ECONOMICS

HSS 301

Part A (Microeconomics) Discussion -4

The Costs of Production
Resources
• Fixed Resources: Can’t be
changed as we produce more. At
Two Types of least not in the short run.
Example: pizza oven, sewing changed with increasing
machine, warehouse production
Example: number of workers,
ingredients
• Variable Resources: Can be
Short Run vs. Long Run

It’s not a set amount of time. It’s an idea.

• A company is in the short run when they have at least one

fixed resource
• In Long run, all resources are variable. Long run represents
what could potentially happen in the future.

• In short run: �� =
The ��(��)
Production Function • In Long run: �� = ��(��,
• It is the relationship between ��)
the quantity of inputs used to
make a good and the quantity
of output of that good. Marginal Product
 • The increase in output that input in the production process
arises from an additional unit of is the change in the quantity of
input output obtained from one
additional unit of that input.
• The marginal product of any
(Quantity of a Marginal
Input (No. of
good Product of
Workers)
produced per
Output/Total hour) Labor
Product
0 0 0 1 50 50 2 110 60 3 150 40 4Output/Total Product is increasing at
175 25 5 185 10 6 185 0 an
7 178 -7 8 168 -10 increasing rate
 Output/Total Product is increasing at Output/Total Product is decreasing
a decreasing rate
Diminishing Marginal Product

• The property whereby the marginal product of an input declines as

the quantity of the input increases

• At first, when only a few workers are hired, they have easy access to
equipment. As the number of workers increases, additional workers
must share equipment and work in more crowded conditions.
Eventually, it becomes so overcrowded that workers often get in
each other’s way. Hence, as more workers are hired, each extra
worker contributes fewer additional output to total production.
Trend in Production

•In short run, production increases at first due to

specialization. But specialization has its limits.

• As you continue to add variable resources to fixed

resources the additional output will eventually decrease. –
 Law of Diminishing Marginal Returns
200

Output/Total Product
180

160

80

60
Production Curve 40
Production
140 20

0
0 2 4 6 8 10
function
120

100
Number of Workers
 20
MPL
10

Marginal 0
0 2 4 6 8 10 -10

Product of -20

Labor
70

60

50

40

30
Number of Workers
 Labor

TP, MP
200 150 100 50 TP MP

Production
Function & 0

-50

Marginal
Product 0 1 2 3 4 5 6 7 8 Quantity of

Production Function & Total Cost

 hour) Cost of Worker
Cost of Factory
(Fixed)
(Variable) Total Cost
Workers Output (per
0 0 30 0 30 1 50 30 10 40 2 110 30 20 50 3 150 30 30 60 4
175 30 40 70 5 185 30 50 80 6 185 30 60 90
70
Total Cost
60

Total cost 50
40
Curve 30
100
20
90
10
80
0

What is Profit?
• Economists normally assume
that the goal of a firm is to
maximize profit, and they find
that this assumption works well
in most cases.

• Profit = Total revenue – Total

0 50 100 150 200 Quantity of Output
cost
Total Revenue Total Cost
• The amount that the firm Amount that the firm pays to buy
receives for the sale of its output inputs that are used in production

• It equals the quantity of output

the firm produces multiplied by Measurement of a firm’s total
the price at which it sells its cost, however, is more subtle.
output. (TR= P*Q)
Costs as Opportunity Costs
• Important to keep in mind one of the Ten Principles:
“The cost of something is what you give up to get
it.”

• Remember? Opportunity cost of an item refers to all the things that

must be forgone to acquire that item.

• When economists speak of a firm’s cost of production, they include

all the opportunity costs of making its output.
 Costs as Opportunity Costs

• Explicit costs: input costs that require an amount of money spent by

the firm.
• Example: paying workers, buying raw materials, paying bills

• Implicit costs: input costs that do not require an amount of money

spent by the firm.
• Example: forgone earning of the owner from an alternative job, forgone
earning of a return from investing financial capital.
Economic Profit vs. Accounting Profit
• Accounting Profit = Total Revenue – Total Explicit Cost

• Economic Profit = Total Revenue – Total Opportunity (Explicit

+ Implicit) Cost

• Usually, Accounting Profit > Economic Profit

 quantity of output
produced. They are rent of outlets, electric
incurred even if the firm bills etc.
produces nothing at all
The Various
Measures of
• Variable costs: costs wages of
Cost that vary with the workers,
• Fixed costs: costs that payments of raw
quantity of output
do not vary with the materials & tools.
produced
The Various Measures of Cost
• Total Cost (in Short Run)*: Sum of variable cost & fixed cost
TC =VC+FC
• Average total cost: total cost divided by the quantity of
output ATC = TC/Q
• Average fixed cost: fixed cost divided by the quantity of
output AFC = FC/Q
• Average variable cost: variable cost divided by the quantity of
output AVC = VC/Q
The Various Measures of Cost
• Marginal cost: the increase in total cost that arises from an
extra unit of production

Marginal cost = Change in total cost/Change in quantity

MC = ∆����/∆��
��
MC = ���� (����)
Various Measures of
Production Cost with
 another Hypothetical
Example
Output VC FC TC AVC AFC ATC MC 0 0 10 10

1 10 10 20 10 10 20 10 2 17 10 27 8.5 5 13.5 7 3 25 10 35 8.33 3.33

11.67 8 4 40 10 50 10 2.5 12.5 15 5 60 10 70 12 2 14 20 6 110 10 120
18.33 1.67 20 50

Cost Curves Shapes

and Their 80
Costs
70
 60
50
40
TC
30 FC
20
10 VC
0
0 1 2 3 4 5 Quantity
VC FC TC

and Their 18
16

Shapes 14
12
Costs
10
Cost Curves 20 8
 6
4
2 AFC
0 MC

ATC AVC

0 1 2 3 4 5 Quantity
AVC AFC ATC MC

Rising Marginal Cost

• MC rises with higher quantity of output. This Upward slope reflects the
 property of diminishing marginal product.
• When small quantity of output is produced, owner hires few workers & much
of the equipment isn’t used. Since he can easily put these idle resource to use,
marginal product of an extra worker is large and marginal cost of producing
an extra unit of that good is small.
• When large quantity of output is produced, the place is crowded with workers
& most of the equipment is fully utilized. Therefore, marginal product of an
extra worker is low and marginal cost of producing an extra unit is high.
U-shaped Average Total Cost

• We already know, ATC = AFC+AVC

• AFC always declines as output rises.
• AVC usually rises as output rises because of diminishing marginal product.

• At very low levels of output, ATC is very high. Because of high AFC •
With higher quantity of output, AFC declines sharply at first which leads to
decreasing ATC.
• Rise of AVC becomes a dominant force afterwards. Thus, ATC starts to increase
again.
Relationship between MC & ATC

• When MC<ATC, ATC is falling.

 • When MC>ATC, ATC is rising

• This leads to an important feature:

“MC curve crosses the ATC curve at its minimum”

N.B. In our graph a few slides ago…MC didn’t cross ATC exactly at its minimum. This was
because of our hypothetical data. You may try yourself and draw with better accuracy.

Important to
3 Properties Most Remember
❖Marginal cost eventually rises
with the quantity of output
❖Marginal cost curve crosses the
❖Average total cost curve is average total cost curve at the
U-shaped minimum of averagetotal cost.
Cost Equations

��
Product A: ���� = �� + ������ +
������
�� ��
Product B: ���� = �� − ���� +
�������� + ������
i. From the cost functions given above find out the functions for
VC,FC,AVC,AFC,ATC & MC for the respective products. ii. At
which production quantity average total cost will be minimum &
how much will that minimum average cost be?
Relationship between Short Run & Long Run ATC

•The long run ATC has a much flatter U-shape. • All

the short run ATC curves lies on or above the long run
ATC curve
 •These properties arise because firms have greater
flexibility in the long run.
& IRS & DRS
Returns to Scale

It shows what happens to production in the long run

• Increasing returns to scale – if inputs are doubled, output becomes

more than double
 • Constant returns to scale – if inputs are doubled, output doubles •
Decreasing returns to scale – if inputs are doubled, output becomes
less than double
While Returns to Scale (RTS) shows what happens
to the scale of production in the long run;
Economies & Diseconomies of Scale shows what
happens to cost in the long run.
Economies of Scale
• It occurs when long run ATC falls as the quantity of output
increases. (Getting bigger is cheaper then)
• Due to specialization among workers, average labor cost of
producing each unit of that good falls.
• Firms can use highly productive machinery which can bring
down average cost of producing each unit.
• Firms can adapt different cost saving measures when it goes
to large scale production.
In the long run, ATC will not always be falling with
increasing quantity of output. After reaching a certain
 minimum level, average cost will stay the same as output
rises. The firm will face constant returns to scale in
production in this phase.
Diseconomies of Scale

• It occurs when long run ATC rises as the quantity of output rises.
(Getting even bigger is now expensive)
• Firms incur diseconomies of scale because of coordination
problems that often occur in a large organization
• When companies become too big, they then need to hire
 managers, buy land. At that phase increasing output is causes
the long run ATC to rise.
Important to Remember
• Concepts like economies of scale help producers to make
decisions. They don’t tell producers exactly how much to
produce.

• One might be thinking firms should produce at the lowest

level of long run average cost. But the amount that firms
should produce doesn’t depend only on cost but also on the
consumer’s demand. Firms aim to maximize profit.
Maximizing profit doesn’t only depend on minimizing
cost.

Thank You