Chapter 6: Costs of

Production
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 Learning Objectives

1. Define and explain the differences

between accounting profit and economic
profit.
2. Understand the law of diminishing returns.
3. Discuss the various production costs that
firms face.
4. Determine a firm’s profit maximizing
decision in the short run.
5. Describe a firm’s shutdown decision.
6. Understand production and costs in the
long run.
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 Profits

n Any firm has one main goal: maximize its

profit
§ What does exactly profit mean?

n We distinguish 3 types of profits

§ Accounting profit

§ Economic profit or excess profit

§ Normal profit

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 Accounting Profit

n Most common profit idea

Accounting profit = total revenue – explicit
costs

Ø Explicit
costs are payments firms make to
purchase
§ Resources (labor, land, etc.) and
§ Products from other firms

n Easy to compute

n Easy to compare across firms

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 Economic Profit

n Economic profit is the difference between a firm's

total revenue and the sum of its explicit and implicit
costs
Ø Economic profit = total revenue – explicit costs –
implicit costs
Ø Economic profit = accounting profit – implicit costs

n Implicit costs are the opportunity cost of the

resources supplied by the firm's owners
Ø Difficult to measure

n Normal profit occurs when economic profits are

equal to zero.

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Accounting and Economic Profit: Example

n Assume firm
Ø Total revenue = $400,000
Ø Explicit costs = workers’ salaries = $250,000
§ Accounting profit = $400,000 - $250,000 =
$150,000
Ø Firm’s
implicit costs = $100,000
Ø Economic profit = $150,000 - $100,000

§ Economic profit < Accounting profit

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Accounting Profit vs. Economic Profit

Explicit Explicit
costs costs
Total
revenue

Accounting
profit

Implicit costs = Economic

opportunity cost of profit
resources supplied
by owners of firm
(a) (b) (c)

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 Economic Profits Guide Decisions

n Kamal is a corn farmer living in Turkey

Ø Kamal’s decision: keep farming or quit?
§ Quit farming and earn $11,000 per year working retail
§ Explicit farm costs are $10,000 (including $6,000 as rent)
§ Total revenue is $22,000

Ø Kamal should stick with farming because EP > 0

§ If revenue fell below $21,000, Kamal should quit

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 Owned Inputs

n What if Kamal inherits the land?

Ø Rent for the farm land is $6,000 of the $10,000 in
explicit costs
§ His rent payments become an implicit cost

n Kamal should abandon farming because EP <

0

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 Production Ideas

n Production converts inputs into outputs

Ø Many different ways to produce the same product
Ø Technology is a recipe for production
n A factor of production is an input used in the
production of a good or a service
Ø Examples are land, labor, capital, and
entrepreneurship

n The short run is the period of time when at least

one of the firm's factors of production is fixed
n The long run is the period of time in which all
inputs are variable
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 Production: Short and Long Run

n Every firm faces the following question: how

much to produce?
Ø Assume a firm that makes Fanoos Ramadan
Lanterns
§ Uses labor (employees) + capital (machine)
• Assume for now only 2 factors of production

Ø Short Run: machine (capital) is assumed to be

fixed and employee (labor) variable
Ø Long Run: both inputs, machine and labor, are
variable

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Production: Short and Long Run

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 Production: Short and Long Run

n Previous table reflects the output –

employment relationship
Ø Add a unit of employment (labor) output grows
Ø Beyond some point the additional output that results
from each additional unit of labor begins to diminish
§ Can be better seen through Marginal Product of Labor
(MP) as a measure of the contribution of additional labor
input to total output

Q Change in output
MP = =
L Change in labor input
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 Production: Short and Long Run

n Marginal Product of Labor

Ø 1 unit of labor to 2 units of labor à MP increases
à increasing returns
Ø 2 units of labor to 3 units of labor à MP decreases
à decreasing returns à law of diminishing
returns

The Law of Diminishing Returns

With all inputs except one fixed,
additional units of the variable input yield
ever smaller amounts of additional output
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Total and Marginal Product

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 Cost Concepts

n A fixed factor of production is an input whose quantity

cannot be changed in the short run
Ø Fixed cost (FC) is the sum of all payments for fixed inputs

n A variable factor of production is an input whose

quantity can be changed in the short run
Ø Variable cost (VC) is the sum of all payments for variable
inputs

n Total cost (TC) is the sum of all payments for inputs

TC = FC + VC

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 Fixed, Variable, and Total Costs of
Lantern Production

Fixed Variable Total Marginal

Lanterns
Workers Costs ($/ Cost ($/ Cost ($/ Cost ($/
per Day
day) day) day) lantern)
0 0 $40 $0 $40
$0.15
1 80 40 12 52
0.10
2 200 40 24 64
0.20
3 260 40 36 76
0.30
4 300 40 48 88
0.40
5 330 40 60 100
0.60
6 350 40 72 112
1.00
7 362 40 84 124

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 Total Cost Curves

140
TC
120

100
Total cost ($/day)

VC
80

60

40 FC

20

0
0 50 100 150 200 250 300 350 400
Total output
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 Marginal Cost

n Marginal cost (MC) is the change in

total cost divided by the change in
output TC Change in total cost
MC = =
Q Change in output

n MC also represents the slope of the

total cost curve
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 Marginal Cost

Total cost curve

140
120
100
Total cost
80
60
40
20
0
0 50 100 150 200 250 300 350 400
Total output

Marginal cost curve

1.2

1
Marginal cost

0.8

0.6
Diminishing returns
0.4 Increasing
returns
0.2

0
0 80 160 240 320 400
Output

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 The Relationship between MP and MC

n MP and MC reflect each other

Ø When MP increases, MC decreases
Ø When MP decreases, MC increases

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 Choosing Output to Maximize Profit

Profit = Total revenue – Total cost = TR – TC

n Total cost = Fixed cost + Variable cost

n Profit = Total revenue – Variable cost – Fixed cost

n The firm must know about both revenues and costs

in order to maximize profits
Ø Increase output if marginal benefit is greater than
marginal cost
Ø Decrease output if marginal benefit is less than
marginal cost

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 Choosing Output to Maximize Profit

n Note here that P = MB = MR = marginal revenue

Ø Marginal revenue = change in total revenue resulting
from a change in output

TR Change in total revenue

MR = =
Q Change in output
n Cost – benefit principles therefore says that if MB =
MR > MC then produce that unit

n Here MR = P = constant = $0.35

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Output, Revenue, Costs and Profit

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 Profit Maximization

Profit maximization
140
TR
120
100
80 TC
60
$/day

40
Profit
20
0
–20 0 50 100 150 200 250 300 350 400
–40
–60
Lanterns/day

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 Choosing Output to Maximize Profit

n What is the output that maximizes profit?

Ø Cost– benefit principles says to produce as
long as MB > MC
§ If price is $0.35 per lantern (MB = $0.35) then
produce 300 (following previous table)
• Is that the profit maximizing output?

Ø Let us calculate the total profits

§ Largest profit = $17 at output of 300 lanterns per day

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 Profit Maximization

n From the previous figure

Ø Profits are maximized at output = 300
lanterns
Ø Profit maximization reflected in:
§ The highest point of the profit curve
§ The largest difference between TR and TC
curves
§ The slope of the profit function is equal to zero

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 Profit Maximization

Change in profit ⇧
= =0
Change in output Q
(T R T C)
=0
Q
TR TC
=0
Q Q
MR = MC
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 Profit Maximization

n From the previous figure

Ø MR = MC à profit is maximized
Ø Slope of TR = slope of TC
Ø TR and TC are parallel

n What if the fixed cost was $45 instead

of $40?
Ø Will
the new fixed cost affect the level of
output to maximize profits?
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 Fixed Costs and Profit Maximization

n Fixed costs have no role in choosing the

profit-maximizing level of output
§ Marginal benefit is the price of the product
§ Fixed costs do not affect marginal costs
n To summarize:
Ø When the Law of Diminishing Returns applies
à when a fixed input exists,
§ Increase output if marginal cost is less than price
§ Decrease output if marginal cost is more than price
• However, some exceptions exist

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 Shut-Down Decision

n Firms can make losses in the short run

Ø Some firms continue to operate
Ø Some firms shut down
§ What determines the decision to stay in the market
or shut-down?
n The Cost – Benefit Principle applies even
to losses
Ø Continue to operate if your losses are less
than if you shut down
Ø Shut down if your losses are more than if you
continued operating
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 Shut-Down Condition

n If the firm shuts down in the short run, it loses

all of its fixed costs
Ø So, fixed costs are the most a firm can lose
n The firm should shut down if revenue is less
than variable cost: P x Q < VC for all levels of
Q
Ø The firm is losing money on every unit it makes
n If the firm's revenue is at least as big as
variable cost, the firm should continue to
produce
Ø Each unit pays its variable costs and contributes to
fixed costs
§ Losses will be less than fixed costs

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 AVC and ATC

n Shut-down if
P x Q < VC
P < VC / Q
P < AVC
n Average values are the total divided by
quantity
Ø Average variable cost (AVC) is
AVC = VC / Q
Ø Average total cost (ATC) is
ATC = TC / Q
§ Shut down if price is less than average variable cost

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 AVC and ATC

0.65
0.60 MC
0.55
Cost ($/lantern)

0.50
0.45
0.40
0.35 ATC
0.30
0.25 AVC
0.20
0.15
0.10
0.05
0 80 200
260 300 362
330 350
Output (lanterns/day)
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 AVC and ATC

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 Profitable Firms

n A firm is profitable if its total revenue is

greater than its total cost
TR > TC OR
P x Q > ATC x Q since ATC = TC / Q
Ø Another way to state this is to divide both
sides of the inequality by Q to get
P > ATC
§ As long as the firm's price is greater than its
average total costs, the firm is profitable

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 Cost Curves

n Notice that MC must intersect both the AVC

and ATC at their respective minimum points
Ø If MC is below the AVC (or ATC) the
corresponding average cost must be falling
Ø If MC is above the AVC (or ATC) the
corresponding average cost must be increasing

n ATC curve is generally U-shaped

Ø Fixed costs dominate at low levels of output
Ø As production increases AFC decreases and AVC
increases (due to diminishing returns) eventually
causing ATC to rise
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 Production and Costs in the Long Run

n Long run = a time period of sufficient

length that all the firm’s factors of
production are variable

Ø This means for the lantern maker that it is

possible, over time, to vary not only the
number of employees but also the capacity of
the lantern-making machine or the number of
lantern-making machines

Ø Hence, all production costs are variable in the

long run

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 Production and Costs in the Long Run

1.2

1 Diseconomies
Average total cost

Economies
of scale of scale
0.8

0.6

0.4 Constant returns to scale

0.2

0
0 2 4 6 8 10 12 14 16
Output (lanterns/day)

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 Production and Costs in the Long Run

n In the long run (LR), ATC curve is U-

shaped
Ø The rationale behind this shape is that the
lantern producer can avert diminishing returns
simply by adding another lantern-making
machine and expanding his/her scale of
operations
§ In other words, increasing returns can be extended
over time by getting more output out of every
additional employee, thus resulting in a decreasing
average total cost
• This explains the decreasing portion of the LRATC à
economies of scale

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 Production and Costs in the Long Run

n As a firm expands its scale of

operations, it eventually experiences
increasing ATC, which economists
describe as diseconomies of scale
Ø This is represented by a rising portion of
the long run ATC
n The area separating the decreasing and
the rising portion of the long run ATC is
described as constant returns to scale
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 Production and Costs in the Long Run

n Economies of scale: When all inputs are

changed by a given proportion, output changes by
more than that proportion
Ø Examples: division of labor, specialization, mass
production, and increased capital efficiency.

n Constant returns to scale: When all inputs are

changed by a given proportion, output changes by
the same proportion

n Diseconomies of scale: When all inputs are

changed by a given proportion, output changes by
less than that proportion
Ø Example: too many management layers
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