Production Cost Functions
Business Firm Organizations
- Business firm.
- Purchase resources from other firms and
- Transform resources into products.
- Sell products to consumers.
- All countries have business firms.
- Firms differ by freedom in decision making.
- Socialist countries have less freedom.
- Firms earn profits..
- If business is doing well, the owners earn
- If business is doing badly, the owners earn
- Strong incentive to
- Produce at low cost.
- Provide good service
- Organizing workers.
- owner contracts with individual workers who work
- Takes time, planning, and has high
- Example: Building a house or office
- Team production
- workers are hired by a firm to work together
- Reduces transaction costs.
- Employees are monitored.
- Prevent shirking.
- employees working at less than normal rate of
- Ex: Long coffee & bathroom
- Types of Business Firms.
- owned by a single individual.
- Owner reliable for his business debts.
- Business is dissolved when owner dies.
- Accounts for 73% of business firms.
- Collects 6% of the business revenue.
- Grocery stores.
- owned by a two or more persons acting as
- High risk, because all partners are
responsible for debts incurred by 1 partner.
- If one partner dies, then business has to
- Accounts for 7% of business firms.
- Collects 5% of the business revenue.
- Law firms.
- Accounting firms.
- owned by stockholders.
- Limited liability
- if corporation bankrupts, the creditors cannot
sue the stockholders.
- The stockholders only loose the value of their stocks.
- Ownership can be easily transferred.
- Easy to buy and sell stock.
- Theoretically, a corporation can live
- The stockholders elect the board directors
who in turn select the managers to run the corporation.
- Issuing stock allows the corporation to
gather large amounts of capital.
- Accounts for 20% of business firms.
- Collects 89% of the business revenue.
- Opportunity costs
- the value or costs from the second best alternative, when an
individual makes a decision
- Look forward.
- Included in all production costs.
- If company could use resources to make a more valuable product, then it
would make that product.
- Sunk costs
- historical costs associated with past decisions
that cannot be changed.
- Provide information.
- Not relevant to current choices.
- Example: A university buys a printing machine
to publish a magazine.
- Machine costs $20,000 and will be
depreciated over 10 years.
- (Depreciation expense is $2,000 per
- In Year 3
, subscription revenue is $3,000.
- Depreciation expense is $2,000.
- Paper/ink costs $2,000.
- What should the company do?
- in Year 1, if the university knew this would be the
outcome, then the machine should of not been purchased.
- In Year 3, the machine cost is sunk cost; do not include this cost
- Revenue is $3,000.
- Paper/ink cost is $2,000 for
- Keep the machine operating.
(Minimizing a loss).
- Activity is contributing $1,000.
- Explicit Costs
- when a monetary payment is made.
- Salaries for labor.
- Tax payments.
- Interest payments.
- Buying resources
- Pay utilities
- Opportunity costs
- resources owned by the firm and do not involve a
- Accountants usually omit opportunity costs.
- A proprietor's opportunity cost is working
for his business and earning salary.
profit = total revenue - explicit
costs - implicit costs
profit = total revenue - explicit costs
Accounting profit >
||Firms earning zero economic profit are
earning a normal rate of return. If economic profit is zero, then accounting profit is
If economic profit <
0, then firms are not using resources efficiently.
|Lemonade Stand at the Mall
1st year income statement
|Someone quit his job (earning $20,000) and used his
savings $5,000 to open a business. His savings was earning
10% per year
|Total Revenue (30,000 lemonades @$1)
| Lemons, sugar, paper cups, etc.
| Labor - employees
| Leasing space
| Foregone interest
He is not using all of his resources efficiently.
There is a non-monetary benefit of being your own
Output and Costs in
the Short Run
- a period of time so short that at least one
factor of production is fixed. Usually buildings and large machines
1. Fixed Costs
- Total Fixed Costs (TFC)
- the costs do not change when production level
- Insurance premiums.
- Property taxes.
- Loans or bonds on factory building or
- Average Fixed Costs
(AFC) - fixed costs per good
- As production level increases, AFC will get
smaller and smaller.
- The fixed costs is spread out over more
AFC = TFC / Output
|Total Fixed Cost
||Average Fixed Cost
2. Variable Costs
- Total Variable Costs
- the costs that varies when the production level changes.
- Labor costs
- Raw material costs
- Average Variable Cost (AVC) -
variable costs per unit of a good produced.
AVC = TVC / Output
|Total Variable Costs
||Average Variable Costs
Marginal Cost (MC)
- the increase in cost as production increases by one unit; MC will decline initially, reach a minimum,
and then rise.
|Cost per unit
- Example: A factory starts with 0 workers.
- Specialization of labor
- Production gains.
- MC decreases.
- 1 worker - output is 10 units (10 units per
- 2 workers - output is 30 units (15 units
- 3 workers - output is 60 units (20 units
- Law of Diminishing Returns
- Output increases by a smaller and smaller
amount as more labor (variable resource) is added to a factory (fixed resource).
- Production inefficiency.
- Exists only in the short run.
- 50 workers - output is 1,000 units (20 units
- 60 workers - output is 1,100 units (18.3
units per worker)
4. The Total Costs and Average
Total Cost (TC)
= Total Fixed Cost + Total Variable Cost
TC = TFC + TVC
Total Cost (ATC) = Average Fixed
Cost + Average Variable Cost.
ATC = AFC + AVC = TC /
All relevant cost functions are graphed below:.
|Total Cost Curves
||Average Cost Curves
- MC < ATC, then ATC is decreasing.
- MC > ATC. then ATC is increasing.
- MC intersects ATC at its minimum point.
- Example: Student's score is 80% and student completed 2 tests.
- 3rd test (i.e. marginal).
- Scores 90%, average increases.
- Scores 70%, average decreases.
5. Product curves - Do not worry
about the shape of these curves.
- Total product - total output of a good associated with different
levels of a variable input (e.g. labor).
- Marginal product - change in total product with a one more unit of a
variable input (e.g. labor).
- Average product
- total product divided by the number of the units
of the variable input (e.g. labor).
||Average Costs Curves
|TC, TVC, TFC
||ATC, AFC, AVC, MC
||Total Product, Marginal Product, Average
|Total costs for output
||Per-unit costs for output
||Output for a resource input
|All curves are related to each other!
However, the Average Costs Curves are the most important, because we can
derive the supply function.
Output and Costs in
the Long Run
1. Long run
- is a period of time sufficient for the firm to
alter all factors of production.
- Firms can enter and exit the industry.
- Long run differs by industry.
- Examples: Long run for an automobile
factory using lots of machines may be 7 years.
- The long run for an internet company may be
- Long-Run ATC
- shows the minimum average cost of producing each
output level when a firm is able to vary all production resources, including factory size.
- Allow the firm to vary among 3 factory
sizes: ATC 1, ATC 2, ATC 3.
Which factory size should the firm produce at?
|Long Run ATC
ATC 2 will give the
factory the lowest per unit costs in the long run. The firm will be able to
recuperate all its total costs, when:
Expected market price (Pe)
> = min. of long-run ATC
2. Why unit costs differ in the long run?
|Long Run ATC
- Economies of scale
- per-unit costs fall as output (plant size)
- Mass production.
- Large amounts of capital and machines.
- Specialization of labor.
- Constant returns
to scale - per-unit costs
are constant as plant size is changed.
- Small firms can be just as efficient as
- Diseconomies of scale
- per-unit costs rises as output (plant size)
- Bureaucratic inefficiencies.
- More difficult to coordinate workers
- Monitoring problems.
- Employees may not be working
Factors that Shift Firm's Cost Functions
- Prices of resources
- if a price of a resource used in production
increases, the cost curves shift higher.
- Labor costs increase.
- Example: Price of steel increases for
- increasing taxes on businesses.
- increasing regulations on businesses. Firm
has to hire compliance specialists, gather data and information, and submit reports.
This can be a large cost.
- Environmental regulations.
- Health & safety regulations.
- Labor regulations.
- allows firms to produce more output while using
the same level of resources.
- Microprocessor - compressed millions of
transistors onto one chip. Uses less silicone wafers, less labor, less wires, uses
less energy, etc.
|Decrease in Production Costs
||Increase in Production Costs