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Industrial Organization
Part 1: Costs of Production
MicroMod5
Objectives
• By the end of this module, SWBAT
– Explain the difference between accounting and
economic profits and explicit vs. implicit costs
– Describe the relationship between the production
function and total cost curve
– Draw and describe the “big three” average cost
curves and then show how marginal cost fits in
– Explain the benefits of economies of scale in the
long run applications of costs of production
SLOs
• Corporations routinely focus on decreasing the
costs of production for goods and services in
order to maximize profit
• Understanding costs is a lifelong learning skill in
the field of economics that explains much firm
behavior
• Also, important to understand the externalities of
minimizing costs
– Layoffs
– Tax shelters
– Undocumented laborers, migrant laborers, etc.
Recap on Profit
• Profit = Total Revenue - Total Cost
• Costs come in two flavors
– Explicit - costs that require expenditures by
business (accountant’s cost)
– Implicit - costs that do not require expenditures by
businesses (i.e. time, energy, other opportunity
costs)
– Explicit + implicit costs = total costs
Recap on Profit
• in similar fashion, accounting profit = TR - total
explicit costs
• economic profit = TR - total cost
• total cost figure forms the basis for a whole
series of curves that provides a detailed
picture of supplier behavior
Production Function
• relationship between quantity of inputs used
to produce and quantity of output
• looks like left half of Laffer Curve
• diminishing marginal product - as amount of
inputs increases, becomes less productive
• common sense tells you this is true - “too
many cooks in the kitchen” adage
Total Cost Curve
• other way to express the same notion as
production function
• diminishing marginal product due to rising
marginal cost
Total Cost Curve
Production Function
Total Cost Curve
The Big Three
• Fixed costs - costs that don’t vary with
quantity of goods, services produced
• Variable costs - costs that DO vary with
quantity of goods, services produced
• Marginal cost - increase in total cost that
arises from the next unit of good, service
The Big Three - Salon Example
• Fixed costs - rent for hair salon
• Variable costs - hair product in terms of gel,
relaxer, mousse, etc.
• Marginal cost - how much the next dye job
you do will cost you in terms of materials
Average Total Cost
• U-shaped graph
• mathematically, it is average fixed cost plus
average variable cost
• AFC graph shaped like an L, AVC graph shaped
like very elastic supply curve
• resulting sum in ATC graph becomes a
flattened U
Average Total Cost
Marginal Cost
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•
•
•
•
steepest rise of all cost curves
initially falls with ATC but then quickly rises
whenever MC < ATC, ATC is decreasing
whenever MC > ATC, ATC is increasing
MC always, always, always intersects ATC at
ATC’s lowest point
• this region called “efficient scale” - place
where business operates at lowest cost margin
Marginal Cost
Long Run vs. Short Run
• Long run curves differ from short run curves
• recall that even though demander usually
more flexible in economic decisions than
supplier, fixed short run costs can become
variable
• (i.e. new production facility, invention of new
production techniques)
Long Run vs. Short Run
• As a result, long run curves much flatter than
short run cost curves in the same way supply
and demand curves are more elastic in the
long run
• three distinct phases
– economies of scale (production up, costs down)
– constant returns to scale (production up, costs
level)
– diseconomies of scale (production up, costs up)
Long Run vs. Short Run