The Costs of Production

• Chapter 13: The Costs of Production
  • 13-1: What Are Costs?
  • 13-2: Production and Costs
  • 13-3: The Various Measures of Cost
  • 13-4: Costs in the Short Run and in the Long Run

Chapter 13: The Costs of Production

13-1: What Are Costs?

Consider a cookie factory. It must buy ingredients for the cookies, machines to make them, and workers to run the machines. Then, she sells the cookies to customers.

Total revenue, Total Cost, and Profit

• Must make the assumption that the goal of a firm is to make profit
• Total Revenue: The amount that the firm receives for the sale of its output (cookies)
• Total Cost: The amount that the firm pays as input (ingredients, machinery, workers)
• Profit: A firm’s total revenue minus its total cost
• The objective is to make the profit as high as possible

Costs as Opportunity Costs

• When considering a firm’s cost of production, the opportunity cost must also come into play
• Explicit Cost: Any cost that requires a firm to pay out some amount of money
• Implicit Cost: Any cost that can’t/isn’t represented by a monetary price
  • If the factory owner can make $100/hr programming, then each hour she spends working on the factory is “losing” $100
• Economists will take into account both the implicit and explicit costs while an accountant will only focus on the explicit cost
  • If programming becomes more profitable than running a factory, than the owner might switch professions; the accountant would fail to recognize this change because the factory is still make a profit on paper

The Cost of Capital as an Opportunity Cost

• An implicit cost that most businesses incur is the opportunity cost of the capital used to finance the business
  • If the factory cost $300k to buy, then that’s $300k that isn’t accruing interest or being put into the stock market
• The accountant will fail to account for this implicit cost because there is no money flowing out of the business, but if it was framed as an interest from a loan that you must pay off, then they would

Economic Profit versus Accounting Profit

• Economic Profit = Total Revenue - All Opportunity Costs (implicit or explicit)
• Accounting Profit = Total Revenue - All Explicit Costs
• Accounting profit is typically larger than economic profit because of the failure to acknowledge implicit costs, but economic profit is more important for firms because it covers all costs

13-2: Production and Costs

Assume that the cookie factory cannot change its size but it can change the number of workers it employs (indicative of the short term rather than the long term)

The Production Function

• Consider the following table:
  • The relationship between quantity of input and quantity of output is called the production function
• Marginal product: The change in the quantity of output from one additional unit of input
  • As seen in the table, the more workers you have, the less the marginal product becomes
  • This phenomenon is known as diminishing marginal product
• Graphical examples:

From the Production Function to the Total-Cost Curve

• Columns 4, 5, and 6 in the above table all show the cost of producing cookies
• The most important relationship in the table is the one between the quantity produced (column 2) and the total cost (column 6)
  • Shown in the above total-cost curve
• The production function and total-cost curve have relatively inverse relationships; production function gets flatter at higher quantities while total-cost gets steeper

13-3: The Various Measures of Cost

Consider a coffee shop with the following data:

Fixed and Variable Costs

• The total cost can be divided into two types
  • Fixed costs do not change with the quantity of output produced; includes rent, building costs, etc.
  • Variable costs do change with the quantity of output produced; includes ingredients, workers, etc.
• The total cost is the sum of these two costs

Average and Marginal Cost

• When considering costs, two questions may be asked
  • 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?
• The cost of a typical unit can be found by dividing the total cost by the quantity of output it produces; known as average total cost (ATC)
  • Can also find the average fixed cost (AFC) and the average variable cost (AVC) by dividing the fixed or variable cost by the quantity of output, respectively
• Average costs are indicative of the cost of a typical unit, but it does not signify by how much the cost will change as the production changes
  • The marginal cost (MC) shows the change in cost when adding 1 unit of output; shown in column 8
• Equations to represent the two costs:

Lecture Notes

• In the short term, the total cost is equal to the hourly wage * labor, as the only thing you can do is add more workers
• AVC = (Wages * Labor) / Quantity = Wages / (Quantity / Labor) = Wages / Average Product of Labor (AP_L)
  • AVC and AP_L are inverse
• MC = Wages * deltaLabor / deltaQuantity = Wages / (deltaQuantity / deltaLabor) = Wages / Marginal Product
  • Marginal Cost and Marginal Product are inverse

Cost Curves and Their Shapes

• The graphs of ATC, AFC, AVC, and MC all follow different shapes:
• Rising Marginal Cost
  • The marginal cost rises as the quantity of output increases due to the property of diminishing marginal product; the more he produces, the more it costs to make 1 more unit
• U-Shaped Average Total Cost
  • The ATC is the sum of the AFC and AVC
  • At low quantities, it costs a lot to make a few cups of coffee, as the AFC is very high due to being spread out over a few units
  • The ATC will decrease until adding more units does not lower the AFC, in which case the AVC takes over and begins increasing the ATC
  • The bottom of the U-Shape that minimizes the ATC is called the efficient scale of the firm; balanced to yield the lowest average total cost
• The Relationship between Marginal Cost and Average Total Cost
  • Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising.
  • This makes sense because, if a marginal cost is higher than the ATC, then it will increase the ATC, while if it is lower than the ATC, then it will decrease the ATC
  • Due to this relationship, the marginal-cost curve crosses the average-total-cost curve at its minimum.
    • The ATC cannot lower any further at this point and must increase

Typical Cost Curves

• This simplified situation showed the property of diminishing marginal product and rising marginal cost, but in real life, this might not always apply
• The following graph best represents the cost curves for a typical firm:
• Despite the differences, there are three properties that are important to remember:
  • Marginal cost eventually rises with the quantity of output
  • The average total cost curve is U-shaped
  • The intersection of the marginal cost and average total cost curves represents the minimum average total cost

13-4: Costs in the Short Run and in the Long Run

The Relationship between Short-Run and Long-Run Average Total Cost

• In the short term, a factory owner cannot immediately create a new factory or new facility to increase production
  • Factories are a fixed cost in the short term but a variable cost in the long term
• In the long run, a company can afford to hire more workers and factories to reduce the average total cost back down
• Graph:

Economies and Diseconomies of Scale

• When the average total cost continues to go down as the output increases, then there is an economy of scale
• When the average total cost continues to go up as the output increases, then there is an diseconomy of scale
• When the average total cost remains constant as output increases, then there are constant returns to scale
• Can be explained by specialization
  • When there are few workers and factories, then the average total cost is high
  • As you add more workers and factories, the cost goes down further because production becomes more efficient
  • If you add too many workers, then the gains of specialization have already been realized, and you have to hire less efficient workers