Weekly Lecture: Week 04
Chaps 10 –Production and Cost
CHAPTER ROADMAP

What
’
sNe
wi
nt
hi
sEdition?
Chapter 10 is largely unchanged from the sixth edition.

Where We Are
In this chapter, we define economic costs and profits. We examine the
relationship between inputs, costs, and production. This chapter lays the
groundwork for the profit-maximizing decisions that are made by firms,
which we study in the next several chapters.
 Whe
r
eWe
’
veBe
e
n
We defined what economics means in terms of scarcity, opportunity cost, choice,
a
nde
f
f
i
c
i
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ntus
eofr
e
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our
c
e
s
.We
’
vee
xpl
or
e
dt
hei
nt
e
r
a
c
t
i
onsofs
uppl
ya
nd
demand that bring about the efficient use of resources and the role of government
intervention in market effic
i
e
nc
y
.We
’
vedi
s
c
us
s
e
dt
her
a
t
i
ona
l
ebe
hi
ndt
he
downward-sloping demand curve using marginal utility analysis.

Whe
r
eWe
’
r
eGoi
ng
After this chapter, we look at the demand and marginal revenue curves for firms
in different industry structures. By combining cost, demand, and revenue curves,
we will see the profit-maximizing operating decisions made by firms.
CHAPTER LECTURE
 10.1 Economic Cost and Profit
TheFi
r
m’
sGoal
 Thef
i
r
m’
sg
oa
li
st
oma
xi
mi
z
epr
of
i
t
.
Accounting Cost and Profit versus Opportunity Cost
 Accountants measure revenue and cost using accounting conventions in order
to ensure that the firm pays the proper amount of tax and to give creditors
information. But the costs as measured by acc
ount
a
nt
sa
r
et
hef
i
r
m’
s
opportunity costs.
 The decisions the firm makes to maximize its profit respond to opportunity
cost and economic profit. The opportunity cost of a firm’
s use of resources is
the highest-valued alternative forgone. Opportunity costs include both explicit
costs and implicit costs.
 An explicit cost is a cost paid in money. Explicit costs are opportunity
costs.
 An implicit cost is an opportunity cost incurred by a firm when it uses a
factor of production for which it does not make a direct money payment.
Implicit costs also are opportunity costs.
Normal Profit and Economic Profit
 Af
i
r
m’
sowne
rs
uppl
i
e
se
ntrepreneurship by organizing the business and
bearing the risk of running it.
 Normal profit is the return to entrepreneurship. The normal profit is part
ofaf
i
r
m’
soppor
t
uni
t
yc
os
tbe
c
a
us
ei
ti
st
hec
os
tofpe
r
s
ua
di
ngt
he
entrepreneur of not running another business.
 Economic profit i
saf
i
r
m’
st
ot
a
lr
e
ve
nuemi
nusi
t
st
ot
a
loppor
t
uni
t
yc
os
t
.An
economic profit is a profit over and above the normal profit.
 10.2 Short-Run Production
Af
i
r
mowne
r
’
sde
c
i
s
i
onsc
a
nbec
a
t
e
g
or
i
z
e
da
sshort run decisions and long run
decisions.
 The short run is a time frame in which the quantities of some resources are
f
i
xe
d.Thef
i
xe
dr
e
s
our
c
e
si
nc
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udet
hef
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m’
sma
na
g
e
me
ntor
g
a
ni
z
a
t
i
on
structure, level of technology, buildings and large equipment. These factors
a
r
ec
a
l
l
e
dt
hef
i
r
m’
splant.
 The long run is a time frame in which the quantities of all resources can be
varied. Long-run decisions are not easily reversed so usually a firm must live
with the plant size that it has created for some time.
 To increase its output in the short run, a firm must increase the quantity of
labor employed. There are three relationships between the quantity of labor
a
ndt
hef
i
r
m’
sout
put
.
Product Schedules
 The total product is the total quantity of
a good produced in a given period.
 The marginal product (MP) of labor is
the increase in total product that results
from a one-unit increase in the quantity
of labor employed with all other inputs
remaining the same.
 The average product of labor is equal
to the total product of labor divided by
Labor
0
Total
Marginal
Average
product
product
product
0
10
1
10
10
20
2
30
15
6
3
36
12
the quantity of labor.
 The table to the right has examples of these product schedules.
 The marginal product curve shows the
additional output generated by each
additional unit of labor. The figure shows
a typical marginal product of labor curve
(MP), with an upside-down U shape. The
shape reflects the point that marginal
product has increasing marginal returns
initially and decreasing marginal returns
eventually.
 Increasing marginal returns occurs
when the marginal product of an
additional worker exceeds the
marginal product of the previous
worker. The marginal product curve has a positive slope. At low levels of
employment, increasing marginal returns is likely because hiring an
additional worker allows large gains from specialization. Eventually these
gains become small or nonexistent and decreasing marginal returns set in.
 Decreasing marginal returns occur when the marginal product of an
additional worker is less than the marginal product of the previous worker.
The marginal product curve has a negative slope. The law of decreasing
returns states that as a firm uses more of a variable input, with a given
quantity of fixed inputs, the marginal product of the variable input
eventually diminishes.
 The average product curve shows the average product that is generated by
labor at each level of labor. The average product of labor curve (AP) has an
upside-down U shape.
 As the figure shows, the marginal product curve and the average product curve
are related: when the marginal product of labor exceeds the average product of
labor, the average product of labor increases; when the marginal product of
labor is less than the average product of labor, the average product of labor
decreases; and the marginal product of labor equals the average product of labor
when the average product of labor is at its maximum.
 10.3 Short-Run Cost
Labor
0
Output
0
Fixed
Variable
cost
cost
(dollars)
(dollars)
50
Average
Average
Average
Marginal cost
Total cost
fixed cost
variable cost
total cost
(dollars)
(dollars)
(dollars)
(dollars)
(dollars)
0
50
10.00
1
10
50
100
150
5.00
10.00
15.00
5.00
2
30
50
200
250
1.66
6.67
8.33
16.67
3
36
50
300
350
1.39
8.33
9.72
The table above continues the previous product schedule table and shows different
costs.
Total Cost
 Total cost (TC) is the cost of all the factors of production a firm uses. Total
fixed cost (TFC)i
st
hec
os
toft
hef
i
r
m’
sf
i
xe
dfactors of production—the cost
of land, capital, and entrepreneurship. Total variable cost (TVC) is the cost of
t
hef
i
r
m’
sva
r
i
a
bl
ei
nputs—the cost of labor. Total cost is the sum of total
fixed cost plus total variable cost:
TC = TFC + TVC.
Marginal Cost and Average Costs
 Marginal cost (MC) is the increase in total cost that results from a one-unit
increase in output.
 Average fixed cost (AFC) is total
fixed cost per unit of output. The
value of AFC falls as output
increases.
 Average variable cost (AVC) is total
variable costs per unit of output. At
low levels of output, AVC falls as
output increases but at higher levels
of output, AVC rises as output
increases.
 Average total cost (ATC) is the total cost per unit of output. ATC = AFC +
AVC. At low levels of output, ATC falls as output increases but at higher levels
of output, ATC rises as output increases.
 The figure illustrates typical MC, AFC, AVC, and ATC curves. As the figure
shows, the MC curve, the AVC curve, and the ATC curve are all U-shaped.
There are other additional important points about this figure:
 The vertical distance between the AVC curve and the ATC curve is the
AFC. Because the AFC decreases as output increases, these curves become
closer to each other as output increases.
 The MC curve intersects the AVC curve and ATC curve at their minimums.
Cost Curves and Product Curves
 The shape of the cost curves is related to the shape of the productivity curves.
 The shape of the AVC curve is determined by the shape of the AP curve.
Over the range of output for which the AP curve is rising, the AVC curve is
falling and over the range of output for which the AP curve is falling, the
AVC curve is rising.
 The shape of the MC curve is determined by the shape of the MP curve.
Over the range of output for which the MP curve is rising, the MC curve is
falling and over the range of output for which the MP curve is falling, the
MC curve is rising.
Shifts in the Cost Curves
 The cost curves shift with changes in technology or changes in resource
prices.
 An increase in technology that allows more output to be produced from the
same resources shifts the cost curves downward. If the technology requires
more capital, a fixed input, then the average total cost curve shifts upward
at low levels of output and downward at higher levels of output.
 A fall in the price of the fixed factor of production shifts the AFC and ATC
curves downward but leaves the AVC and MC curves unchanged. A fall in
the price of a variable factor of production shifts the AVC, ATC, and MC
curves downward but leaves the AFC curve unchanged.
 10.4 Long-Run Cost
In the long run, a firm can vary the quantity of both labor and capital, so in the long
run all costs are variable costs.
Plant Size and Cost
 In the long run, when a firm changes its plant size, its average total cost might
rise, fall, or not change
 Economies of scale a
r
ef
e
a
t
ur
e
sofaf
i
r
m’
st
e
c
hnol
ogyt
ha
tma
kea
ve
r
a
g
e
total cost fall as output increases. The main source of economies of scale is
greater specialization of both labor and capital.
 Diseconomies of scale are features of a f
i
r
m’
st
e
c
hnology that make
average total cost rise as output increases. Diseconomies of scale arise
from the difficulty of coordinating and controlling a large business.
 Constant returns to scale a
r
ef
e
a
t
ur
e
sofaf
i
r
m’
st
e
c
hnol
ogyt
ha
tke
e
p
average total cost constant as output increases. Constant returns to scale
occur when a firm is able to replicate its existing production facility
including its management system.
The Long-Run Average Cost Curve
 In the long run, a firm can use
different plant sizes. Each plant size
has a different short-run ATC curve.
Each short-run ATC curve is
U-shaped and the larger the plant
size, the greater is the output at
which the average total cost is a
minimum.
 The figure illustrates three average
total cost curves for three plant sizes.
ATC1 pertains to the smallest plant
size and ATC3 to the largest.
 The long-run average cost curve,
LRAC, is the curve that shows the lowest average total cost at which it is
possible to produce each output when the firm has sufficient time to change
both its plant size and labor employed. This curve is derived from the
short-run average total cost curves. It shows the lowest average total cost to
produce a given level of output. In the figure, the LRAC curve is the darkened
parts of the three short-run ATC curves.
 The LRAC slopes downward when the firm has economies of scale, is
horizontal when the firm has constant returns to scale, and slopes upward
when the firm has diseconomies of scale.