eco

1. Total Revenue, Total Cost, Profit
 We assume that the firm’s goal is to maximize
profit.
Professor Sumner La Croix
Profit = Total revenue – Total cost
University of Hawai′i-Mānoa
Econ 130(3)
the amount a the market
November 6 & 9, 2009 firm receives value of the
from the sale inputs a firm
of its output uses in
production
0 THE COSTS OF PRODUCTION 1
Costs: Explicit vs. Implicit Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
 Explicit costs require an outlay of money,
The interest rate is 5%.
e.g., paying wages to workers.
 Implicit costs do not require a cash outlay,  Case 1: borrow $100,000
e.g., the opportunity cost of the owner’s time.  explicit cost = $5000 interest on loan
 The cost of something is the highest value  Case 2: use $40,000 of your savings,
opportunity foregone. borrow the other $60,000
 explicit cost = $3000 (5%) interest on the loan
 This is true whether the costs are implicit or  implicit cost = $2000 (5%) foregone interest you
explicit. Both matter for firms’ decisions. could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION 2 THE COSTS OF PRODUCTION 3
Economic Profit vs. Accounting Profit The Production Function
 Accounting profit  A production function shows the relationship
= total revenue minus total explicit costs between the quantity of inputs used to produce a
good and the quantity of output of that good.
 Economic profit
= total revenue minus total costs (including  It can be represented by a table, equation, or
explicit and implicit costs) graph.
 Accounting profit ignores implicit costs,  Example 1:
so it’s higher than economic profit.  Farmer Akira grows wheat.
 He has 5 acres of land.
 He can hire as many workers as he wants.
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2. Ex 1: Farmer Akira’s Production Function Marginal Product
 If Akira hires one more worker, his output rises
L Q
(no. of (bushels
3,000 by the marginal product of labor.
workers) of wheat) 2,500
 The marginal product of any input is the
Quantity of output
0 0 2,000 increase in output arising from an additional unit
of that input, holding all other inputs constant.
1 1000 1,500
 Notation:
2 1800 1,000
∆ (delta) = “change in…”
3 2400 500 Examples:
4 2800 0 ∆Q = change in output, ∆L = change in labor
0 1 2 3 4 5 ∆Q
5 3000
No. of workers  Marginal product of labor (MPL) =
∆L
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Why MPL Is Important Why MPL Diminishes
 Because rational owners of firms think at the  Farmer Akira’s output rises by a smaller and
margin! smaller amount for each additional worker. Why?
 When Farmer Akira hires an extra worker,  As Akira adds workers, the average worker has
 his costs rise by the wage he pays the worker less land to work with and will be less productive.
 his output rises by MPL  In general, MPL diminishes as L rises
 Comparing them helps Akira decide whether he whether the fixed input is land or capital
would benefit from hiring the worker. (equipment, machines, etc.).
 Diminishing marginal product:
the marginal product of an input declines as the
quantity of the input increases (other things equal)
THE COSTS OF PRODUCTION 8 THE COSTS OF PRODUCTION 9
Marginal Cost EXAMPLE 1: Total and Marginal Cost
 Marginal Cost (MC) Q
is the increase in Total Cost from Total Marginal
(bushels
Cost Cost (MC)
producing one more unit: of wheat)
0 $1,000
∆TC ∆Q = 1000 ∆TC = $2000 $2.00
MC =
∆Q 1000 $3,000
∆Q = 800 ∆TC = $2000 $2.50
1800 $5,000
∆Q = 600 ∆TC = $2000 $3.33
2400 $7,000
∆Q = 400 ∆TC = $2000 $5.00
2800 $9,000
∆Q = 200 ∆TC = $2000 $10.00
3000 $11,000
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3. EXAMPLE 1: The Marginal Cost Curve Why MC Is Important
Q  Farmer Akira is rational and wants to maximize
(bushels TC MC his profit. To increase profit, should he produce
MC usually rises
of wheat) as Q rises,
more or less wheat?
0 $1,000 as in this example.  To find the answer, Farmer Akira needs to
$2.00 “think at the margin.”
1000 $3,000
$2.50  If the cost of additional wheat (MC) is less than
1800 $5,000
$3.33
the revenue he would get from selling it,
2400 $7,000 then Akira’s profits rise if he produces more.
$5.00
2800 $9,000
$10.00
3000 $11,000
THE COSTS OF PRODUCTION 12 THE COSTS OF PRODUCTION 13
Fixed and Variable Costs EXAMPLE 2
 Fixed costs (FC) do not vary with the quantity of  Our second example is more general,
output produced. applies to any type of firm
 For Farmer Akira, FC = $1000 for his land producing any good with any types of inputs.
 Other examples:
cost of equipment, loan payments, rent
 Variable costs (VC) vary with the quantity
produced.
 For Farmer Akira, VC = wages he pays workers
 Other example: cost of materials
 Total cost (TC) = FC + VC
THE COSTS OF PRODUCTION 14 THE COSTS OF PRODUCTION 15
EXAMPLE 2: Costs EXAMPLE 2: Marginal Cost
$800 FC
Q FC VC TC $700 VC Q TC MC Recall, Marginal Cost (MC)
TC
0 $100 $0 $100 $600 is the change in total cost from
0 $100
1 100 70 170 $70 producing one more unit:
$500 1 170
50 ∆TC
Costs
2 100 120 220 $400 MC =
2 220 ∆Q
3 100 160 260 40
$300 3 260 Usually, MC rises as Q rises, due
4 100 210 310 50 to diminishing marginal product.
$200 4 310
5 100 280 380 70 Sometimes (as here), MC falls
$100 5 380
6 100 380 480 100 before rising.
$0 6 480
7 100 520 620 0 1 2 3 4 5 6 7 140 (In other examples, MC may be
7 620 constant.)
Q
THE COSTS OF PRODUCTION 16 THE COSTS OF PRODUCTION 17
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4. EXAMPLE 2: Average Fixed Cost EXAMPLE 2: Average Variable Cost
Q FC AFC Average fixed cost (AFC) Q VC AVC Average variable cost (AVC)
0 $100 n/a
is fixed cost divided by the is variable cost divided by the
0 $0 n/a
quantity of output: quantity of output:
1 100 $100 1 70 $70
AFC = FC/Q AVC = VC/Q
2 100 50 2 120 60
3 100 33.33 3 160 53.33
Notice that AFC falls as Q rises: As Q rises, AVC may fall initially.
4 100 25 The firm is spreading its fixed 4 210 52.50 In most cases, AVC will
5 100 20 costs over a larger and larger eventually rise as output rises.
5 280 56.00
number of units.
6 100 16.67 6 380 63.33
7 100 14.29 7 520 74.29
THE COSTS OF PRODUCTION 18 THE COSTS OF PRODUCTION 19
EXAMPLE 2: Average Total Cost EXAMPLE 2: Average Total Cost
Q TC ATC AFC AVC Average total cost Q TC ATC $200
(ATC) equals total Usually, as in this example,
$175
0 $100 n/a n/a n/a 0 $100 n/a
cost divided by the the ATC curve is U-shaped.
$150
1 170 $170 $100 $70 quantity of output: 1 170 $170
$125
Costs
2 220 110 50 60 ATC = TC/Q 2 220 110
$100
3 260 86.67 33.33 53.33 3 260 86.67
Also, $75
4 310 77.50 25 52.50 4 310 77.50 $50
ATC = AFC + AVC
5 380 76 20 56.00 5 380 76 $25
6 480 80 16.67 63.33 6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57 14.29 74.29 7 620 88.57
Q
THE COSTS OF PRODUCTION 20 THE COSTS OF PRODUCTION 21
EXAMPLE 2: The Various Cost Curves Together EXAMPLE 2: Why ATC Is Usually U-Shaped
$200 As Q rises: $200
$175 Initially, $175
$150 falling AFC $150
ATC pulls ATC down.
$125 $125
Costs
Costs
AVC
$100 Eventually, $100
AFC
$75 rising AVC $75
MC
pulls ATC up.
$50 $50
$25 Efficient scale: $25
$0
The quantity that $0
0 1 2 3 4 5 6 7 minimizes ATC. 0 1 2 3 4 5 6 7
Q Q
THE COSTS OF PRODUCTION 22 THE COSTS OF PRODUCTION 23
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5. EXAMPLE 2: ATC and MC Costs in the Short Run & Long Run
When MC < ATC, $200 ATC  Short run:
ATC is falling. MC Some inputs are fixed (e.g., factories, land).
$175
When MC > ATC, $150 The costs of these inputs are FC.
ATC is rising. $125  Long run:
Costs
The MC curve $100 All inputs are variable
crosses the $75 (e.g., firms can build more factories,
ATC curve at $50 or sell existing ones).
the ATC curve’s
$25  In the long run, ATC at any Q is cost per unit
minimum.
$0 using the most efficient mix of inputs for that Q
0 1 2 3 4 5 6 7 (e.g., the factory size with the lowest ATC).
Q
THE COSTS OF PRODUCTION 24 THE COSTS OF PRODUCTION 25
EXAMPLE 3: LRATC with 3 factory Sizes EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose To produce less
from 3 factory Avg than QA, firm will Avg
sizes: S, M, L. Total choose size S Total
Cost ATCS ATCM in the long run. Cost ATCS ATCM
Each size has its ATCL ATCL
own SRATC curve. To produce
between QA
The firm can and QB, firm will LRATC
change to a choose size M
different factory in the long run.
size in the long
Q To produce more Q
run, but not in the QA QB
than QB, firm will
short run.
choose size L
in the long run.
THE COSTS OF PRODUCTION 26 THE COSTS OF PRODUCTION 27
A Typical LRATC Curve How ATC Changes as
the Scale of Production Changes
In the real world,
ATC Economies of ATC
factories come in
many sizes, scale: ATC falls
each with its own as Q increases.
LRATC LRATC
SRATC curve. Constant returns
So a typical to scale: ATC
LRATC curve stays the same
looks like this: as Q increases.
Q Diseconomies of Q
scale: ATC rises
as Q increases.
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6. How ATC Changes as
the Scale of Production Changes
 Economies of scale occur when increasing
production allows greater specialization:
workers more efficient when focusing on a
narrow task.
 More common when Q is low.
 Diseconomies of scale are due to coordination
problems in large organizations.
E.g., management becomes stretched, can’t
control costs.
 More common when Q is high.
THE COSTS OF PRODUCTION 30
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