Why does production
have a cost?
because ...
Scarcity
• Inputs are scarce.
• They have opportunity costs.
What do entrepreneurs want?
• Maximum profit?
• Satisfaction from career?
• To serve others?
• Thrills from competition?
Revenue
• All gains.
• Sales: prices times quantities
• Also from subsidies.
Profit and cost
• Revenue minus cost.
• Cost: foregone opportunity.
• Costs: explicit and implicit.
• Supply costs include all
opportunity costs.
Explicit costs
• Paid to someone else.
• Recorded by an accountant or
bookkeeper.
• Includes annual depreciation,
because the purchase is
explicit.
Implicit costs
• Non-recorded opportunity
costs.
• Example: highest wage a selfemployed person could earn
as an employee.
• Example: normal returns to
assets, .e.g. interest on bonds.
Two types of profit
• Accounting profit: Revenue
minus explicit costs.
• Economic profit: Revenue
minus all costs.
• Which is the real profit?
• Which do economists use?
Production
• Short run:
• at least one input is fixed;
• does not vary with output.
• Long run:
• all costs are variable.
The production function
• Q = f (I), I a vector of inputs.
• A physical, not financial, relationship.
• Maximum output obtainable from inputs.
Products
• Average product of a factor:
Quantity of output divided by the
units of the factor.
• E.g. output divided by workers.
• Marginal product: the additional
output from obtaining one more
factor unit, all else constant.
The law of diminishing returns
• Only for the short run.
• At least one fixed input.
• As one adds units of a variable input,
eventually its marginal product
declines.
• The marginal product crosses the
average product at the quantity for
which ... ?
Marginal and average product
• Where do they cross?
What range?
• At what range of quantity does
a profit maximizing firm
produce, relative to MP and
AP?
*
.
Cost and product
•
•
•
•
•
When marginal product is rising,
marginal cost is falling.
When average product is rising,
average cost is falling.
Marginal cost crosses average cost at
its minimum.
Scales
• Scale: the size of a firm or
production unit. Not these:
Returns to scale
• Economies of scale: lower average
cost with greater scale.
• Diseconomies: greater average cost
with greater scale.
• Constant returns to scale: no change
in AC when scale increases.
Short and long-run costs
• Short-run cost curves are above and
tangent to the long-run curve.