The Firm s Objective. The Costs of Production. The economic goal of the firm is to maximize profits. A Firm s Profit. Chapter 13

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1 The Costs of Production Chapter 13 Copyright 2001 by Harcourt, Inc. All rights reserved. Requests for permission to make copies of any part of the work should be mailed to: Permissions Department, Harcourt College Publishers, 6277 Sea Harbor Drive, Orlando, Florida The Firm s Objective The economic goal of the firm is to maximize profits. A Firm s Profit Profit is the firm s total revenue minus its total cost. Profit = Total revenue - Total cost Total Cost includes all of the opportunity costs of production 1

2 Economic Profit versus Accounting Profit How an Economist Views a Firm How an Accountant Views a Firm Revenue Economic profit Implicit costs Explicit costs Total opportunity costs Accounting profit Explicit costs Revenue What happens to profit though as you keep on adding workers? Marginal product = Additional output Additional input Diminishing Marginal Product Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment. 2

3 Your Journal Question You have just been given 10 acres of land. The land is of varying quality. The amount of land remains fixed. What will happen to your yield as you keep on adding workers? Can you write down an example of diminishing returns from your experience? A Production Function... Quantity of Output (cookies per hour) Production function Number of Workers Hired Fixed and Variable Costs Fixed costs are those costs that do not vary with the quantity of output produced. Variable costs are those costs that do change as the firm alters the quantity of output produced. Short Run vs. Long Run Costs 3

4 Family of Total Costs Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Costs (TC) TC = TFC + TVC Family of Total Costs Quantity Total Cost Fixed Cost Variable Cost 0 $ 3.00 $3.00 $ Total-Cost Curve... $16.00 $14.00 Total-cost curve $12.00 Total Cost $10.00 $8.00 $6.00 $4.00 $2.00 $ Quantity of Output (glasses of lemonade per hour) 4

5 Relation Between Production Function and Total Cost. Dimininish ing Returns Average Costs Average costs can be determined by dividing the firm s costs by the quantity of output produced. The average cost is the cost of each typical unit of product. Family of Average Costs Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVC 5

6 Family of Average Costs Quantity AFC AVC ATC 0 1 $3.00 $0.30 $ Marginal Cost Marginal cost (MC) measures the amount total cost rises when the firm increases production by one unit. Marginal cost helps answer the following question: How much does it cost to produce an additional unit of output? Marginal Cost (Change in total cost) MC = (Change in quantity) = ΔTC ΔQ 6

7 Average-Cost and Marginal-Cost Curves... $3.50 $3.00 Costs $2.50 $2.00 $1.50 $1.00 MC ATC AVC $0.50 AFC $ Quantity of Output (glasses of lemonade per hour) Relationship Between Marginal Cost and Average Total Cost $3.50 $3.00 Costs $2.50 $2.00 $1.50 MC ATC $1.00 $0.50 $ Quantity of Output (glasses of lemonade per hour) Three Important Properties of Cost Curves Marginal cost eventually rises with the quantity of output. Law of Diminishing Marginal Returns The average-total-cost curve is U-shaped. The marginal-cost curve crosses the averagetotal-cost curve at the minimum of average total cost. Work on homework assignment! 7

8 Costs in the Long Run For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered. In the short run some costs are fixed. In the long run fixed costs become variable costs. Average Total Cost in the Short and Long Runs... Average Total Cost ATC in short run with small factory ATC in short run with medium factory ATC in short run with large factory ATC in long run 0 Quantity of Cars per Day Economies and Diseconomies of Scale Average Total Cost ATC in long run Economies of scale Constant Returns to scale Diseconomies of scale 0 Quantity of Cars per Day 8

N. Gregory Mankiw Principles of Economics. Chapter 13. THE COSTS OF PRODUCTION

N. Gregory Mankiw Principles of Economics Chapter 13. THE COSTS OF PRODUCTION Solutions to Problems and Applications 1. a. opportunity cost; b. average total cost; c. fixed cost; d. variable cost; e. total