Up to now, the supply curve has served as a summary
of the behavior of (competitive) firms.
In the next few chapters: A more detailed look at firm
First, in chapter 13:
What are firms trying to achieve?
How do a firm’s costs vary with the quantity of
output it produces?
Basic behavioral assumption of the economic theory of
Firms try to maximize profit.
Profit = total revenue - total cost.
Total revenue: the amount a firm receives for the sale
of its output.
Total cost: the opportunity cost of the firm’s inputs.
Two kinds of opportunity costs of inputs:
Explicit costs: opportunity costs that require an outlay
of money by the firm
(wages of employees, payments for the purchase of
raw materials, rent, utility bills, etc.)
Implicit costs: opportunity costs that do not require an
outlay of money by the firm
(Usually, these are opportunity costs of using
resources already owned by the firm.)
The two most important implicit costs:
Opportunity costs of:
. . . owner’s labor (measured by foregone earnings),
. . . owner’s financial capital (measured by foregone
return on next best alternative investment.)
“Accounting profit” vs. “Economic profit”
Economists recognize explicit and implicit costs.
Accountants generally recognize explicit costs only.
Example: Dave’s Dependable Do-dads.
If Dave weren’t running his own business, he would work
as a machinist for somebody else; salary = $50,000/yr.
Dave invests $300,000 of his savings in his business. Next best
alternative investment would pay interest @ 5%/yr.
2010 total revenue = $600,000
explicit costs = $530,000
(wages, raw materials, rent,
utility bills, etc.)
implicit costs = $ 65,000
(opportunity cost of Dave’s
labor ($50,000) and financial
capital ($300,000 @ 5% = $15,000))
Accounting profit = $70,000
Economic profit = $5,000
Accountants are mainly interested in keeping track of
Economists are mainly interested in predicting business
Dave’s positive economic profit (+$5,000) means that
his business is more than covering all costs . . .
. . . including the opportunity costs of the
resources he owns and invests in business
(his labor and financial capital).
This means Dave should keep the business going.
(The resources he owns and has invested are earning
a higher return than they would in their next-best
Suppose that the “going wage” for machinists
(opportunity cost of Dave’s labor) increases to
No change in accounting profit.
Economic profit falls to -$5,000 (negative!! $5,000).
Negative economic profit means that Dave would be
better off investing his labor and financial capital in
He should close Dave’s Dependable Do-dads.
Recall second basic question in chapter 13:
How do a firm’s costs vary with the quantity of
output it produces?
First: How does a firm’s output vary with inputs?
For real-world firms, production usually requires many
different kinds of inputs . . .
. . . that differ in how rapidly their employment levels
can be adjusted.
raw materials: usually pretty easy to change (up or
down) the quantities that are delivered each month.
low-skill labor: usually pretty easy to hire more workers
and train them -- or to lay off some current workers.
management/technical personnel: recruiting and
training take a little longer than for low-skill workers.
specialized machinery: often a relatively long wait for
delivery and installation.
build new (or expand current) factory: many months
spent in planning and construction.
Simple “thought model” for analysis of firm decision-
Two time frames for decision making: “short-run”
and “long run”
Short-run: Some inputs (“variable inputs”) are freely
variable; other inputs (“fixed inputs”) are absolutely
Long-run: All inputs are freely variable.
Let’s make it even a little simpler: Just two inputs.
All fixed inputs lumped together and called “factory.”
All variable inputs lumped together and called “labor.”
Technological factors determine how much output can
be produced from given inputs.
From economist’s point of view, production technology
production function: describes the relationship between
the quantity of inputs used and the quantity of
Symbolically: Q = f(X1, X2, . . ., Xk),
where Q is quantity of output and X1, X2, . . ., Xk are
quantities of k different inputs.
A tabular presentation of a simple, two input, short-run,
production function. For a factory of given size . . .
Quantity of Quantity of Marginal
labor output product
(workers/day) (widgets/day) (widgets/worker)
Marginal product: the increase in output that arises
from an additional unit of one input, holding other
Diminishing marginal product: the property of a
production function whereby the marginal product
declines as the quantity of the input increases.
A feature of almost all real-world production functions.
As “labor” (the variable input) increases, the size of the
“factory” (the fixed input) is held fixed.
If both labor and factory were increasing (each extra
worker brought with her some “extra factory”),
perhaps we’d expect roughly equal increments to
output with each increase in inputs.
When we add extra workers only, additional workers
have to share materials and equipment, work in more
crowded conditions, etc.
Output continues to increase with each extra worker,
but by smaller and smaller increments.
A brief digression for those who know some calculus:
Our definition of marginal product . . .
(increase in output for 1 unit increase in input)
. . . is an approximation to the rate of change of
output with respect to the input.
Marginal products are partial derivatives.
With the production function represented by:
Q = f(X1, X2, . . ., Xk),
. . . the marginal product of the second input, for
example, is the partial derivative of
f(X1, X2, . . ., Xk) with respect to X2:
Diminishing marginal product says that . . .
. . . as X2 increases, holding X1, X3, . . . Xk fixed, . . .
. . . this partial derivative decreases.
Recap: Production function (in tabular form, for
example) describes how output varies, in the short-
run as the variable input increases.
Next: How do costs vary, in the short-run, as output
Definitions of some short-run cost functions:
fixed costs (FC): costs that do not vary with the
quantity of output produced (costs of fixed inputs).
variable costs (VC): costs that do vary with the quantity
of output produced (costs of variable inputs).
total costs (TC): costs of both fixed and variable inputs.
TC = FC + VC.
average fixed cost (AFC): fixed costs per unit of output.
AFC = FC ÷ Q.
average variable cost (AVC): variable costs per unit of
output. AVC = VC ÷ Q.
average total cost (ATC): total costs per unit of output.
ATC = TC ÷ Q.
Note: ATC = AFC + AVC.
marginal cost (MC): the increase in total cost that arises
from an extra unit of production.
This “marginal cost” accompanies “total cost.”
How about “marginal fixed cost”? . . .
. . . or “marginal variable cost”?
Building on the short-run production function from
earlier . . .
. . . and adding some extra assumptions:
Cost of factory = $30/day.
(Firm has entered a long-term lease that calls for
payment of rent = $30/day, even if the firm produces
nothing at all.)
Workers are hired at a wage of $10/worker/day.
The first two columns are the same as before:
labor output FC VC TC AFC AVC ATC MC
(wrkrs/d) (wdgt/d) --- ($/day) --- --- ($/widget) --- ($/wdgt)
0 0 30 0 30 -- -- --
1 50 30 10 40 0.60 0.20 0.80
2 90 30 20 50 0.33 0.22 0.55
3 120 30 30 60 0.25 0.25 0.50
4 140 30 40 70 0.21 0.29 0.50
5 150 30 50 80 0.20 0.33 0.53
Recall: Marginal cost = the increase in total cost due to
a 1 unit increase in production.
The data tell us the increases in total cost (DTC’s) due
to output increases (DQ’s) of more than 1 unit.
Estimate marginal cost:
MC = DTC ÷ DQ
Graphing the three average costs and marginal cost:
Note: For best approximation graphing MC, I’ve plotted
each value against midpoint of corresponding
Three key things to note about this graph:
1. MC increases as output increases.
MC = DTC ÷ DQ
= wage ÷ [DQ due to additional worker]
(because of the way our table is set up)
= wage ÷ MP
Diminishing MP implies increasing marginal cost.
2. There is a special relationship between MC and ATC.
Q1 Q3 Q2 (widgets/day)
Where MC < ATC, ATC is falling. “Average-
Where MC > ATC, ATC is rising. marginal
Where MC = ATC, ATC is “flat.”
Example: Cumulative GPA (“average”) and the grade in
the next course you take (“marginal”).
Cumulative GPA Grade in “marginal” course.
3. ATC is “U-shaped.”
This follows from first two (increasing MC and
Initially low MC pulls ATC down to start, but . . .
. . . increasing MC eventually crosses ATC . . .
. . . and, thereafter, pulls ATC up.
The numbers in our example are hypothetical, . . .
. . . but they do reflect one important feature of
real-world production functions:
diminishing marginal product.
We’ve seen how this feature leads to three key
properties of short-run cost curves:
1. Increasing MC
2. “Average-marginal rules”
3. “U-shaped” ATC.