Lecture 2
Production, Economic Costs,
Economic Profits
1
Overview
 Goal of this section: to understand the supply
decisions of firms
 Firms take inputs and transform them into outputs
 Firms’ use of scarce inputs causes them to incur costs
 Firms’ sale of their outputs generates revenues
 Firms’ challenge is to choose outputs that maximize
profits
 Related to that challenge is to employ inputs so as to
minimize the cost of producing the chosen outputs
 This requires us to understand production theory, cost
theory, and the concept of economic profits
Types of production decisions
managers make
 Imagine yourself the owner/manager of a fast-food restaurant in
Monastiraki.
 You get a phone call asking you if you can accommodate three busloads of
senior citizens for lunch tomorrow at 12:30 p.m. This would at least double
your usual rate of output during the lunch rush. How would you vary your
use of inputs to accomplish this?
 https://www.youtube.com/watch?v=Xedkk1xvgeo ;
https://www.youtube.com/watch?v=FXrgYbT_0sA
 Alternatively, you read in the paper that Greece is expanding the size of the
Piraeus port to allow more cruise ships to dock. You anticipate this will add
40% or more to your daily output. How would you vary your use of inputs to
accommodate this increase in demand?
 http://discoverarbys.com/blog/arbys-restaurant-design-smart-inviting/
Production Function
The Production Function indicates the
highest output that a firm can produce for
every specified combination of inputs
given the state of technology.
Shows what is technically feasible when
the firm operates efficiently.
Want the production function general
enough to describe what Boeing does as
well as what Microsoft does.
4
Production Function
The production function for two inputs:
Q = F(K,L)
Q = Output, K = Capital, L = Labor
For a given technology.
– Change technology and get a different F().
Just a way of expressing how inputs are
combined to make outputs.
5
Production Function
Example of different technology
– Use a standard drill to extract oil from the
ground or extract oil using hydraulic fracturing
Different technology but the output is the
same—oil
6
Production Function
Observations:
1) For any level of K, output increases
with more L.
2) For any level of L, output increases
with more K.
3) Various combinations of inputs
produce the same output.
7
Short-run production relationships
 Short run: different inputs can be varied over different time
horizons. Depending on the time horizon over which the firm
wants to vary output, it may not be able to alter the amounts
of all inputs. The short run is a time period so short that the
firm is unable to alter the amounts of all inputs.
 Fixed inputs cannot be varied over the production time period.
 Variable inputs can be varied over the production time period.
 Short-run production function: Q = f(L, Ǩ). Capital is fixed but
labor can be varied, so increases in output can only be
achieved by adding more labor to the fixed amount of capital.
 In your fast-food restaurant, what inputs are fixed and what
inputs are variable over a 24-hour time horizon? Can you
think of a production process where L is the least variable
input (i.e. fixed)? (hint: think UK)
Consider production in the short-run with
one variable input (Labor)
Amount
of Labor (L)
Amount
Total
of Capital (K) Output (Q)
Average
Product
Marginal
Product
0
10
0
---
---
1
10
10
10
10
2
10
30
15
20
3
10
60
20
30
4
10
80
20
20
5
10
95
19
15
6
10
108
18
13
7
10
112
16
4
8
10
112
14
0
9
10
108
12
-4
10
10
100
10
-8 9
Production with one variable input (Labor)
With additional workers output (Q) initially
increases, reaches a maximum, and then
decreases.
The average product of labor (AP), or
output per worker, increases and then
decreases.
Output
Q
AP =
=
Labor Input L
10
Production with one variable input (Labor)
The marginal product of labor (MP), or
output of the additional worker, increases
rapidly initially and then decreases and
becomes negative.
∆Output
∆Q
MPL =
=
∆Labor Input ∆L
11
Production with one variable input (Labor)
Output
per
Month
D
112
Total Product
C
60
A: slope of tangent = MP (20)
B: slope of 0B = AP (20)
C: slope of 0C= MP & AP
B
A
0 1
2 3
4
5 6
7 8
9
10 Labor per Month
12
Production with one variable input (Labor)
Output
per
Month
Observations:
Left of E: MP > AP & AP is increasing
Right of E: MP < AP & AP is decreasing
E: MP = AP & AP is at its maximum
30
Marginal Product
E
20
Average Product
10
0 1
2 3
4
5 6
7 8
9
10 Labor per Month
13
Production with one variable input (Labor)
As the use of an input increases in equal
increments, a point will be reached at
which the resulting additions to output
decreases (i.e. MP declines).
Known as the Law of Eventually
Diminishing Marginal Returns.
– Governs all short-run production relationships
14
Law of Diminishing Marginal Returns
When the labor input is small, MP
increases due to specialization.
When the labor input is large, MP
decreases due to inefficiencies.
15
The Effect of Technological Improvement
Output
per
time
period
Labor productivity
can increase if there
are improvements in
technology, even though
any given production
process exhibits
diminishing returns to
labor.
C
100
B
O3
A
O2
50
O1
0 1
2 3
4
5 6
7 8
9
10
Labor per
time period
16
Long-run production relationships
 Long run: different inputs can be varied over different
time horizons. Given sufficient amount of time to
adjust, a firm can vary the amounts of all inputs used
in its production process
 There are no fixed inputs in the long run—all inputs
are variable.
 Long-run production function: Q = f(L, K). Both labor
and capital can be varied, so increases in output can
be achieved by adding more labor or more capital or
more of both.
 How long is the long run? For fast-food restaurants
(e.g. KFC)? For vertically integrated electric power
companies (e.g. Public Power Corp of Greece)?
Isoquant
Draw a curve showing all the possible
combinations of inputs that produce the
same output.
– Call this curve an isoquant.
Consider the following table showing how
many tons of steel we get from various
amounts of capital and labor.
18
Production of Steel
Labor Input
Capital Input 1
2
3
4
5
1
20
40
55
65
75
2
40
60
75
85
90
3
55
75
90
100
105
4
65
85
100
110
115
5
75
90
105
115
120
19
Production with Two Variable Inputs (L,K)
Capital
per year
The Isoquant Map
E
5
4
3
A
B
The isoquants are derived
from the production
function for output
of 55, 75, and 90.
C
2
Q3 = 90
D
1
Q2 = 75
Q1 = 55
1
2
3
4
5
Labor per year
20
Isoquants
 The isoquants emphasize how different input
combinations can be used to produce the same
output.
 This information allows the producer to respond
efficiently to changes in the markets for inputs.
 An isoquant is drawn assuming both factors can
be changed.
– It may take longer to vary some inputs
21
Production with Two Variable Inputs
Assume capital is 3 and labor increases
from 0 to 1 to 2 to 3 (A→B→C).
–
Notice output increases at a decreasing rate
(55, 20, 15) illustrating diminishing returns
from labor in the short-run and long-run.
Assume labor is 3 and capital increases
from 0 to 1 to 2 to 3 (D→E→C).
–
Output also increases at a decreasing rate
(55, 20, 15) due to diminishing returns from
capital.
22
The Shape of Isoquants

The slope of each isoquant shows the
trade-off between two inputs while keeping
output constant.
–

Similar to the slope of the indifference curve.
Call the slope of the isoquant the marginal
rate of technical substitution (MRTS).
23
Marginal Rate of Technical Substitution

The marginal rate of technical substitution
equals:
MRTS = - Change in capital/Change in labor input
MRTS = − ∆K
∆L
(for a fixed level of Q)
24
Cost Theory: accounting costs vs. economic
costs
 Financial accounting: GAAP and FASB, outsiders vs. insiders,
audited financial statements, efficient capital markets in advanced
economies, why study financial accounting?
 Managerial accounting: do companies typically release internal cost
accounting reports to the public? Why not? Who sees them and
how are they used?
 If our goal is to understand how firms make supply decisions, which
perspective on costs seems more appropriate?
 Going forward in this course, we will put on our managerial
accounting hats and think about costs as good cost accountants do.
Economic Profits vs. Accounting Profits

Warren Buffet on the topic:
o Our long-term economic goal … is to maximize the average annual rate of gain in intrinsic business
value on a per-share basis. We do not measure the economic significance or performance of Berkshire
by its size; we measure by per-share progress. We … will be disappointed if our rate does not exceed
that of the average large American corporation.
o Our preference would be to reach this goal by directly owning a diversified group of businesses that
generate cash and consistently earn above-average returns on capital. Our second choice is to own
parts of similar businesses, attained primarily through purchases of marketable common stocks ...
o Because of this two-pronged approach to business ownership and because of the limitations of
conventional accounting, consolidated reported earnings may reveal relatively little about our true
economic performance. I … virtually ignore such consolidated numbers. However, we will also report to
you the earnings of each major business we control, numbers we consider of great importance. These
figures, along with other information we will supply about the individual businesses, should generally aid
you in making judgments about them.
o Accounting consequences do not influence our operating or capital-allocation decisions. When
acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us
under standard accounting principles than to purchase $1 of earnings that is reportable. ... In aggregate
and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value
through capital gains.
o ... We will only do with your money what we would do with our own, weighing fully the values you can
obtain by diversifying your own portfolios through direct purchases in the stock market.
Running with the big
dogs
 Robert L. Bartley, long-time editor of the WSJ, on whether you are ready to
work for Berkshire-Hathaway:
“EPS, the familiar earnings per share, is supposed to measure corporate profit, as
determined by GAAP, or generally accepted accounting principles. But economists have
long recognized that profit is something of a mystery, and that economic profit is by no
means the same thing as accounting profit.”
“The purpose of capital markets is to direct scarce capital to its highest uses. The
highest uses depend on economic profit -- rates of return on assets -- not on accounting
profits. Yet the Sarbanes-Oxley Act that established the Accounting Oversight Board also
enshrined EPS and GAAP more firmly than ever. The act puts impediments to revealing
economic-profit numbers such as Mr. Wallison's cash flow or Mr. Stewart's EVA.”
“Yet these are precisely the kind of numbers sophisticated CEOs and CFOs use for
internal management. At its best, indeed, securities analysis is about converting reported
accounting profits into meaningful economic profits, but analysts who can do that are hired
away to run hedge funds and the like. They leave behind the earnings-per-share crowd to
hector managers about accounting profits, persuading them that this is what drives share
prices.”
Opportunity Cost—the most important intuition you
can develop for running a business
 Opportunity cost: the highest valued alternative
use of a scarce resource is the cost of employing
that resource in its current place.
 Examples
 Cost of getting an MBA
 Cost to your instructor of holding a help session on
Thursday afternoons
 Renting vs. owning your dwelling
 Financing your education
 Cost of owning and operating a car for a year while
getting your MBA
Nikos’s sandal shop
 Total revenue from sale of goods = €80,000
 Explicit costs of operating the business:
cost of goods sold
€40,000
taxes and utilities
€5,000
rent
€10,000
 Accounting profit = €25,000
Additional information
– Nikos works full time in the shop and doesn’t pay
himself a salary. He used to work as a mechanic
and earned €24,000 per year.
– Nikos and his wife have €40,000 tied up in the
business at any point in time—working capital.
They took that money out of an investment
account where they earned 5% per year.
– Nikos had to buy a computer (€3,000) and install
carpeting (€5,000) when she opened the
business. Both of these have an expected life of
4 years, at which point they will both have to be
replaced.
If you were him, what would you do?
 Accounting profits = €25,000
 How much would Nikos have at the end of
the year if he were not operating this shop
and instead pursued his next best
alternative?
 Implicit costs:
– opportunity cost of his time = €24,000
– foregone interest on investment = €2,000
– economic depreciation (annualized) = €2,000
Economic Profits
Economic profits = Total Revenue – total
explicit costs – total implicit costs
€80k - €55k - €28k = - €3,000
Nikos is doing €3,000 worse than his next
best alternative!!
He would be better off working as a
mechanic, earning interest on his
investments, and not putting money into
carpet and a computer that wear out.
What would you pay for this business if Jan
wants to retire and sell it?
 If you currently work as a mechanic earning
€24,000 per year? [answer: nothing—you’re
better off staying in your current job!]
 If you are a high school dropout earning
€18,000 per year working at KFC selling
chicken?
 Hint: calculate the economic profits you
would earn if you quit JJ’s and bought Jan
out.
 What would you pay for a government bond
that pays €3,000 per year in perpetuity?
Opportunity Costs
Whenever we talk about costs in this class
we will talk about the cost including the
opportunity cost.
This includes the cost of labor.
– what the workers could earn working
somewhere else.
As well as the cost of capital.
– The return the capital could earn invested
somewhere else.
34
Sunk Cost
Another type of economic cost is Sunk
Cost.
Sunk Cost
–
–
Expenditure that has been made and cannot
be recovered.
Should not influence a firm’s decisions.
35
Sunk Cost—An Example
Consider the recent decision of UK to sell
a pharmaceutical lab for $30M
UK invested $47M to set up the lab;
should this matter?
No. That money is sunk and UK has no
way of recovering it. Only consider the
revenue that is generate from selling the
lab vs. the revenue from continuing to
operate the lab
36
Sunk Cost—An Example
Need to consider the potential return on
investment and riskiness of the venture
prior to making the original investments
when costs aren’t sunk.
37
Measuring Costs: Which Costs Matter?
Next, consider fixed costs and variable
costs.
Total output is a function of variable inputs
and fixed inputs.
Therefore, the total cost of production
equals the fixed cost (the cost of the fixed
inputs) plus the variable cost (the cost of
the variable inputs), or…
TC = FC + VC
38
Measuring Costs: Which Costs Matter?
Fixed Cost (FC)
– Does not vary with the level of output
Variable Cost (VC)
– Cost that varies as output varies
39
Measuring Costs: Which Costs Matter?
It is important to understand the distinction
between fixed costs and sunk costs.
Fixed Cost
– Cost paid by a firm that is in business
regardless of the level of output. Short run
concept
Sunk Cost
– Cost that has been incurred and cannot be
recovered
40
Fixed Costs
Examples of Fixed Costs Include:
– Rent—A dentist must pay the rent on his
office regardless of the number of patients
she sees
– Insurance
– Licenses fee—Dentist must also pay a yearly
fee for her license which does not vary with
the number of patients
– Interest on debt
41
Variable Costs
Costs that vary with the amount of output
you produce include:
– Wages
– Electricity
– Fuel
In general, anything we need more of to
produce more output
42
Costs in the Short Run
Marginal Cost (MC) is the cost of
expanding output by one unit. Since fixed
cost has no impact on marginal cost, it can
be written as:
∆VC ∆TC
MC =
=
∆Q
∆Q
43
Costs in the Short Run
Average Total Cost (ATC) is the cost per
unit of output, or average fixed cost (AFC)
plus average variable cost (AVC). This
can be written as:
TFC TVC
ATC =
+
Q
Q
44
Cost Curves for a Firm
Total cost
is the vertical
sum of FC
and VC.
Cost 400
(€ per
year)
TC
VC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.
300
200
Fixed cost does not
vary with output
100
FC
50
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Output
45
Cost Curves for a Firm
Cost
(€ per
unit)
100
MC
75
50
ATC
AVC
25
AFC
0
1
2
3
4
5
6
7
8
9
10
11
Output (units/yr.)
46
Important concepts RE short-run cost
curves
 Shape of AFC curve: “spreading one’s overhead”
 Shape of AVC curve: can you see the law of eventually
diminishing marginal returns at work?
 Shape of the MC curve: can you see the output at which
diminishing returns set in?
 Shape of the Short-run ATC curve: Always U-shaped!!
Why?
 SRATC = SRAFC + SRAVC [shape of AFC + shape of
AVC => shape of ATC]
 What is the designed operating capacity of the plant in
the previous diagram? What would happen if you built a
different plant size?
Relationship between short-run costs
and productivity
So we have:
w
MC =
MPL
… and a low marginal product (MP) leads
to a high marginal cost (MC) and vice
versa
48
Relationship between short-run costs
and productivity
 Using similar logic we can derive the following
relationship:
w
AVC =
APL
 These equations imply that MC is at a minimum
when MPL is at a maximum and AVC is at a
minimum when APL is at a maximum.
49
Costs in the Long Run
Consider costs in the long run where we
can vary all of our inputs.
– No fixed costs
How does a firm select the inputs needed
to produce a given level of output at a
minimum cost?
– Assume firms want to produce in a way that
minimizes costs.
50
Costs in the Long Run
Assume a firm uses two inputs into
production, capital (K) and labor (L).
Price of labor is w, the wage rate.
Price of capital is r, the user cost of capital
per dollar of capital.
51
Cost Minimizing Input Choice
Define the Isocost line:
–
C = wL + rK
–
Isocost: A line showing all combinations of L
& K that can be purchased for the same cost
52
The Isocost Line
Capital
per year
C/r
Slope=-(w/r)
C/w
Labor per year
53
Cost Minimizing Input Choice
In order to choose the cost minimizing
input choice we combined the isocost line
with the isoquant.
54
Producing a Given Output at Minimum
Cost
Capital
per
year
Q1 is an isoquant
for output Q1.
Isocost curve C0 shows
all combinations of K and L
that cost C0.
K2
Isocost C2 shows quantity
Q1 can be produced with
combination K2L2 or K3L3.
However, both of these
are higher cost combinations
than K1L1.
CO C1 C2 are
three
isocost lines
A
K1
Q1
K3
C0
L2
L1
C1
L3
C2
Labor per year
55
Costs in the Long Run
Relationship between Isoquants and
Isocosts and the Production Function
MPL
∆
K
−
=
−
MRTS =
∆L
MPK
Slope of isocost line =
− ∆K
=
−w
∆L
r
MPL
MPK
=w
r
56
Costs in the Long Run
The minimum cost combination can then
be written as:
MPL
w
= MPK
r
MPL gives us the additional output we get
from hiring one more unit of labor.
 w tells us the cost of hiring one more unit
of labor

57
Costs in the Long Run
MPL/w tells us how much additional output
we get from spending one more dollar on
labor.
MPK/r tells us how much additional output
we get from spending one more dollar on
capital.
By setting them equal this says that at the
cost minimizing point I get the same
increase in output from a dollar spent on
either capital or labor.
58
Input Substitution When an Input
Price Changes
Consider what happens when we change
prices.
w is now higher so the isocost curve is
steeper.
Assume we want to keep producing same
level of output.
59
Input Substitution When an Input
Price Changes
Capital
per
year
If the price of labor
changes, the isocost curve
becomes steeper due to
the change in the slope -(w/r).
This yields a new combination
of K and L to produce Q1.
Combination B is used in place
of combination A.
The new combination represents
the higher cost of labor relative
to capital and therefore capital
is substituted for labor.
B
K2
A
K1
Q1
C2
L2
L1
C1
Labor per year
60
Long-Run Cost Curves
 Long-Run total costs (LTC) shows how costs
change with output when we vary all inputs
 Long-Run Average Cost (LAC) is given by:
LTC
LAC =
Q
 Long-Run Marginal Cost is given by:
∆LTC
LMC =
∆Q
61
Long-Run Cost Curves
The shape of these curves depends on
whether the production function exhibits
increasing, constant, or decreasing returns
to scale.
62
Long-Run Average Cost (LAC)

Constant Returns to Scale
– If input is doubled, output will double and
average cost is constant at all levels of output.
– LAC curve will be a flat line.

Increasing Returns to Scale
– If input is doubled, output will more than
double and average cost decreases at all
levels of output.
– LAC curve is downward sloping.
63
Long-Run Average Cost (LAC)

Decreasing Returns to Scale
– If input is doubled, the increase in output is
less than twice as large and average cost
increases with output.
– LAC curve is upward sloping.
64
Long-Run Average Cost (LAC)

In the long-run, firms initially experience
increasing returns to scale at low output
and then decreasing returns to scale at
higher output and therefore long-run
average cost is “U” shaped
–
Evidence suggests that it may “L” be shaped
65
Long-Run Average Cost and Long-Run
Marginal Cost
Cost
($ per unit
of output
LMC
LAC
Minimum efficient size
is the firm size where
long-run average cost
is at a minimum
A
At Q* firm is operating
at the minimum
efficient size
Quantity of Output
Q*
66
Choosing a plant size: Long-run average costs
and the firm’s planning curve
 Now let’s get serious about opening up a fast-food
restaurant in Monastiraki. You find a location and
choose a franchise chain. You set up a meeting with
company representatives, at which they open a
briefcase and pull out some spreadsheets and
blueprints which contain the following information:
 [see next slide]
 Then they ask you: How many customers do you
envision yourself wanting to serve each day?
 Answer #1: Duh?
 Answer #2: Well, I’ve done some demand forecasting
and I envision serving roughly X meals per day.
Long-Run costs with economies and
diseconomies of scale
Cost
(€ per unit
of output
SATC1
SATC2
SATC3
A
B
C
400
800
1000
Output
The LRAC curve and economies of
scale
 Given sufficient time to plan and execute, firms can
vary all inputs optimally for whatever scale of
operation they desire.
 So in reality, firms can choose from many different
plant sizes. The LRAC curve is the envelope of all the
SRATC curves associated with each different plant
size.
 The LRAC curve tells us the minimum possible
average total cost for producing each output level.
 The shape of the LRAC curve tells us how per unit
costs change as the firm changes the scale of its
operations.
Long-Run costs with economies and
diseconomies of scale
Cost
(€ per unit
of output
SATC1
SATC2
SATC3
A
LRAC
B
C
400
800
1000
Output
Economies and diseconomies of scale
 If per unit costs fall as the firm increases the scale of its
operations, the LRAC curve will be downward sloping.
We say that the firm experiences economies of scale.
 If per unit costs do not change as the firm increases the
scale of its operations, the LRAC curve will be flat. We
say that the firm experiences constant returns to scale.
 If per unit costs rise as the firm increases the scale of its
operations, the LRAC curve will be upward sloping. We
say that the firm experiences diseconomies of scale.
Returns to Scale
Important to note that decreasing returns
to scale is not the same as the law of
diminishing returns.
– The law of diminishing returns is a short-run
concept and tells us that marginal output will
fall as we add more of one input holding the
other input fixed.
– Decreasing returns to scale is a long-run
concept and says that output goes up by less
than twice as much when we double all
inputs.
72
Minimum Efficient Scale
Economies of
scale or
increasing
returns to scale
Constant
returns to scale
Diseconomies
of scale or
decerasing
returns to scale
Q’ = minimum efficient scale
73
Minimum Efficient Scale (MES)
 How big does the firm have to be in order to produce
the product as cheaply as possible?
 We call the scale of operations (Q) at which the LRAC
curve reaches its minimum level of cost the Minimum
Efficient Scale, or MES.
 Firms operating at a smaller scale could lower their
per unit costs by increasing their scale. Firms
operating at a sub-optimal scale will be at a
competitive disadvantage relative to firms that have
attained MES.
 MES, market demand, and the number of firms in a
competitive market? How many fast-food restaurants
are there in Athens? In Kalamata? Why?
Summary
A production function describes the
maximum output a firm can produce for
each specified combination of inputs.
An isoquant is a curve that shows all
combinations of inputs that yield a given
level of output.
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Summary
Average product of labor measures the
productivity of the average worker,
whereas marginal product of labor
measures the productivity of the last
worker added.
The law of diminishing returns explains
that the marginal product of an input
eventually diminishes as its quantity is
increased.
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Summary
Managers must take into account the
opportunity cost associated with the use of
the firm’s resources.
Firms are faced with both fixed and
variable costs in the short-run.
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Summary
When there is a single variable input, as in
the short run, the presence of diminishing
returns determines the shape of the cost
curves.
In the long run, all inputs to the production
process are variable.
A firm enjoys economies of scale when it
can double its output at less than twice the
cost.
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Summary
In long-run analysis, we focus on the firm’s
choice of its scale or size of operation.
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