Chapter 13: The Costs of Production

Q1. What Are Costs?

Cost is the economic sacrifice made by a firm to produce goods or services. It refers to the value of all
resources used in production, such as labor, capital, raw materials, and time.
(a) Total Revenue (TR)
Total revenue is the total amount of money a firm receives from selling its output.
TR = P * Q

(b) Total Cost (TC)

Total cost is the sum of all costs incurred in producing output.
It includes explicit costs and implicit costs.
TC = FC + VC

(c) Profit
Profit is the difference between total revenue and total cost.
 Accounting Profit
AP = TR – Explicit and
 Economic Profit
EP = TR – ( Explicit cost+ Implicit cost)

(d) Cost as an Opportunity Cost

The cost of producing something includes the value of the next best alternative forgone.
Both explicit costs (paid in money) and implicit costs (not paid) are opportunity costs.

(e) Cost of Capital as Opportunity Cost

The cost of capital is the income the owner could have earned by investing money elsewhere, instead of using it
in the business.

(f) Economic Profit vs Accounting Profit

Accounting Profit Economic Profit
Considers only explicit costs Considers explicit + implicit costs
Used by accountants Used by economists

Quick Quiz (Farmer McDonald)

Given:
 Teaching banjo: $20 per hour
 Time spent farming: 10 hours
 Seeds cost: $100
 Crop value: $200
(a) Opportunity Cost Incurred
 Forgone teaching income:
 Seeds cost: $100
👉 Total opportunity cost = $300

(b) Cost Measured by Accountant

 Only explicit cost = $100 (seeds)

(c) Accounting Profit

200 - 100 = $100

(d) Economic Profit

200 - 300 = $100

Q2. Production and Cost

(a) Production Function
A production function shows the relationship between inputs and maximum output that can be produced.

(b) Marginal Product

Marginal product is the increase in output from using one additional unit of input.
MP = change in Total product

(c) Diminishing Marginal Product

Diminishing marginal product occurs adding more workers gives less extra output.
For example MP increases first then starts falling (from 20 to 15)

(d) Slope of Production Function

The slope of the production function represents the marginal product of the input.

Quick Quiz (Farmer Jones)

Bags of Seeds Output (Bushels)
0 0
1 3
2 5
3 6
Production Function Shape
 Output increases at a decreasing rate
 Shows diminishing marginal product

Total Cost Curve

 Cost per bag = $100
 TC rises linearly as more seeds are used
 TC curve is upward sloping

Explanation of Shapes
 Production function: gets flatter due to diminishing marginal product
 Total cost curve: gets steeper as more output requires more inputs

Q3. Various Measures of Cost

(a) Fixed Cost

Costs that do not change with output
Example: Rent
Average fix cost
fix cost per unit of output
AFC = FC / Q

(b) Variable Cost

Costs that change with output
Example: Raw materials

(c) Average Costs

 Average Total Cost (ATC)
Cost for unit of output
ATC = TC / Q
ATC = AFC + AVC
 Average Variable Cost (AVC)
Variable cost per unit of output
AVC = VC / Q

(d) Marginal Cost (MC)

Marginal cost is the increase in total cost from producing one more unit.
MC = ∆TC / ∆ Q

(e) Relationship between MC and ATC

 If MC < ATC → ATC falls
 If MC > ATC → ATC rises
 MC intersects ATC at its minimum point

Quick Quiz (Honda)

Given:
 TC of 4 cars = $225,000
 TC of 5 cars = $250,000
Average Total Cost of 5 Cars

ATC = \frac{250,000}{5} = \$50,000

Marginal Cost of 5th Car

MC = 250,000 - 225,000 = \$25,000

Why MC and ATC Curves Cross

MC crosses ATC at its lowest point, because MC pulls ATC down or pushes it up.

Economies of Scale
When long-run average total cost falls as output increases.

Diseconomies of Scale
When long-run average total cost rises as output increases.

Quick Quiz (Boeing)

Given:
 9 jets → $9.0 million → ATC = $1.0 million
 10 jets → $9.5 million → ATC = $0.95 million
Answer
Since ATC falls when output increases, Boeing exhibits:
✅ Economies of scale

✅ Final Exam Summary

 Costs include opportunity costs
 Economic profit ≠ accounting profit
 Production shows diminishing marginal product
 MC intersects ATC at minimum
 Long-run equilibrium depends on economies of scale
What is a Competitive Market?
A competitive market is a market in which many buyers and many sellers trade identical products, and no
single firm can influence the market price. Each firm is a price taker.
Characteristics :
 There are many buyers and many sellers in the market.
 Firms can freely enter or exit the market.
 Price taker firms
 Products of all firms are the same.
Revenue of a comparative firm :
A competitive firm is a price taker, so it sells its output at the market-determined price.
Total Revenue (TR) is calculated as:
TR = P * Q
Therefore, for a competitive firm:
AR = P = MR
Q) When a competitive firm doubles the amount it sells, what happens to:
(a) Price of output
The price remains unchanged, because a competitive firm is a price taker.
(b) Total Revenue
Total revenue doubles, because:
TR = P * Q
Profit Maximization
A firm maximizes profit by producing the level of output at which the difference between total revenue and
total cost is maximum.
Profit = TR – TC
Example of Profit Maximization

Output TR TC Profit
1 40 30 10
2 80 50 30
3 120 100 20
4 150 130 20
Profit is highest at 2 units, so this is the profit-maximizing output.
Three General Rules for Profit Maximization
 If MR > MC , the firm should increase its output.
 If MC > MR, the firms should decrease its output.
 At the profit maximizing level of output , then MR = MC .
Short-Run Decision: Shut Down
Shutdown Rule
In the short run, a firm should shut down if:
P < AVC
Sunk Cost (Spilt Milk Concept
Sunk costs are costs that cannot be recovered, even if the firm stops production.
Example
Money spent on machines or buildings.
Spilt Milk Concept
Sunk costs should be ignored in production decisions because they have already occurred.
Long-Run Decision: Exit or Enter the Market
Exit the Market
A firm exits in the long run if:
P < ATC
Entre the market :
A firm enter in the long run if :
P > ATC
Q1) Why Monopolies Arise
A monopoly arises when
 One firm is the only seller of a product
 No close substitutes are available
 High entry barriers

Monopolies arise for three main reasons

1) Monopoly Resources
A monopoly can arise when one firm owns or controls a key resource needed to produce a good.
Example:
A company that owns the only diamond mine in a country.

2) Government-Created Monopolies
The government may give exclusive rights to a firm to produce or sell a product.

a) Government Regulation (Legal Monopoly)

Government gives Monopoly through patents and licences.
Example:
Postal services or electricity supply companies.

3) Natural Monopoly (Production Process)

A monopoly arises when one firm can supply the entire market at a lower cost than many firms.
Example:
Water supply, gas pipelines, electricity distribution.

Quick Quiz (Q1)

What are the three reasons a market might have a monopoly?
Answer:
1. Control over key resources
2. Government-created monopolies
3. Natural monopoly due to production process

Two Examples of Monopolies with Reasons

Example 1: Electricity Company
 Reason: Natural monopoly
 Explanation: High infrastructure cost, one firm is more efficient.
Example 2: Patent Medicine Company
 Reason: Government-created monopoly
 Explanation: Patent gives exclusive production rights.

Q2) How Monopolies Make Production and Pricing Decisions

Perfect Competition Monopoly
Many sellers. One seller
Price taker Price maker
Demand = MR MR < Demand
A Monopoly’s Revenue
 Total Revenue (TR) = Price × Quantity
 Marginal Revenue (MR) = Change in TR from selling one more unit
 For a monopoly: MR is always less than price

Profit Maximization by Monopoly

A monopolist maximizes profit where:
MR = MC (Marginal Cost)
Steps:
1. Find quantity where MR = MC
2. Use demand curve to find price for that quantity

Monopoly Profit
 Monopoly can earn economic profit in the long run
 No entry of new firms because of barriers to entry

Quick Quiz (Q2)

How does a monopolist choose output and price?
Answer:
A monopolist:
1. Produces the quantity where MR = MC
2. Charges the highest price consumers are willing to pay for that quantity, shown on the
demand curve

Output and price effect

Output effect : selling more units increases revenue

Price effect : lower price reduces revenue per unit

In Monopoly

Output effect is positive and price affect is negative

Production Function
A production function shows the relationship between quantity of inputs (like labor) and
quantity of output produced.
Marginal Product of Labor (MPL)
The marginal product of labor is the extra output produced when one more worker is
hired, keeping other inputs fixed.
Diminishing Marginal Product of Labor
Diminishing marginal product means that as more workers are hired, the additional
output from each new worker decreases.
Reason: Machines and space are fixed, so workers become less productive.
Value of the Marginal Product (VMP)
The value of marginal product is the extra revenue earned from hiring one more worker.
Formula:
VMP = MPL × Price of output
Labor Demand Curve
 A firm’s demand for labor is determined by VMP
 Labor demand curve slopes downward because of diminishing MPL

Causes of Shift in Labor Demand Curve

The labor demand curve shifts when VMP changes.
Main Causes:
 Change in price of output ( higher price vmp increases , labour demand
increases
 Change in productivity (technology, skills)
 Change in technology ( advance technology higher MPL and higher labour
demand)

The Supply of Labor

The Trade-off Between Work and Leisure
People choose between:
 Working (earning income)
 Leisure (rest, family time)
Working more means less leisure and enjoying leisure means less income.
Labor Supply Curve
 Shows how many hours people are willing to work at different wages
 Usually upward sloping
What Causes the Labor Supply Curve to Shift?
Main Causes:
 Changes in tastes (preference for leisure or work)
 Changes in alternative opportunities
 Immigration
 Changes in taxes and benefits