CHAPTER+12

The  Cost  of  Production

 - We used the __supply curve__ to summarize firms’ production decisions. - Firms are willing to produce and sell a **greater quantity** of a good when the price of the **good is higher.** - Because of the reason above, a __supply curve slopes upward__.

• The Market Forces of Supply and Demand – // Supply  // and // demand // are the two words that economists use most often. – // Supply // and // demand // are the forces that make market economies work. – Modern microeconomics is about supply, demand, and market equilibrium. * **Industrial Organization**: the study of how firms’ decisions about prices and quantities depend on the market conditions they face.  - A firm’s costs are a key determinant of its production and pricing decisions. * Total Revenue: the amount a firm receives for the sale of its output * Total Cost: the market value of the inputs a firm uses in production • **//Profit //** is the firm’s total revenue minus its total cost. • Profit = Total revenue - Total cost - Firm’s objective is to make the profit as large as possible. COSTS AS OPPORTUNITY COSTS - Opportunity cost: whatever must be given up to obtain some item - Firm’s cost of production includes all the opportunity costs of making its output of good and services. • A firm’s cost of production includes all the opportunity costs of making its output of goods and services. • Explicit and Implicit Costs • A firm’s cost of production includes // explicit costs// and // implicit costs.// • Explicit costs are input costs that require a direct outlay of money by the firm. • Implicit costs are input costs that do not require an outlay of money by the firm. • Economists measure a firm’s //economic profit // as total revenue minus total cost, including both explicit and implicit costs. • Accountants measure the //accounting profit // as the firm’s total revenue minus only the firm’s explicit costs. • • When total revenue exceeds both explicit and implicit costs, the firm earns economic profit. • Economic profit is smaller than accounting profit. PRODUCTION AND COSTS • The Production Function – The //production function // shows the relationship between quantity of inputs used to make a good and the quantity of output of that good. – • Marginal Product • The //marginal product // of any input in the production process is the increase in output that arises from an additional unit of that input. • • //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. • Diminishing Marginal Product • 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. • The relationship between the quantity a firm can produce and its costs determines pricing decisions. • The total-cost curve shows this relationship graphically. • THE VARIOUS MEASURES OF COST • Costs of production may be divided into //fixed costs // 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 vary// with the quantity of output produced. – • Total Costs • Total Fixed Costs (TFC) • <span style="font-family: Arial; color: rgb(51, 153, 102);">Total Variable Costs (TVC) • <span style="font-family: Arial; color: rgb(51, 153, 102);">Total Costs (TC) • //<span style="font-family: Arial; color: rgb(51, 153, 102);">TC //<span style="font-family: Arial; color: rgb(51, 153, 102);"> = //TFC// + //TVC// • // Average Costs // • // Average costs can be determined by dividing the firm’s costs by the quantity of output it produces. // • // The average cost is the cost of each typical unit of product. // • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Average Fixed Costs (AFC) // • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Average Variable Costs (AVC) // • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Average Total Costs (ATC) // • //<span style="font-family: Arial; color: rgb(51, 153, 102);">ATC = AFC + AVC //
 * Economic Profit versus Accounting Profit **
 * Economic Profit versus Accounting Profit **
 * Diagram: Economists versus Accountants **
 * The Production Function **
 * The Production Function **
 * The Production Function **
 * From the Production Function to the Total-Cost Curve **
 * Fixed and Variable Costs **


 * // Average and Marginal Costs //**

• Marginal Cost • // Marginal cost // (MC) measures the increase in total cost that arises from an extra unit of production. • Marginal cost helps answer the following question: • How much does it cost to produce an additional unit of output?

• Marginal cost rises with the amount of output produced. • This reflects the property of diminishing marginal product. • • The average total-cost curve is U-shaped. • At very low levels of output average total cost is high because fixed cost is spread over only a few units. • Average total cost declines as output increases. • Average total cost starts rising because average variable cost rises substantially. • The bottom of the U-shaped ATC curve occurs at the quantity that minimizes average total cost. This quantity is sometimes called the efficient scale of the firm. • 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. • Relationship between Marginal Cost and Average Total Cost • The marginal-cost curve crosses the average-total-cost curve at the efficient scale. • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Efficient scale // is the quantity that minimizes average total cost. • It is now time to examine the relationships that exist between the different measures of cost. • 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. COSTS IN THE SHORT RUN AND IN THE LONG RUN • For many firms, the division of total costs between fixed and variable costs depend on the time horizon being considered. – In the short run, some costs are fixed. – In the long run, //all// 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. • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Economies of scale // refer to the property whereby long-run average total cost falls as the quantity of output increases. • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Diseconomies of scale // refer to the property whereby long-run average total cost rises as the quantity of output increases. • //<span style="font-family: Arial; color: rgb(51, 153, 102);">Constant returns to scale //<span style="font-family: Arial; color: rgb(51, 153, 102);"> refer to the property whereby long-run average total cost stays the same as the quantity of output increases.
 * Cost Curves and Their Shapes **
 * Typical Cost Curves **
 * Economies and Diseconomies of Scale **



<SUMMARY> • The goal of firms is to maximize profit, which equals total revenue minus total cost. • When analyzing a firm’s behavior, it is important to include all the opportunity costs of production. • Some opportunity costs are explicit while other opportunity costs are implicit. • A firm’s costs reflect its production process. • A typical firm’s production function gets flatter as the quantity of input increases, displaying the property of diminishing marginal product. • A firm’s total costs are divided between fixed and variable costs. Fixed costs do not change when the firm alters the quantity of output produced; variable costs do change as the firm alters quantity of output produced. • Average total cost is total cost divided by the quantity of output. • Marginal cost is the amount by which total cost would rise if output were increased by one unit. • The marginal cost always rises with the quantity of output. • Average cost first falls as output increases and then rises. • The average-total-cost curve is U-shaped. • The marginal-cost curve always crosses the average-total-cost curve at the minimum of ATC. • A firm’s costs often depend on the time horizon being considered. • In particular, many costs are fixed in the short run but variable in the long run.

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