Chapter 7

Cost and Industry Structure

Principles of Microeconomics with
OpenStax
 Production & Profits
Production: Costs:
Purchase inputs to Inputs used in production
produce output to sell. must be purchased.
Topics: Topics:
Production Function Short-Run Costs of
Fixed Inputs Production:
Variable Inputs Fixed Costs (FC) or (TFC)
Marginal Product (MP) Variable Costs (VC) or (TVC)
Total Costs (TC)
Marginal Costs (MC)
Average Total Costs (ATC)
Average Variable Costs (AVC)
Average Fixed Costs (AFC)
Relationships:
MP and MC
MC and ATC
MC and AVC
Profit:
Firms get revenue from
selling the outputs they
produced.
Topics:
Accounting vs
Economic Profit
Chapter 8
Total Revenue = P x Q
Profit = TR – TC
Profit > 0 if TR > TC
Profit = 0 if TR = TC
Profit < 0 if TR < TC
 How Many Businesses Are
There?

http://econofact.org/could-increasing-market-power-among-firms-be-hurting-
workers-wages
 Two Types of Costs
Explicit Cost: Implicit Costs:
Expenses paid by the Include all opportunity costs of
producer for inputs used in using resources that belong to
production. Money paid out. the firm. Opportunity forgone.
 Two Types of Profits
Accounting profit: Economic Profit =
Total Revenue – Explicit Costs TR – Explicit costs – implicit costs.

Suppose you quit your job earning 50K per year to open a bakery. Your
explicit costs are 100K and your revenues are 140K.

Accounting profit: Economic Profit =

Total Revenue – Explicit Costs TR – Explicit costs – implicit costs.
= 140K – 100K = 40K = 140K – 100K – 50K = -10K
 Normal Profit
When Economic Profit = 0
Normal profit:
When economic profit = 0.
I.e. You earn enough revenue to cover
your opportunity costs but no more.
Positive Economic profit:
Economic profit greater than zero,
above and beyond your
opportunity cost.

Suppose Suppose instead.

Total Revenue = 150 TR = 175
Explicit Costs = 100 Explicit Costs = 100
Implicit Costs = 50 Implicit Costs = 50

Economic Profit Economic Profit

= 150 – 100 – 50 = 0 Note that = 175 – 100 – 50 = 25.
accounting
(Normal Profit). profit would be
50K here.
 Homework Question

Accounting Profit = TR – Explicit Costs Economic Profit = TR – Explicit

Costs – Implicit Costs
 Profit in General

Assume that implicit costs are included.

Profit = Total Revenue – Total Costs
Total Revenue (TR) = P X Q
Total Costs (TC) = ATC x Q
Profit = TR – TC
Profit = P x Q – ATC x Q
Factor out Q …
Profit = Q (P – ATC)
Homework Question

Assume that the cost includes implicit

costs so that we are calculating economic
profit.

Hint: Total Revenue = P x Q &

Total Cost = cost per laptop produced x Q

Profit = Total Revenue – Total Costs

Profit = P x Q – per laptop cost x Q
= Q x (P – per laptop cost)
 Solution

Profit = TR – TC
TR = P x Q
TR = 550 x 325 = $178,750
TC = cost per laptop x # of laptops
TC = 478 x 325 = $155,350
Profit = $178,750 - $155,350 = $23,400

Profit = TR – TC
TR = P x Q
TC = cost per laptop x # of laptops
Profit = P X Q – cost per laptop x Q
Profit = Q x (P – Cost per laptop)
Profit = 325 x (550 – 478) =
Profit = 325 x 72 = $23,400
 We analyze costs in the Short-Run and the Long-Run
In the Short - Run:
At least one factor of production
cannot be increased. Example,
factory size.
Costs of production are short-run
costs and include the costs of the
fixed input and the costs of the
variable inputs.
Total Costs = Fixed Costs + Variable
Costs
In the Long - Run:
No inputs are fixed. All inputs can
be varied. Firms can decide to
build or close factories.
Costs of production are described
as Long-Run-Average-Total Costs
(LRATC). LRATC is a like series of
short-run cost at different levels of
capital expenditure.
Firms can enter and exit markets.
 In the Short-Run there are “fixed” inputs…

The amount that can be produced (Q) depends on levels of fixed and
variable inputs.
Production Function: Q = f(inputs) or Q = f(K, L

Fixed Inputs: (Capital) Variable Inputs: (Labor)

Amount of this input cannot
increase, at least in the short-run.
Things that take time to increase.
E.g. Factory space, capital
equipment.
Amount of this input must
increase to increase production
and is easy to get more of when
you need it.
E.g. Labor, ingredients.

Discussion: What are some fixed and variable inputs used in a cupcake factory?
Homework Question
Definitions: Short-Run Costs of Production
Total fixed costs (TFC) or (FC)
– Cost of Fixed Inputs
– FC > 0 when Q = 0 and
constant after that.
Total variable costs (TVC) or
(VC)
– Cost of variable inputs.
– VC = 0 when Q = and
increasing with Q after that.
Total cost (TC)
– TFC + TVC
– or ATC x Q
Marginal Costs
– MC = ΔTC/ΔQ
Average Fixed costs (AFC)
– TFC / Q
– Per unit fixed cost
Average variable costs (AVC)
– TVC / Q
– Per unit variable cost
Average Total cost (ATC)
– TC / Q
– Per unit total cost
What are these costs in the barber shop
example?
 Costs of Production
Barber Shop Example
L = # of FC = cost of VC = cost of the variable
Workers. The the fixed inputs = # of workers x wage.
variable input. inputs.

ATC =TC/Q
Q = # of units TC = FC + VC
produced.
MC =
ΔTC/ΔQ AVC =VC/Q
 Homework Question

Hint: Use the fact

that fixed costs
are constant over
output levels.

Hint: Use the formula TC = FC + VC

 The Marginal Product of Labor and the
Costs of Production
Example: A barber shop that employs Marginal Product of Labor (MP):
barbers and produces haircuts. The change in output / the change
in labor =(Δ Q / Δ L).

How many more haircuts can be Notice that each barber increases
produced by adding more barbers? output but by less and less.

Marginal Product = Δ Q / Δ L
= 40 – 16 / 2 – 1
= 24 / 1
= 24
 Marginal Product Continued
(L) (Q) MP = Δ Q / Δ L

0 0 --
1 16 = 16–0 / 1 – 0 = 16/ 1 = 16
2 40 = 40-16 / 2 – 1 = 24/1 = 24 Notice: After the 2nd barber
3 60 20 is hired adding more
4 72 12 barbers increases output
but by smaller and smaller
5 80 8 amounts.
6 84 4
7 82 2 Diminishing Marginal
Product / Diminishing
Marginal Returns
 MP Continued
Diminishing Marginal Returns: When hiring another worker increases
output by less than hiring the last worker did. i.e. MP curve is downward
sloping. Additional workers are less productive due to have fixed inputs (e.g.
factory space).
DMR: Starts
when the 3rd
worker is hired.
Increasing Marginal Returns: MP
When hiring another worker 30

increases output by more than

25
hiring the last worker did. When
the MP curve is upward sloping. 20

Caused by specialization and 15

synergy in production.
10

0
0 1 2 3 4 5 6 7 8
 Costs Graphed
Marginal Cost (MC) Curve is “J-Shaped”

Average Total Costs (ATC) & Average

Variable Costs (AVC) are “U-Shaped”

Minimum ATC: Where MC = ATC

Minimum AVC: Where MC = AVC

If MC < ATC If MC = ATC If MC > ATC

then ATC is then ATC is then ATC is
falling. minimized. rising.
 Some Relationships

MP

16 MC < ATC

24 MC < ATC

20 MC < ATC

12 MC = ATC

8 MC > ATC

4 MC > ATC

Note the following Relationships:

When MP is rising MC is falling / When MP is falling MC is rising.
When MC < ATC; ATC is falling
When MC = ATC; ATC is minimum (Q = 72 units).
When MC > ATC; ATC is rising
Same as between MC and AVC
MC minimized where MP is maximized.
 Relationship Between Marginal Costs &
Marginal Product
Recall from table data that Q = 40 When MP is rising MC is falling.
when L = 2 When MP is falling MC is rising.

Maximum MP at L = 2 Lowest MC at L = 2

30 MP

25

20

15

10

0
0 1 2 3 4 5 6 7 8

Diminishing Marginal Returns means decreasing MP and increasing MC.

Generalized Cost Curves
MC is “J-Shaped” due
to diminishing marginal
returns.

ATC & AVC are “U-Shaped”

ATC is above AVC.

MC intersects ATC / AVC at their

lowest points.

Average Fixed Costs are always

declining over output and below
AVC.
Homework Problem
Homework Problem
Homework Problem
 Getting Numbers from Graphs

Sometimes you don’t have table data and need to get cost information from graphs.

What is ATC when Q = 120?

1. Find where Q = 120 on the x-axis

3 2
2. Go up to the curve of the value
that you want to calculate.

3. Go over the x-axis to read the

value. ATC = $40 when Q = 120.

1
By the same process AVC = $30 and
AFC = $10 when Q = 120.
 Using ATC, AVC, and AFC to Calculate Total
Values
What is the total cost of producing 120 units?

Recall:
ATC = 40
AVC = 30
AFC = 10
When Q = 120 3 2

We can now calculate total values

using this information.

Recall the following definitions:

ATC = TC /Q
AVC = VC/ Q
AFC = FC /Q
1
Rearrange terms (i.e. multiply both
sides by Q) to get: Plug in numbers and solve:
TC = ATC x Q TC = ATC x Q = 40 x 120 = 4800
VC = AVC x Q VC = AVC x Q = 30 x 120 = 3600
FC = AFC x Q FC = AFC x Q = 10 x 120 = 1200
 Practice Problem

1. Calculate Total Costs when Q = 35.

2. Calculate Variable Costs when Q = 30.

 Solution

1. Calculate Total Costs when Q = 35. 2. Calculate Variable Costs when Q =

35.
TC = ATC x Q
VC = AVC x Q
TC = 8 x 35 = $280
VC = 6 x 35 = $180
 Long-Run Costs of Production
In the long run, firms can
choose their level of fixed
input (i.e. factory size.)

Each level of a fixed input is

associated with a new
possible short-run cost
curve (SRATC).

The long-run average total cost curve (LRATC) is represented by

connecting these short run cost curves.
 Homework Question

Hint: Hint:
Fixed costs ar Calculate TC at Q = 0 and Q = 1.
constant even VC = 0 when Q = 0
VC = AVC x Q when Q = 1
when Q = 0 TC = FC + VC
MC = Change in TC / Change in Q
 Long-Run Average Total Costs
Economics of Scale:
LRATC is downward sloping.
Increasing output lowers per-
unit cost of production.

Constant Returns to Scale:

LRATC flat. Increasing
output does not change per-
unit cost of production.

Diseconomies of Scale:
LRATC is upward sloping.
Increasing output increases
per-unit costs of production.

Minimum Efficient Scale:

Minimum Q required to reach
constant returns to scale.
 Sources Economies of Scale
Economies of scale: falling per-unit
costs
• Can use mass-production
techniques.
• Spreading costs of management
over more units.
• Can make several products that
utilize complementary
production techniques.
Diseconomies of scale: rising per-
unit costs
• It can be difficult for managers
to monitor activities of
employees.
• Too big to be efficient
• Using so many inputs that input
costs are driven up.
Homework Question
Real World Costs