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Chapter 6: Costs of
Production
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Learning Objectives
1. Define and explain the differences between
accounting profit and economic profit.
2. Understand the law of diminishing returns.
3. Discuss the various production costs that
firms face.
4. Determine a firm’s profit maximizing decision
in the short run.
5. Describe a firm’s shutdown decision.
6. Understand production and costs in the long
run.
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Profits
 Any Firm has one main goal: maximize its
profit

What does exactly profit mean?
 We distinguish 3 types of profits

Accounting profit

Economic profit or excess profit

Normal profit
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Accounting Profit
 Most common profit idea
Accounting profit = total revenue – explicit costs
 Explicit
purchase


costs are payments firms make to
Resources (labor, land, etc.) and
Products from other firms
 Easy to compute
 Easy to compare across firms
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Economic Profit
 Economic profit is the difference between a
firm's total revenue and the sum of its explicit
and implicit costs
 Economic
profit = total revenue – explicit costs
– implicit costs
 Economic profit = accounting profit – implicit
costs
 Implicit costs are the opportunity cost of
the resources supplied by the firm's owners
 Difficult
to measure
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Accounting and Economic Profit: Example
 Assume firm
 Total
revenue = $400,000
 Explicit costs = workers’ salaries = $250,000

Accounting profit = $400,000 - $250,000 = $150,000
 Firm’s
implicit costs = $100,000
 Economic profit = $150,000 - $100,000


Economic profit < Accounting profit
Accounting profit – Economic profit = Normal profit
• Normal profit = opportunity cost of the resources used by the
firm
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Three Kinds of Profit
Total Revenue = Explicit Costs + Accounting Profit
Total
Revenue
Explicit
Costs
Explicit
Costs
Accounting
Profit
Economic
Profit = Accounting Profit – Normal Profit
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Normal
Profit
Economic
Profit
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Economic Profits Guide Decisions
 Kamal is a corn farmer living in Turkey
 Kamal’s



decision: keep farming or quit?
Quit farming and earn $11,000 per year working retail
Explicit farm costs are $10,000 (including $6,000 as rent)
Total revenue is $22,000
Accounting Profit
$12,000
 Kamal

Economic Profit
$1,000
Normal Profit
$11,000
should stick with farming because EP > 0
If revenue fell below $21,000, Kamal should quit
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Owned Inputs
 What if Kamal inherits the land?
 Rent
for the farm land is $6,000 of the $10,000 in
explicit costs

His rent payments become an implicit cost
Total Revenue
$20,000
Accounting Profit
$16,000
Explicit Costs
$4,000
Economic Loss
$1,000
Implicit Costs
$17,000
Normal Profit
$17,000
 Kamal should abandon farming because EP < 0
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Production Ideas
 Production converts inputs into outputs


Many different ways to produce the same product
Technology is a recipe for production
 A factor of production is an input used in the
production of a good or a service

Examples are land, labor, capital, and entrepreneurship
 The short run is the period of time when at least one
of the firm's factors of production is fixed
 The long run is the period of time in which all inputs
are variable
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Production: Short and Long Run
Every firm faces the following question: how
much to produce?
 Assume

a firm that makes glass bottles
Uses labor (employees) + capital (machine)
• Assume for now only 2 factors of production
 Short
Run: machine (capital) is assumed to be
fixed and employee (labor) variable
 Long Run: both inputs, machine and labor, are
variable
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Production: Short and Long Run
Total # of Employees
per day
Total Output per
day
0
0
1
80
80
2
200
120
3
260
60
4
300
40
5
330
30
6
350
20
7
362
12
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Marginal Product of
Labor
12
Production: Short and Long Run
Previous table reflects the output –
employment relationship
 Add
a unit of employment (labor) output grows
 Beyond some point the additional output that results
from each additional unit of labor begins to diminish

Can be better seen through Marginal Product of Labor
(MP) as a measure of the contribution of additional
labor input to total output
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Production: Short and Long Run
 Marginal Product of Labor
1
unit of labor to 2 units of labor  MP increases 
increasing returns
 2 units of labor to 3 units of labor  MP decreases 
decreasing returns  law of diminishing returns
The Law of Diminishing Returns
With all inputs except one fixed,
additional units of the variable input yield
ever smaller amounts of additional output
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Total and Marginal Product
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Cost Concepts
 A fixed factor of production is an input whose quantity
cannot be changed in the short run

Fixed cost (FC) is the sum of all payments for fixed inputs
 A variable factor of production is an input whose
quantity can be changed in the short run

Variable cost (VC) is the sum of all payments for variable
inputs
 Total cost (TC) is the sum of all payments for inputs
TC = FC + VC
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Fixed, Variable, and Total Costs of Lantern
Production
Workers
Lanterns
per Day
Fixed
Costs
($/day)
Variable
Cost
($/day)
Total
Cost
($/day)
0
0
$40
$0
$40
Marginal
Cost
($/lanter
n)
1
80
40
12
52
$0.15
2
200
40
24
64
0.10
3
260
40
36
76
0.20
4
300
40
48
88
0.30
5
330
40
60
100
0.40
6
350
40
72
112
0.60
7
362
40
84
124
1.00
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Total and Marginal Cost
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Cost Concepts
 Marginal cost (MC) is the change in total
cost divided by the change in output
 MC also represents the slope of the total cost
curve
 MP and MC reflect each other
 When
MP increases, MC decreases
 When MP decreases, MC increases
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Choosing Output to Maximize Profit
Profit = Total revenue – Total cost = TR – TC
 Total cost = Fixed cost + Variable cost
 Profit = Total revenue – Variable cost – Fixed cost
 The firm must know about both revenues and costs in
order to maximize profits
Increase output if marginal benefit is at least as great as
marginal cost
 Decrease output if marginal benefit is greater than marginal
cost

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Choosing Output to Maximize Profit
What is the output that maximizes profit?
 Cost
– benefit principles says to produce as long as
MB > MC

If price is $0.35 per lantern (MB = $0.35) then produce
300 (following previous table)
• Is that the profit maximizing output?
 Let

us calculate the total profits
Largest profit = $17 at output of 300 lanterns per day
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Choosing Output to Maximize Profit
 Note here that P = MB = MR = marginal
revenue
 Marginal
revenue = change in total revenue resulting
from a change in output
 Cost – benefit principles therefore says that if MB
= MR > MC then produce that unit
 Here MR = P = constant = $0.35
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Output, Revenue, Costs and Profit
Worker
s
Output
(lanterns/da
y)
TR
($/day)
MR
($/lanter
n)
TC
($/day)
MC
($/lanter
n)
0
0
0
1
80
28
0.35
52
0.15
-24
2
200
70
0.35
64
0.10
6
3
260
91
0.35
76
0.20
15
4
300
105
0.35
88
0.30
17
5
330
115.5
0.35
100
0.40
15.5
6
350
122.5
0.35
112
0.60
10.5
7
362
126.7
0.35
124
1.00
2.7
40
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Profits
($/day)
-40
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Profit Maximization
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Profit Maximization
From the previous figure
 Profits
are maximized at output = 300 lanterns
 Profit maximization reflected in:



The highest point of the profit curve
The largest difference between TR and TC curves
The slope of the profit function is equal to zero
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Profit Maximization
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Profit Maximization
From the previous figure
 MR
= MC  profit is maximized
 Slope of TR = slope of TC
 TR and TC are parallel
What if the fixed cost was $45 instead of
$40?
 Will
the new fixed cost affect the level of
output to maximize profits? Will the shutdown
point still be the same?
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Fixed Costs and Profit Maximization
Fixed costs have no role in choosing the
profit-maximizing level of output


Marginal benefit is the price of the product
Fixed costs do not affect marginal costs
To summarize:
 When
the Law of Diminishing Returns applies
 when a fixed input exists,


Increase output if marginal cost is less than price
Decrease output if marginal cost is more than price
• However, some exceptions exist
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Shut-Down Decision
 Firms can make losses in the short run
 Some
firms continue to operate
 Some firms shut down

What determines the decision to stay in the market or
shut-down?
 The Cost – Benefit Principle applies even to
losses
 Continue
to operate if your losses are less than if
you shut down
 Shut down if your losses are less than if you
continued operating
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Shut-Down Condition
 If the firm shuts down in the short run, it loses all
of its fixed costs

So, fixed costs are the most a firm can lose
 The firm should shut down if revenue is less than
variable cost: P x Q < VC for all levels of Q

The firm is losing money on every unit it makes
 If the firm's revenue is at least as big as variable
cost, the firm should continue to produce

Each unit pays its variable costs and contributes to
fixed costs

Losses will be less than fixed costs
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AVC and ATC
 Shut-down if
P x Q < VC
P < VC / Q
P < AVC
 Average values are the total divided by
quantity
 Average
variable cost (AVC) is
AVC = VC / Q
 Average
total cost (ATC) is
ATC = TC / Q

Shut down if price is less than average variable cost
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Profitable Firms
A firm is profitable if its total revenue is
greater than its total cost
TR > TC
OR
P x Q > ATC x Q
since ATC = TC / Q
 Another
way to state this is to divide both
sides of the inequality by Q to get
P > ATC

As long as the firm's price is greater than its
average total costs, the firm is profitable
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Workers Lanterns
per day
per day
Variable
AVC ($
Cost
per unit)
($/day)
Total
Cost
40
ATC ($ Marginal
Cost
per unit)
($/unit)
0
0
0
1
80
12
0.15
52
0.65
2
200
24
0.12
64
0.32
3
260
36
0.135
76
0.292
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0.15
0.10
0.20
33
Cost Curves
 Notice that MC must intersect both the AVC
and ATC at their respective minimum points
 If
MC is below the AVC (or ATC) the
corresponding average cost must be falling
 If MC is above the AVC (or ATC) the
corresponding average cost must be increasing
 ATC curve is generally U-shaped
 Fixed
costs dominate at low levels of output
 As production increases AFC decreases and AVC
increases (due to diminishing returns) eventually
causing ATC to rise
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Production and Costs in the Long Run
 Long run = a time period of sufficient length
that all the firm’s factors of production are
variable
 This
means for the bottle maker that it is possible,
over time, to vary not only the number of
employees but also the capacity of the bottlemaking machine or the number of bottle-making
machines
 Hence,
run
all production costs are variable in the long
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Production and Costs in the Long Run
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Production and Costs in the Long Run
In the long run (LR), ATC curve is U –
shaped
 The
rationale behind this shape is that the
bottle producer can avert diminishing returns
simply by adding another bottle-making
machine and expanding its scale of operations

In other words, increasing returns can be extended
over time by getting more output out of every
additional employee, thus resulting in a decreasing
average total cost
• This explains the decreasing portion of the LRATC 
economies of scale
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Production and Costs in the Long Run
As a firm expands its scale of operations, it
eventually experiences increasing ATC,
which economists describe as
diseconomies of scale
 This
is represented by a rising portion of the
long run ATC
The area separating the decreasing and the
rising portion of the long run ATC is
described as constant returns to scale
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Production and Costs in the Long Run
 Economies of scale: When all inputs are changed by
a given proportion, output changes by more than that
proportion

Examples: division of labor, specialization, mass production,
and increased capital efficiency.
 Constant returns to scale: When all inputs are
changed by a given proportion, output changes by the
same proportion
 Diseconomies of scale: When all inputs are changed
by a given proportion, output changes by less than that
proportion

Example: too many management layers
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Production and Costs in the Long Run
Economies of scale:
Q
= f(L;K)  f(2*L;2*K) > 2*Q = QNew
Constant returns to scale:
Q
= f(L;K)  f(2*L;2*K) = 2*Q = QNew
Diseconomies of scale:
Q
= f(L;K)  f(2*L;2*K) < 2*Q = QNew
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