Microeconomics – The Costs of Production

TOTAL REVENUE, TOTAL COST & PROFIT

Total revenue is a firm’s return from sale of output. Total cost is the amount paid for inputs used to make outputs. Profits are total revenue minus total cost, TR – TC. The economic goal of a firm is to maximise profit.

COSTS AS OPPORTUNITY COSTS

Production costs equal all opportunity costs. It includes explicit and implicit costs. Explicit costs are input costs that require money outlay. Implicit costs are input costs that don’t require money outlay.

ECONOMIC & ACCOUNTING PROFIT

Economists measure a firm’s economic profit as total revenue minus total cost, including both explicit and implicit costs. Economic profit is smaller than accounting profit. Accountants measure the accounting profit as the firm’s total revenue minus only the firm’s explicit costs. Land has an implicit cost – it can grow trees or grass for cows. Firms were making accounting profit, but not economic.Implicit costs matter because they change behaviour.

THE PRODUCTION FUNCTION

The production function shows relationship between quantity of inputs and quantity of output. Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.Example: each additional worker adds fewer and fewer products to the total. The slope of the production function measures the marginal product of an input, such as a worker. When the marginal product declines, the production function becomes flatter. Production function, an increase in inputs change in output, increase in costs, total costs. Output links the production function to the firms costs.

THE VARIOUS MEASURES OF COSTS

Two types of production costs: fixed costs (do not vary with quantity of output produced) and variable costs (do vary with quantity of output produced). Total costs = total fixed costs plus total variable costs (TC = TFC + TVC). Average total cost = average fixed costs plus average variable costs and is the cost of each typical unit of a product. ATC = AFC + AVC. Average costs are determined by dividing the firm’s costs by the quantity of output it produces.

Marginal cost (MC) is the increase in total cost caused by an extra unit of production. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output? The marginal-cost curve rises with the amount of output produced. This reflects the property of diminishing marginal product. The average total-cost curve is U-shaped. High at low output levels because AFC is high. High at high output levels because AVC is high.

The relationship between marginal cost and average total cost. Whenever MC is less than ATC, ATC is falling. Whenever MC is greater than ATC, ATC is rising. The relationship between marginal cost and average total cost. The MC curve crosses the ATC curve at the efficient scale. Efficient scale is the quantity of output that minimises ATC.

TYPICAL COST CURVES

Three important properties of cost curves. Marginal cost eventually rises with the quantity of output. The average-total-cost curve is U-shaped. The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost. For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run, many costs are fixed. In the long run, fixed costs become variable costs. Because many costs are fixed in the short run but variable in the long run, a firm’s long-run cost curves differ from its short-run cost curves.

ECONOMIES OF SCALE

Economies of scale refer to the property whereby long-run average total cost falls as the quantity of output increases. The movies The Twilight Zone, Harry Potter and The Lord of the Rights all have economies of scale. Not because they were based on books, but because they were all filmed at the same time to reduce such costs. Diseconomies of scale refer to the property whereby long-run average total cost rises as the quantity of output increases. Constant returns to scale refers to the property whereby long-run average total cost stays the same as the quantity of output changes.