Chapter 13: The Costs of Production

Welcome to Last Minute Lecture.

This free chapter overview is designed to help students review and understand key concepts.

These summaries supplement, not replace the original textbook and may not be redistributed or resold.

For complete coverage, always consult the official text.

Welcome to the deep dive.

Oh.

Okay, let's unpack this.

Today, we're diving into something really fundamental, maybe a bit overlooked sometimes, but crucial for every business.

The costs of production.

Absolutely, it sounds basic, maybe even a little dry.

Right, but it dictates so much.

The price of your coffee, the cars available, you name it.

Whether you're running a huge company or just the local coffee shop we'll talk about later.

These ideas are vital.

So our deep dive today is based on a key chapter from N.

Gregory Mankiw's Principles of Microeconomics.

We really wanna give you a clear, engaging understanding of something that can seem technical.

But it's really not just technical.

No, not at all.

Trust me, once you get this, it really changes how you see the whole business world.

And that's spot on.

What's fascinating, I think, is how these costs really drive market dynamics.

Like, you ever wonder why your town might have tons of pizzerias, but maybe only one cable company?

Yeah, that's a great example.

Understanding cost structures is the key to unlocking puzzles like that.

By the end of this, you'll have a really solid handle on how economists measure costs, how the different types interact, and why it all matters for, well, pretty much everything economic.

Okay, so let's pull back the curtain.

Economists usually start with a core assumption.

Firms wanna maximize profit.

Sounds simple enough.

Right.

Let's use an example, say, Chloe's cookie factory.

She buys ingredients, hires people, uses ovens, sells cookies.

Her whole goal is making the biggest profit possible.

Makes sense.

So we define total revenue as just all the money the firm gets from selling its stuff.

If Chloe sells, say, 10 ,000 cookies at $2 each, that's $20 ,000 in total revenue.

Okay.

Then there's total cost.

That's everything the firm pays for.

Inputs, flour, sugar, wages, electricity for the ovens, all that.

Got it.

And profit.

It's just total revenue minus total cost.

Chloe wants that number as big as possible.

But, and this is a big but for economists, our definition of cost is actually broader than just the checks, Chloe writes.

Broader how?

When we talk about production costs, we mean all the opportunity costs involved.

Remember, an opportunity cost is basically what you give up to get something.

Okay, right.

What you sacrifice.

Exactly.

And these costs come in two main flavors.

First,

explicit costs.

These are the obvious ones.

They require a direct cash payment.

Like the flour bill.

Yep, Chloe's $1 ,000 flour bill or the wages she pays her bakers.

Money actually leaves her account.

Those are explicit.

Okay, that's straightforward.

What's the other kind?

The other kind are implicit costs.

And these are the ones people often miss.

They're opportunity costs that don't need a direct cash payment.

Hmm, like what?

Well, imagine Chloe is also a fantastic computer programmer.

She could be earning say $100 an hour doing that.

Okay.

Every hour she spends managing the cookie factory, she's giving up that $100 she could have earned programming, that lost income.

That's a real economic cost to her business, even though no money changes hands inside the cookie factory for it.

It's an implicit cost.

Ah, okay.

So her own time has an opportunity cost.

What about the money she put into the factory itself, like buying the ovens and stuff?

That feels explicit.

It could be a mix.

And this is where it gets a bit subtle, but really important.

Let's say Chloe needed $300 ,000 to start the factory.

Maybe she used $100 ,000 of her own savings.

Right.

If she hadn't put that $100 ,000 into the factory, maybe she could have put it in a savings account, earning 5 % interest.

That's $5 ,000 a year she's not getting.

That foregone $5 ,000 in interest is an implicit cost of using her own capital.

Now, if she borrowed the other $200 ,000 from a bank and pays, say, $10 ,000 a year in interest on that loan.

That $10 ,000 is explicit because she pays it out.

Exactly.

So the economist sees the total opportunity cost of her capital as both the explicit interest paid on loans and the implicit interest she gave up by using her own funds.

It's the full picture of sacrifice.

Wow.

Okay, so this means a business could look profitable on paper like to an accountant.

But if you factor in these implicit costs, it might actually be losing money from an economic perspective.

That seems like a huge deal for making actual decisions.

It absolutely is.

And this leads straight to the difference between economic profit and accounting profit.

Accounting profit is simple.

Total revenue minus only the explicit costs.

That's what you usually see on financial statements.

Right, the bookkeeping view.

But economic profit is total revenue minus all opportunity costs, both explicit and implicit.

So the accountant's profit figure will often look bigger because it ignores those hidden implicit costs.

The economist's view gives a smaller but arguably more accurate picture of the business's true performance.

So why is that distinction so critical for Chloe or any business owner?

It's huge.

If a firm is making a positive economic profit, that means its revenue is covering absolutely everything, all the explicit bills, plus compensating the owner for their time and their invested capital.

That business is sustainable.

It's creating value.

But if a firm has negative economic profit, even if its accounting profit looks okay, it means the resources, the owner's time, their capital could be better used elsewhere.

They could earn more doing something else.

It's a signal that maybe they need to change things or even think about exiting that market.

It's fundamental for making smart, long run choices.

That makes perfect sense.

Okay, so we've got to handle on what costs really are, including those hidden ones.

Now let's link this to the actual doing the production side of things.

How does making stuff affect these costs?

Let's stick with Chloe's cookie factory and let's simplify for a moment.

Assume in the short run, her factory size is fixed.

She can't just instantly get a bigger kitchen.

Reasonable starting point.

So the only way she can bake more cookies is by hiring more bakers.

Okay, and this brings us to the production function.

It sounds technical, but it's just the relationship between the quantity of inputs used like workers and the quantity of output produced cookies.

So how many cookies you get for how many workers you hire?

Exactly, so table one in the chapter shows this.

Zero workers,

zero cookies.

One worker, maybe 50 cookies an hour.

Two workers, maybe they'd make 90 cookies together.

Three workers get you 120 and so on.

If you were to graph that with workers on the horizontal axis and cookies produced on the vertical, you'd see the production function curve sloping upwards.

More workers, more cookies.

But does each additional baker add the same amount?

If the first one adds 50, does the second one also add 50, making it 100, you said 90.

Good catch.

Usually, no.

This is where marginal product comes in.

It's the increase in output you get from adding one more unit of input, like one more worker.

So the first worker adds 50 cookies, marginal product is 50.

The second worker takes output from 50 to 90, so their marginal product is 40.

The third takes it from 90 to 120, so their marginal product is only 30.

See the pattern?

Yeah, it's going down.

Each extra worker adds less than the one before.

Precisely.

This is a super important principle, diminishing marginal product.

As you add more and more workers to a fixed resource,

Chloe's fixed size kitchen and ovens, each new worker contributes less and less to total production.

Why is that?

Well, think about it.

The kitchen gets crowded,

workers might have to wait to use an oven or share mixing bowls or just bump into each other.

They become less efficient at the margin.

Okay, that makes intuitive sense.

And on that graph of the production function.

That diminishing marginal product makes the production function curve get flatter as you add more workers.

The output still goes up, but by smaller and smaller amounts for each additional worker.

So the takeaway is, making each additional cookie eventually gets harder or requires more input than the one before it.

That sounds like a fundamental challenge for any business.

It absolutely is.

Yeah.

And it directly connects to total costs.

Oh, so.

Well, let's put some costs on this.

Suppose Chloe's factory costs $30 an hour to run.

That's fixed, remember.

And each worker costs $10 an hour.

That's variable.

With one worker making 50 cookies, her total cost is $30 factory plus $10.

Worker, read me $40.

With two workers making 90 cookies, total cost is $30 factory plus $20.

Two workers equals $50.

Right.

Now, if we grab this relationship, plotting the quantity of cookies on the horizontal axis and the total cost on the vertical,

we get the total cost curve.

And what does that curve look like?

Because of diminishing marginal product, the total cost curve gets steeper as output increases.

Think about it.

To get those later increments in cookies where marginal product is low, Chloe has to hire more and more workers for each extra cookie.

So costs rise at an accelerating rate.

Ah, so the flattening production function and the steepening total cost curve are like mirror images.

Exactly.

They're two sides of the same coin, driven by the reality of diminishing marginal product in the short run.

That's a really clear connection.

Okay, let's shift gears slightly.

Forget cookies for a second.

Let's imagine Caleb's coffee shop.

His total cost curve would likely have that same steepening shape, right?

Because of diminishing returns in his coffee shop too.

Same principle applies.

Baristas eventually get crowded around the espresso machine.

But Caleb, like Chloe, needs more detail than just total cost.

Businesses need to break costs down further, don't they?

They really do.

It's crucial for making good decisions.

So we split total costs into two main types again, but slightly differently now.

Fixed costs, FC, and variable costs, VC.

Okay, what are those?

Fixed costs are costs that don't change with the quantity of output.

Caleb pays these even if you make zero coffee.

Think about his rent for the shop space, maybe $3 an hour, or perhaps a flat fee for bookkeeping services.

Those costs are fixed, regardless of coffee sales.

Right, they're locked in, at least in the short term.

Exactly.

Then you have variable costs.

These do change as the quantity of output changes.

For Caleb, this is things like coffee beans, milk, sugar, paper cups.

The more coffee he makes, the more beans he uses.

Precisely.

And also, typically, the wages for his baristas, assuming he pays them hourly and needs more staff to make more coffee, those costs go up, his output goes up.

Okay, so fixed plus variable, total cost.

That's the basic identity.

TC equals FC plus VC.

Yep, that's the one.

So Caleb knows his total cost, and he knows what parts are fixed and what parts vary.

But now, say he wants to figure out, what's the cost of a typical cup of coffee?

Or maybe, how much does my total cost go up if I decide to make just one more cup?

Those feel like really practical questions.

They are, and they lead to different but related cost measures.

To find the cost of a typical unit, Caleb calculates average total cost, ATC.

That's simply total cost divided by the quantity of output, TCQ.

Cost per cup, basically.

Exactly, and we can break that down too.

Average fixed cost, AFC, is fixed cost divided by quantity, FCQ.

And average variable cost, AVC, is variable cost divided by quantity, VCQ.

And just like TC, FC plus VC, does ATC equals AFC plus AVC?

It does, the averages add up too.

Now, for your second question, how much does total cost rise if he makes one more cup?

That's where marginal cost MC comes in.

Marginal cost, the cost of the next one.

Precisely, it's the increase in total cost from producing one additional unit.

Mathematically, it's the change in total cost divided by the change in quantity.

So, if Caleb goes from making two cups to three cups, and his total cost goes from $3 .80 to $4 .50.

Then the marginal cost of that third cup is $0 .70.

You got it.

And knowing that MC is crucial for deciding whether producing that extra unit is actually profitable.

So, if we were to like graph these average and marginal costs, what would they look like?

Do they have typical shapes?

They absolutely do, and the shapes tell us a lot.

First, marginal cost, MC.

For most firms, like Caleb's shop, the MC curve slopes upward.

As output increases, the cost of making that next unit tends to rise, why?

Diminishing marginal product again, the crowded coffee shop.

Exactly, as the shop gets busier, making one more cup requires maybe more effort, more maneuvering, maybe even paying overtime, so the marginal cost goes up.

Now, average total cost, ATC, typically has a U shape.

A U shape, why is that?

It's the result of two opposing forces.

First, average fixed cost, AFC, is always falling as output increases.

That $3 rent gets spread over more and more cups, so the AFC per cup goes down, down, down.

Okay, that pulls the average down initially.

Right, but then you have average variable cost, AVC.

That usually starts to rise at some point, again, because of diminishing marginal product.

Making more coffee eventually requires proportionally more beans, milk, labor per cup.

So the rising AVC starts to pull the average up.

Exactly, at low output levels, the falling AFC is the dominant effect, so ATC slopes down.

But at higher output levels, the rising AVC takes over and pulls the ATC curve back up, hence the U shape.

And the very bottom point of that U.

That lowest point on the ATC curve represents the efficient scale of the firm.

It's the quantity of output where the average total cost is minimized.

For Caleb, maybe that's making five or six cups per hour.

That's where he's most efficient on a per cup basis.

Okay, that's really useful.

And you mentioned there's a key relationship between the marginal cost curve and this U -shaped average total cost curve.

Yes, a crucial one.

Think about your grade point average, your GPA.

That's like ATC.

Now think about the grade you get in your next course.

That's like marginal cost.

Okay.

If your next grade, MC, is lower than your current GPA, ATC, what happens to your GPA?

It goes down.

Right.

And if your next grade, MC, is higher than your GPA, ATC.

It goes up.

Exactly the same logic applies here.

Whenever marginal cost is below average total cost, ATC must be falling.

Whenever marginal cost is above average total cost, ATC must be rising.

So the MC curve must cross the ATC curve precisely at the ATC curve's minimum point

where it stops falling and starts rising.

Ringo.

It's a mathematical necessity.

The MC curve intersects the ATC curve right at the efficient scale.

It's a really fundamental relationship for understanding cost structures.

And while we've mostly talked about diminishing returns kicking in right away, is it possible for marginal cost to actually fall initially?

Yes, that can happen, especially at very low levels of output.

Sometimes adding a second or third worker allows for specialization gains that weren't possible with just one.

Like one focuses on the espresso, the other on steaming milk.

Exactly.

That specialization could actually make them more productive initially,

causing marginal product to rise and marginal cost and average variable cost to fall for a bit before diminishing returns eventually set in.

So you might see MC and AVC dip down before they start rising, making the AVC curve also U -shaped in some cases.

But even with those initial variations.

Right, even with those, three properties generally hold true for typical cost curves.

One, marginal cost eventually rises with output.

Two, the average total cost curve is U -shaped.

And three, the marginal cost curve crosses the average total cost curve at the ATC's minimum.

These are really reliable futures.

This then brings us to a really interesting twist, the idea of the time horizon.

Because what counts as fixed isn't fixed forever, really.

Not at all.

Time changes everything when it comes to costs.

How so?

Well, the division of costs into fixed and variable really depends on how much time you're looking at.

Let's take a big company like Ford.

In the short run, maybe a few months, a year,

Ford can't easily change the number or size of its factories.

That's pretty much fixed.

To produce more cars now, they mainly have to hire more workers, run more shifts at the existing plants.

So factory costs are fixed, labor is variable.

That makes sense.

They're constrained by their current setup.

But in the long run, say, over several years, Ford has much more flexibility.

They can decide to build new factories, expand existing ones, close down older ones.

So over a longer timeframe, even the factory size isn't fixed anymore.

Exactly.

In the long run, pretty much all costs become variable, including the costs associated with the factories themselves.

Ford can choose the factory size, the technology, everything.

So how does this long run flexibility affect their cost curves?

It makes the long run average total cost, LRTC curve, look different.

It's generally much flatter than any single short run ATC curve, though it's also typically U -shaped.

You can think of the long run curve as tracing out the lowest possible average cost for producing any given quantity of output after the firm has had time to adjust its factory size optimally.

So each short run curve representing a specific factory size kind of sits on or above this long run curve.

Precisely.

The long run curve shows the best the firm can do for any output level, once it has chosen the most efficient factory size for that level.

Let's say Ford wants to boost daily production from 1 ,000 to 1 ,200 cars.

In the short run, using its current medium -sized factory, maybe costs per car jump from 10 ,000 to $12 ,000 because of inefficiencies like crowding.

Right.

But in the long run, Ford could build a larger factory perfectly suited for 1 ,200 cars a day, potentially bringing that average cost back down to $10 ,000 per car.

The long run offers the ability to achieve economies of scale.

Okay, so why does that long run ATC curve also tend to be U -shaped?

What drives costs down and then eventually up as a company gets really big?

Great question.

The downward sloping part of the LRATC curve reflects economies of scale.

This happens when long run average total cost falls as output increases.

Why does that happen?

Often it's due to increased specialization.

Think about Adam Smith's famous pin factory example he wrote about centuries ago.

Yes, the pin factory.

Right.

He observed that if one worker did all the steps to make a pin, they can maybe make 20 pins a day.

But if you had 10 workers, each specializing in just one or two steps, drawing the wire, straightening it, cutting it, sharpening the point, adding the head,

they could collectively produce thousands of pins per worker per day.

Wow, massive increase in productivity.

Huge.

That specialization allows for greater efficiency and drives down the average cost per pin.

That's economies of scale.

But eventually the curve slopes upward.

Yes.

At very high levels of output, firms can run into diseconomies of scale.

This is when long run average total cost starts to rise as output increases.

And what causes that?

Often it boils down to coordination problems in massive organizations.

Imagine managing hundreds of thousands of employees across multiple continents, coordinating complex supply chains.

It gets incredibly difficult.

Management can become stretched thin, communication lines get complex, bureaucracy might creep in, making the firm less nimble and pushing average costs up.

So too big can become inefficient.

It can, yes.

And sometimes in between, a firm might experience constant returns to scale where long run average total cost stays flat as output changes.

So that U -shape reflects the journey from benefiting from specialization to potentially struggling with the complexities of massive scale.

What a fantastic overview.

Okay, so let's just quickly recap the big ideas we've hit today.

We really dug into how firms think about costs.

We started with the basics, total revenue, total cost, profit.

But then we got into that crucial economic view of cost, highlighting the difference between explicit out -of -pocket costs and those often hidden implicit opportunity costs.

And how that leads to the vital distinction between accounting profit and the more informative economic profit.

You're right.

Then we linked production to costs through the production function and the concept of diminishing marginal product, which explains why cost curves behave the way they do.

Making the production function flatten and the total cost curve speak in.

Exactly.

Then we sliced costs differently into fixed and variable costs.

And from there, we looked at the per unit costs,

average total cost, average fixed, average variable, and that all -important marginal cost.

Understanding their typical shapes, the rising MC, the U -shaped ATC, and especially that key relationship where MC crosses ATC at its minimal.

And finally, we brought in the time dimension, contrasting the short run, where some costs are fixed, with the long run, where firms have the flexibility to adjust everything, leading to economies or diseconomies of scale.

Thinking about Ford choosing its factory size.

Perfect example.

All these tools, these concepts, they're really essential building blocks for understanding how firms decide what to produce, how much to produce, what price to charge, essentially how markets work.

And maybe this prompts a final thought for you, listing.

How could understanding this difference between explicit and implicit costs maybe help you think about your own decisions?

Not just business ideas, but maybe career choices or even personal investments.

What are the hidden opportunity costs you face?

That's a great point.

And connecting it back.

Next time you see a new product or think about a service you use, maybe pause and consider, what kinds of costs likely went into making that?

How might those costs change if that company gets bigger or smaller?

Thinking about fixed versus variable, short run versus long run, it just gives you a much richer way to understand the economic world unfolding around you.