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Production Cost Functions
Lecture 7


Business Firm Organizations


  1. Business firm.
    • Purchase resources from other firms and households.
    • Transform resources into products.
    • Sell products to consumers.
  2. All countries have business firms.
    • Firms differ by freedom in decision making.
    • Socialist countries have less freedom.
  3. Firms earn profits..
    • If business is doing well, the owners earn profits.
    • If business is doing badly, the owners earn a loss.
    • Strong incentive to
      • Produce at low cost.
      • Provide good service
  4. Organizing workers.
    • Contracting - owner contracts with individual workers who work independently.
      • Takes time, planning, and has high transaction costs.
      • Example: Building a house or office building.
    • Team production - workers are hired by a firm to work together under supervision.
      • Reduces transaction costs.
      • Employees are monitored.
      • Prevent shirking.
      • Shirking - employees working at less than normal rate of productivity.
        • Ex: Long coffee & bathroom breaks.
  5. Types of Business Firms.
    • Proprietorship - 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.
        • Farms.
        • Grocery stores.
        • Restaurants.
    • Partnership - owned by a two or more persons acting as co-owners.
      • High risk, because all partners are responsible for debts incurred by 1 partner.
      • If one partner dies, then business has to be reorganized.
      • Accounts for 7% of business firms.
      • Collects 5% of the business revenue.
        • Law firms.
        • Accounting firms.
    • Corporation - 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 forever.
      • 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.

Economic Costs

  • 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 year).
      • In Year 3 , subscription revenue is $3,000.
      • Depreciation expense is $2,000.
      • Paper/ink costs $2,000.
        • A $1,000 loss.
    • What should the company do?
    • Economists - 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 paper/ink.
      • 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 monetary payment.
    • Accountants usually omit opportunity costs.
    • A proprietor's opportunity cost is working for his business and earning salary.

Economic profit = total revenue - explicit costs - implicit costs

Accounting profit = total revenue - explicit costs

Accounting profit > Economic profit


Blue arrow Firms earning zero economic profit are earning a normal rate of return. If economic profit is zero, then accounting profit is positive.

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) $30,000
Explicit Costs  
     Lemons, sugar, paper cups, etc. $10,000
     Taxes $2,000
     Labor - employees $5,000
     Leasing space $3,000
Accounting profit $10,000
Opportunity Costs  
     Salary $20,000
     Foregone interest $500
Economic profit ($10,500)

Blue arrow He is not using all of his resources efficiently.

Note: There is a non-monetary benefit of being your own boss.


Output and Costs in the Short Run


Short run - a period of time so short that at least one factor of production is fixed. Usually buildings and large machines and equipment.

1. Fixed Costs

  • Total Fixed Costs (TFC) - the costs do not change when production level changes.
    • Insurance premiums.
    • Property taxes.
    • Loans or bonds on factory building or machines.
  • Average Fixed Costs (AFC) - fixed costs per good produced.
    • As production level increases, AFC will get smaller and smaller.
    • The fixed costs is spread out over more units.

AFC = TFC / Output


Total Fixed Cost Average Fixed Cost
Costs Per-Unit Costs
Total fixed costs Average fixed costs
Output/Quantity Output/Quantity

2. Variable Costs

  • Total Variable Costs (TVC) - 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
Costs Per-Unit Costs
Total variable costs Average variable costs

3. Marginal Cost (MC) - the increase in cost as production increases by one unit; MC will decline initially, reach a minimum, and then rise.

Marginal Cost
Cost per unit
Marginal costs
  • Example: A factory starts with 0 workers.
    • Specialization of labor
      • Production gains.
      • MC decreases.
    • 1 worker - output is 10 units (10 units per worker).
    • 2 workers - output is 30 units (15 units per worker).
    • 3 workers - output is 60 units (20 units per worker).
    • 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 per worker).
    • 60 workers - output is 1,100 units (18.3 units per worker)

4. The Total Costs and Average Curves

Total Cost (TC) = Total Fixed Cost + Total Variable Cost


Average Total Cost (ATC) = Average Fixed Cost + Average Variable Cost.

ATC = AFC + AVC = TC / Output

All relevant cost functions are graphed below:.

Total Cost Curves Average Cost Curves
Total cost Per-unit cost
Total costs Average total costs
Output/Quantity Output/Quantity
  • 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).
Cost Curves Average Costs Curves Product Curves
TC, TVC, TFC ATC, AFC, AVC, MC Total Product, Marginal Product, Average Product
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 1 year.
  • 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
Per-Unit Cost
Long-run average total costs
Blue arrow

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
Long-run average total costs
  • Economies of scale - per-unit costs fall as output (plant size) expands.
    • 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 large firms.
      • Apparel.
      • Publishing.
      • Lumber.
      • Retailing.
  • Diseconomies of scale - per-unit costs rises as output (plant size) expands.
    • Bureaucratic inefficiencies.
    • More difficult to coordinate workers
    • Monitoring problems.
    • Employees may not be working

Factors that Shift Firm's Cost Functions


  1. 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 automobile industry.
      • Supply decreases.
  2. Taxes - increasing taxes on businesses.
    • Supply decreases.
  3. Regulations - 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.
      • Supply decreases.
  4. Technology - 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.
      • Supple increases.
Decrease in Production Costs Increase in Production Costs
Per-unit cost Per-unit cost
A decrease in production costs An increase in production costs
Output/Quantity Output/Quantity

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