accounting profit.
• Quick Quiz 1
Copyright © 2004 South-Western/
Figure 1 Economic versus Accountants
How an Economist
Views a Firm
How an Accountant
Views a Firm
Economic
profit
Accounting
profit
Revenue
Implicit
costs
Revenue
Total
opportunity
costs
Explicit
costs
Explicit
costs
Copyright © 2004 South-Western
Quick Quiz #1
• Farmer McDonald gives banjo lessons for $20
an hour. One day, he spends 10 hours planting
$100 worth of seeds on his farm. What
opportunity cost has he incurred? What cost
would his accountant measure? If these seeds
yield $200 worth of crops, does McDonald earn
an accounting profit? Does he earn an
economic 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 shows
the relationship
between
quantity of
inputs used to
make a good
and the quantity
of output of that
good
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Quick Quiz #2
• Plot Helen’s production function; place the
level of labor on the x-axis against the level of
output on the y-axis.
• What happens to the marginal change in output
as Helen hires more workers?
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The Production Function
• Marginal Product = increase in output that arises
from an additional unit of input
• Marginal Product of Labor = slope of the production
function (change in output / change in labor)
• Property of Diminishing Marginal Product =
marginal product of an input declines as the quantity
of the input increases
• Short-run phenomenon!
• 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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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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RICE GAME
• I need two volunteers to start the
game…
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Refresher #1
• Answer the following in your notes:
• Draw the production function curve using the data from
our simulation. What does the slope of this curve
indicate? (Put output on the y-axis and labor on the xaxis).
• How did this simulation demonstrate the law of
diminishing marginal product?
• How would the results of this simulation differ if we were
looking at the long-run scenario?
Copyright © 2004 South-Western/
Economics, Yada, Yada, Yada…
• Happy Thursday. Any Seinfeld fans in here???
Copyright © 2004 South-Western/
Lots of Graphing Today…
• Production Function Curve
• (We did this on yesterday)
•
•
•
•
•
Total Cost Curve
Marginal Cost Curve
Average Total Cost Curve
Average Fixed Cost Curve
Average Variable Cost Curve
• (We are doing these today)
Copyright © 2004 South-Western/
Total-Cost Curve
• Relationship between quantity firm can produce
and its costs determines pricing decisions
• Total-cost curve shows this relationship
graphically.
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Copyright © 2004 South-Western/
Quick Quiz #1
• If Farmer Jones plants no seeds on his farm, he
gets no harvest. If he plants 1 bag of seeds, he
gets 3 bushels of wheat. If he plants 2 bags, he
gets 5 bushels. If he plants 3 bags, he gets 6
bushels. A bag of seeds costs $100, and seeds
are his only cost. Use these data to graph the
farmer’s production function and total-cost
curve. Explain their shapes.
Copyright © 2004 South-Western/
VARIOUS MEASURES OF COST
• Costs of production may be divided into:
• Fixed costs: do not vary with the quantity of output
produced
• Variable costs: do vary with the quantity of output
produced
TC = TFC + TVC
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Krzyzanowski quits her teaching job…
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… and opens a coffee shop!
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Decisions, Decisions…
• How should I price my coffee? How much
should I make?
• Things to consider:
• How much does it cost to make the typical cup of
coffee?
• How much does it cost to increase production of
coffee by 1 cup?
Copyright © 2004 South-Western/
Average Costs
• Represents AFC  Fixed cost  FC
Quantity
Q
cost of each
typical unit
Variable cost VC
produced
AVC 

Quantity
Total cost TC
ATC 

Quantity
Q
Copyright © 2004 South-Western/
Q
Marginal Cost
• Tells us how much it costs to produce an
additional unit of output
(change in total cost) TC
MC 

(change in quantity)
Q
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Why it’s important to understand
both ATC & MC…
• ATC tells us cost of the typical unit, but doesn’t
tell us how much total cost will change as a
firm alters its level of production – MC does!
• Business managers need to keep both in mind
when deciding how much of their product to
supply to the market!
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Plot the following curves on your graph:
ATC, AFC, AVC, and MC
Hypothesize:
• Why is each
curve shaped
the way it is?
Come up with a
hypothesis for
each.
• What is the
relationship
between ATC
and MC?
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Cost Curves & Their Shapes
• MC < ATC 
ATC decreases
• MC > ATC 
ATC rises
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Quick Quiz 2:
Relationship Between MC & ATC
• Two twins are enrolled in AP Microeconomics. They
each had a “B” average (GPA = 3.0) before taking the
class.
1. Twin One gets a “C” in the course. What happens to her
GPA?
2. Twin Two gets an “A” in the course. What happens to her
GPA?
3. What can you imply about a “marginal” grade lower than
the average?
4. What can you imply about a “marginal” grade higher than
the average?
Copyright © 2004 South-Western/
Cost Curves & Their Shapes
• Marginal cost
rises with the
amount of output
produced.
• Positive slope
reflects the
property of
diminishing
marginal
product.
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Cost Curves & Their Shapes
• Average Fixed
Cost always
declines as
output rises b/c
FC is spread
over larger # of
units (reflected
in negative
slope)
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Cost Curves & Their Shapes
• Average Variable
Cost typically rises
as output increases
b/c of diminishing
marginal product
(Think about what
happened during our game
on Thursday as we added
more workers! Variable
costs increased but
productivity declined!)
Copyright © 2004 South-Western/
Cost Curves and Their Shapes
• ATC curve is U-shaped and
reflects both AFC & AVC.
• At very low levels of output
ATC is high because fixed
cost is spread over only a
few units.
• ATC declines as output
increases.
• Eventually, ATC starts
rising because average
variable cost rises
substantially.
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Cost Curves and Their Shapes
• Bottom of the U-shaped ATC
curve occurs at quantity that
minimizes average total cost
• Called the efficient scale of the
firm
• The marginal-cost curve
crosses the average-total-cost
curve at the efficient scale
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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
Average
Total
Cost
ATC in short
run with
small factory
ATC in short ATC in short
run with
run with
medium factory large factory
$12,000
ATC in long run
0
1,200
Quantity of
Cars per Day
Copyright © 2004 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
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Figure 7 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
0
Constant
returns to
scale
1,000 1,200
Diseconomies
of
scale
Quantity of
Cars per Day
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