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Chapter 13 The Costs of Production

WHAT ARE COSTS? Firms always try to maximize their profit. Profit = Total revenue – Total cost Total revenue is the amount that the firm receives after selling its products, and the total cost is the amount that the firm spends to make the products.

There are two types of opportunity costs for producing goods: explicit costs and implicit costs. Explicit costs are input costs that require an outlay of money by the firm, and implicit costs are input costs that do not require an outlay of money. Economists count both explicit and implicit costs as firm’s opportunity cost, whereas accountants only regard explicit costs as opportunity cost. Therefore, economic profit is total revenue minus both explicit and implicit costs, and accounting profit is total revenue minus only explicit cost.

PRODUCTION AND COSTS

The Production Function Production Function is a relationship between the quantity of inputs and quantity of output. The marginal product of any input is the increase in the quantity of output from one additional unit of that input. As the number of workers increases, the marginal product declines. This property is called diminishing marginal product, and this happens because each additional worker have to share equipment and work in more and more crowded conditions. The total-cost curve is the graph that shows a relationship between the quantity of output and the total cost. It gets steeper as the quantity of output increases, whereas production function graph gets flatter as the quantity of input increases. Both property reflects the diminishing marginal property.

THE VARIOUS MEASURES OF COST

The total cost can be divided into two types: fixed costs and variable costs. Fixed costs are the costs that do not vary with the quantity of output produced. Variable costs, on the contrary, are the costs that change with the quantity of output produced. Average total cost is total cost divided by the quantity of output, and it represents the cost of the typical unit produced. Average fixed cost is the fixed cost divided by the quantity of output, and average variable cost is the variable cost divided by the quantity of output. Finally, marginal cost is the increasing in total cost from an extra unit of production. Marginal cost = Change in total cost/Change in quantity Marginal cost rises with the quantity of output produced due to the property of diminishing marginal product. Average total cost is U-shaped. Average fixed cost always declines as output rises, and average variable cost typically rises as output increases. The bottom of the U-shape of average total cost represents the quantity that minimizes average total cost, and this quantity is called the efficient scale of the firm.

Whenever marginal cost is less than average total cost, average total cost declines. Whenever marginal cost is greater than average total cost, average total cost rises. Therefore, the marginal-cost curve intersects with the average-total-cost curve at its minimum.

COSTS IN THE SHORT RUN AND IN THE LONG RUN

In the short run, many costs are fixed costs, but they are variable costs in the long run. Therefore, the long-run average-total-cost curve is a much flatter U-shape than the short-run average-total-cost curve. When the long-run average total cost declines as output increases, there are economies of scale. When the long-run average total cost rises as output increases, there are diseconomies of scale. When the long-run average total cost stays the same as output changes, there are constant returns to scale.

Summary -Every firm always tries to maximize their profit. -There are two types of opportunity costs: explicit costs and implicit costs. -Marginal product eventually starts to decrease. -Production function gets flatter as the quantity increases, and total-cost curve gets steeper as the quantity increases. -Total cost can be divided into two types: fixed costs and variable costs. -Average total cost is total cost divided by the quantity of output, and marginal cost is increase in total cost from additional unit of output. -Marginal cost curve intersects average total cost at its minimum. -Many costs are fixed costs in the short run but are variable costs in the long run.

Review Questions 1. Describe the shape of fixed cost, marginal cost, average total cost. Fix cost always declines as output increases. Marginal cost rises as output increases. Average total cost is U-shaped. It falls at the beginning but starts to rise at some point.

2. How do you calculate firm's profit, average total cost, and marginal cost? profit = total ravenue - total cost average total cost = total cost / quantity marginal cost = change in total cost / change in quantity