COST OF PRODUCTIONETP Economics 101FIRMS OBJECTIVEThe Firms ObjectiveThe economic goal of the firm is to maximize profits.TOTAL REVENUE AND TOTAL COSTTotal RevenueThe amount a firm receives for the sale of its output.R(Q)=P(Q) *QTotal CostThe market value of the inputs a firm uses in production.C(Q)PROFITProfit is the firms total revenue minus its total cost.Profit = Total revenue - Total costProfit = Total revenue - Total cost Profit (Q)=R(Q)-C(Q)Profit (Q)=R(Q)-C(Q)FIRMS COST OF PRODUCTIONA firms cost of production includes all the opportunity costs of making its output of goods and services.Explicit and Implicit CostsA firms cost of production include explicit costs and implicit costs.Explicit costs are input costs that require a direct outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm.ECONOMIC PROFIT AND ACCOUNTING PROFITEconomists measure a firms economic profit as total revenue minus total cost, including both explicit and implicit costs.Accountants measure the accounting profit as the firms total revenue minus only the firms explicit costs.When total revenue exceeds both explicit and implicit costs, the firm earns economic profit.Economic profit is smaller than accounting profit.FIGURE 1 ECONOMIC VERSUS ACCOUNTANTSCopyright 2004 South-WesternRevenueTotal opportunity costsHow an Economist Views a FirmHow an Accountant Views a FirmRevenueEconomic profitImplicit costsExplicit costsExplicit costsAccounting profitEXAMPLE: JOE RUNS A SMALL BOAT FACTORYJoe can make 10 boats/year and can sell them for $25,000 each.It costs Joe $150,000 for raw materials.Joe Invests $400,000 in factory and equipments: $200,000 from his own savings and $200,000 borrowed at 10% interest (assume Joe could have loaned his money out at 10% interest). Joe can work at a competing boat factory for $70,000/year.EXAMPLE: CONTINUEDTotal revenue=10*25,000=$250,000Explicit costs =$150,000+($200,000*0.1)=$170,000Total opportunity costs=Explicit +Implicit =$150,000+($200,000*0.1)+($200,000*0.1)+$70,000 =$260,000Accounting profit=$250,000-$170,000=$80,000Economic profit=$250,000-$260,000=-$10,000PRODUCTION FUNCTIONThe Production FunctionThe production function shows the relationship between quantity of inputs used to make a good and the quantity of output of that good.Q= f(L, K), where L is labor and K is capitalMARGINAL PRODUCTMarginal ProductThe marginal product of any input in the production process is the increase in output that arises from an additional unit of that input.Diminishing Marginal ProductDiminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers (labors) are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment (capital). FIGURE 2 HUNGRY HELENS PRODUCTION FUNCTIONCopyright 2004 South-WesternQuantity of Output (cookies per hour)150140130120110100908070605040302010Number of Workers Hired012345Production functionSLOPE OF PRODUCTION FUNCTIONDiminishing Marginal Product The slope of the production function measures the marginal product of an input, such as a worker.When the marginal product declines, the production function becomes flatter.PRODUCTION FUNCTION AND TOTAL COST CURVEThe relationship between the quantity a firm can produce and its costs determines pricing decisions.The total-cost curve shows this relationship graphically.FIGURE 3 HUNGRY HELENS TOTAL-COST CURVECopyright 2004 South-WesternTotalCost$8070605040302010Quantity of Output (cookies per hour)01020 30150130110907050401401201008060Total-cost curveFIXED AND VARIABLE COSTSCosts of production may be divided into fixed costs and variable costs.Fixed costsFixed costs are those costs that do not vary with the quantity of output produced.Variable costsVariable costs are those costs that do vary with the quantity of output produced.FORMULA OF TOTAL COSTTotal Costs (TC)Total Fixed Costs (TFC)Total Variable Costs (TVC)Total Costs (TC) TC = TFC + TVCAVERAGE COSTSAverage Costs Average costs can be determined by dividing the firms costs by the quantity of output it produces. The average cost is the cost of each typical unit of product. Average Costs Average Fixed Costs (AFC) Average Variable Costs (AVC) Average Total Costs (ATC) ATC = AFC + AVCAVERAGE COSTSMARGINAL COSTSMarginal CostMarginal cost (MC) measures the increase in total cost that arises from an extra unit of production.Marginal cost helps answer the following question:How much does it cost to produce an additional unit of output?FORMULA OF MARGINAL COSTNOTEMarginal Cost= Change in Total Cost/Change in Quantity= Change in Variable Cost/Change in QuantityCASE: THIRSTY THELMAS LEMONADE STANDFIGURE 5 THIRSTY THELMAS AVERAGE-COST AND MARGINAL-COST CU