Economics Chapter 13
The cost of Production
Total revenue, total cost, profit
We assume that the firms goal is to maximize profit.
Profit = Total Revenue – Total Cost
[The market value of the inputs a firm uses in production]
[The amount a firm receives from the sale of its output]
Costs: Explicit vs. Implicit
Explicit Costs: require an outlay of money, e.g., paying wages to workers.
Implicit Cost: Do not require a cash outlay, e.g., the opportunity cost of the owners times
Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business. The interest rate is 5%.
Case 1: borrow $100,000
explicit cost = $5000 interest on loan
Case 2: use $40,000 of your savings,
borrow the other $60,000
explicit cost = $3000 (5%) interest on the loan
implicit cost = $2000 (5%) foregone interest you could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
Economic Profit vs. Accounting Profit
= total revenue minus total explicit costs
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs, so it’s higher than economic profit. Exercise 1 Economic Profit vs. Accounting profit
The equilibrium rent on office space has just increased by $500/month.
Compare the effects on accounting profit and economic profit if
A) you rent your office space
B) you own your office space
The rent on office space increases $500/month.
A) You rent your office space.
Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.
B) You own your office space.
Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month
(opp. cost of using your space instead of renting it), so economic profit falls by $500/month.
The Production Function
A production function shows the relationship between the quantity of inputs used to produce a good
and the quantity of output of that good.
It can be represented by a table, equation, or graph.
Farmer Jack grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.
Example 1: Farmer Jack’s Production Function Marginal Product
If Jack hires one more worker, his output rises by the marginal product of labour.
The marginal product of any input is the increase in output arising from an additional unit of that
input, holding all other inputs constant.
∆ (delta) = “change in…”
∆Q = change in output, ∆L = change in labour
Marginal product of labour (MPL) = ∆Q
EXAMPLE 1: Total & Marginal Product Example 1: MPL= Slope of Prod Function
Why MPL is Important
Recall one of the Ten Principles:
Rational people think at the margin.
When Farmer Jack hires an extra worker,
his costs rise by the wage he pays the worker
his output rises by MPL
Comparing them helps Jack decide whether he would benefit from hiring the worker.
Farmer Jack’s output rises by a smaller and smaller amount for each additional worker. Why?
As Jack adds workers, the average worker has less land to work with and will be less productive.
In general, MPL diminishes as L rises whether the fixed input is land or capital (equipment, machines,
Diminishing marginal product: the marginal product of an input declines as the quantity of the input
increases (other things equal) EXAMPLE 1: Farmer Jack’s Costs
Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Jack’s costs are related to how much wheat he produces….
Ex.1: Farmer Jack’s Total Cost Curve
Marginal Cost (MC) is the increase in Total Cost from producing one more unit:
Example 1: Total and marginal Cost Example 1: The marginal Cost Curve
Why MC Is Important
Farmer Jack is rational and wants to maximize his profit. To increase profit, should he produce
more or less wheat?
To find the answer, Farmer Jack needs to “think at the margin.”
If the cost of additional wheat (MC) is less than the revenue he would get from selling it, then
Jack’s profits rise if he produces more. Fixed