Cost of Production – Unit 6

Firm and Production

• Firm (or producer or business) combines inputs of labor, capital, land,
and technology to produce outputs
• Production: is manufacturing, and any process or service that creates
value, including transportation, distribution, wholesale and retail sales
• Each business, regardless of size or complexity, tries to earn a profit
Profit = Total Revenue – Total Cost
Total Revenue = Price X Quantity
• Total cost is what the firm pays for producing and selling its products
• Explicit and Implicit costs
Explicit and Implicit costs
• Explicit costs: out-of-pocket costs, which are actual payments
• E.g. Wages, office rent, equipment costs

• Implicit costs: more subtle but equally important. They represent the
opportunity costs of using resources that the firm already owns.
• E.g. Owners who work in a business while not earning a formal salary
• E.g. Depreciation of goods, materials, and equipment necessary for company
to operate
Profit – Accounting and Economic
• Accounting Profit: is a cash concept and is a difference between
dollars brought in and dollars paid out
• Accounting Cost = Explicit cost
• Account profit = Revenue – explicit costs

• Economic Profit is total revenue

• Economic cost = Explicit cost + Implicit cost
• Economic profit = Revenue – explicit costs – implicit costs

From now on, all costs are automatically ECONOMIC COSTS

Profit – Sample problem
• Anita currently works for a corporate law firm and makes $125k per
year. She is considering opening her own legal practice, where she
expects to earn $200k per year once she establishes herself. To run
her own firm, she would need an office and a law clerk. She has
found the perfect office, which rents for $50k per year. She could hire
a law clerk for $35k per year. If these figures are accurate, would
Anita’s legal practice be profitable?
Profit - Solution
• Total explicit costs: $85k
• Total implicit costs: $125k
• Accounting profit: $115k
• Economic profit: -$10k

• Implicit costs can include other things as well. May be Anita values
her leisure time and starting her own firm would require her to put in
more hours than at her current job. In this case, lost leisure would
also be an implicit cost that would subtract from economic profits
Normal profit
• Condition of zero economic profit is called Normal profit
• If a firm’s normal profit is zero, resources cannot be made better off
in any other activity
• E.g. Roger Federer decides to open a pizza shop

Accounting vs Economic profit

Sales from Federer's pizza shop $ 5 million
Explicit costs $ 2 million
Accounting profit $ 3 million
Implicit costs (Tennis income) -$ 25 million
Economic profit or (loss) -$ 22 million
Production inputs
To earn profit, firms must make products (output)
Inputs are the resources used to make outputs.
Input resources are also called FACTORS.

• Fixed inputs: are those that can’t be increased or decreased in a short

period of time. E.g. in a restaurant, the building is a fixed input
• Fixed inputs define the firm’s maximum output capacity. This is analogous to
potential real GDP shown by society’s production possibilities curve

• Variable inputs: that can be easily increased or decreased in a short

period of time. E.g. Food ingredients or workers
Total product and Marginal product
• Total product: amount of output produced with a given amount of
labor and a fixed amount of capital
• Marginal product: is additional output of one more worker
Marginal product = Change in Output / Product
Change in Input
• Average Product = Total Output
Variable Input
Production Function – sample problem
Total Product (TP)
Quantity of Input Marginal Product Average Product
(gallons of grape
(workers hired) (MP) (AP)
juice)
0 0 - -
1 5 5 5
2 20 15 10
3 45 25 15
4 60 15 15
5 70 10 14
6 72 2 12
7 63 -9 9

• Consider the production function above for gallons of grape juice

produced by different number of workers
• Calculate Marginal Product and Average Product
 Production Function - solution
Total Product (TP)
Quantity of Input Marginal Product Average Product
(gallons of grape
(workers hired) (MP) (AP)
juice)
0 0 - -
1 5 5 5
2 20 15 10
3 45 25 15
4 60 15 15
5 70 10 14
6 72 2 12
7 63 -9 9

• Each worker adds more marginal product initially due to specialization of

labor – increasing marginal returns
• As more workers are hired, each worker adds less to MP due to more
variable resources being added to fixed resources (grape-stomping vats) –
diminishing marginal returns – however TP is still increasing
• Finally, after a certain point, MP turns negative leading to negative amounts
of production and TP falling – negative marginal returns
Three Stages of Returns
Stage I: Increasing Marginal Returns
MP rising. TP increasing at an increasing rate.
Why? Specialization.
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor
Marginal Product
Three Stages of Returns
Stage II: Decreasing Marginal Returns
MP Falling. TP increasing at a decreasing rate.
Why? Fixed Resources. Each worker adds less and less.
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor
Marginal Product
Three Stages of Returns
Stage III: Negative Marginal Returns
MP is negative. TP decreasing.
Workers get in each other’s way
Total
Product
Total
Product

Quantity of Labor

Marginal
and
Average Average Product
Product

Quantity of Labor 14
Marginal Product
Law of Diminishing Marginal Product
• When we add more inputs (workers), marginal product increases at
first but sooner or later additional workers will have decreasing
marginal product
• Eventually, there may be no effect or negative effect on output
• This is Law of Diminishing Marginal Product
• Similar to Law of Diminishing Marginal Utility

Too many cooks in the

kitchen!
Practice
• Calculate MP and AP; then discuss what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0
1 10
2 25
3 45
4 60
5 70
6 75
7 75
8 70
Practice
• Calculate MP and AP; then discuss what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10
2 25 15
3 45 20
4 60 15
5 70 10
6 75 5
7 75 0
8 70 -5
Practice
• Calculate MP and AP; then discuss what the graphs for TP, MP, and AP look like.
Remember quantity of workers goes on the x-axis.
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75
Identify the three stages of returns
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75
Identify the three stages of returns
# of Workers Total Product(TP) Marginal Average
(Input) PIZZAS Product(MP) Product(AP)
0 0 - -
1 10 10 10
2 25 15 12.5
3 45 20 15
4 60 15 15
5 70 10 14
6 75 5 12.5
7 75 0 10.71
8 70 -5 8.75
Production Function
• MP always intersects AP at AP’s highest
point

• If MP is higher than AP, AP is rising

• If MP is below AP, AP is falling

More Examples of the Law of Diminishing Marginal Returns
Example #1: Learning curve when studying for an exam
• Fixed Resources-Amount of class time, textbook, etc.
• Variable Resources-Study time at home
Marginal return-
• 1st hour-large returns
• 2nd hour-less returns
• 3rd hour-small returns
• 4th hour- negative returns (tired and confused)
Example #2: A Farmer has fixed resource of 8 acres planted of corn. If he
doesn’t clear weeds he will get 30 bushels. If he clears weeds once he will
get 50 bushels. Twice -57, Thrice-60. Additional returns diminishes each
time.
Costs of Production
Production (Short run vs Long run)
• Short run: is a period of time when at least one production input is
fixed and supply cannot fully adjust to changes in demand
• E.g. A restaurant is limited to using its current premises while it is in a
lease – the owner can’t choose a larger or smaller building
• Long run: is period of time during which all resources used in
production are variable and supply can adjust to changes in demand
• E.g. The same restaurant can move to a larger or smaller place one the
lease expires
Different Economic Costs
Total Costs
• FC = Total Fixed Costs
• VC = Total Variable Costs
• TC = Total Costs
Per Unit Costs
• AFC = Average Fixed Costs
• AVC = Average Variable Costs
• ATC = Average Total Costs
• MC = Marginal Cost
Costs in Short-run (Fixed and Variable costs)
• Fixed costs: are costs of fixed inputs (E.g. Capital)
• They do not change regardless of level of production
• E.g. Factory or retail space rent, cost of machinery or equipment,
research and development, advertising to popularize a brand
name
• Variable costs: are costs of variable inputs (E.g. Labor)
• They increase or decrease with output
• E.g. Labor, raw materials
• Total Cost = Fixed cost + Variable cost
Costs in Short-run (Average and Marginal)
• Average cost is the cost on average of producing a given quantity
Average Cost = Total Cost / Quantity of output
• Marginal cost is the cost of producing an additional unit of output
Marginal Cost = Change in Total cost / Change in quantity

Marginal cost of first unit of output is always the same as total cost
Costs in Short-run - continued

• Fixed cost of space and equipment: $160

• Each barber costs $80 per day
• Total cost = Fixed cost + Variable cost
Costs in Short-run - continued
• At zero production, fixed cost (FC) of
$160 is still present
• When product starts, total costs (TC)
and variable costs (VC) rise
• While initially VC rises at a decreasing
rate, at some point they begin
increasing at an increasing rate
• Too many barbers will lead to a lower
output
• Another example could be watering
the fields
ATC, AVC, MC and AFC
• Average Total Cost (or Average cost) =
Total cost / Quantity of output
• ATC starts off relatively high because at low levels
of output total costs are dominated by fixed cost
• Average Variable Cost =
Variable cost / Quantity of output
• AVC curve will always lie below curve for ATC
• As output grows, fixed costs become relatively
less important so AVC curve gets closer to ATC
curve
ATC, AVC, MC and AFC
• Marginal Cost is additional cost of producing
one more unit of output
MC = Change in Total cost / Change in
quantity
• MC curve is generally upward sloping because of
law of diminishing marginal returns that states
that additional units are more costly to produce
• Average Fixed Cost:
AFC = Total fixed cost / quantity of output
Practice – Calculate TC, VC, FC, ATC, AFC, MC
TP VC FC TC MC AVC AFC ATC
0 0 100
1 10
2 16
3 21
4 26
5 30
6 36
7 46
Draw this in your notes
Practice – Calculate TC, VC, FC, ATC, AFC, MC
TP VC FC TC MC AVC AFC ATC
0 0 100
1 10 100
2 16 100
3 21 100
4 26 100
5 30 100
6 36 100
7 46 100
Practice – Calculate TC, VC, FC, ATC, AFC, MC
TP VC FC TC MC AVC AFC ATC
0 0 100 100
1 10 100 110
2 16 100 116
3 21 100 121
4 26 100 126
5 30 100 130
6 36 100 136
7 46 100 146
Total Costs Graphically
Combining VC TC
With FC to get
800 VC
Total Cost
700 Fixed Cost
Costs (dollars)

600
500
400
300
200
100 FC
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
Total Costs Graphically
Combining VC TC
With FC to get
800 VC
Total Cost
700 Fixed Cost
Costs (dollars)

600
500 What is the TOTAL
400 COST, FC, and VC
300
for producing 9
units?
200
100 FC
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 -
1 10 100 110
2 16 100 116
3 21 100 121
4 26 100 126
5 30 100 130
6 36 100 136
7 46 100 146
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 -
1 10 100 110 10
2 16 100 116 6
3 21 100 121 5
4 26 100 126 5
5 30 100 130 4
6 36 100 136 6
7 46 100 146 10
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - -
1 10 100 110 10 10
2 16 100 116 6 8
3 21 100 121 5 7
4 26 100 126 5 6.5
5 30 100 130 4 6
6 36 100 136 6 6
7 46 100 146 10 6.6
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - -
1 10 100 110 10 10 100
2 16 100 116 6 8 50
3 21 100 121 5 7 33.3
4 26 100 126 5 6.5 25
5 30 100 130 4 6 20
6 36 100 136 6 6 16.67
7 46 100 146 10 6.6 14.3
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Per Unit Costs
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 40.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Per Unit Costs (Average and Marginal)
MC
12
11
10 ATC
9
AVC
Costs (dollars)

8
7
6 How much does
5
4
the 11th unit costs?
3
2
1 AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
Per-Unit Costs (Average and Marginal)
MC ATC and AVC get
closer and closer but
12 NEVER touch
11
10 ATC
9
AVC
Costs (dollars)

8
7
6
5 Average
4 Fixed Cost
3
2
1 AFC
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
Per-Unit Costs (Average and Marginal)

At output Q, what
area represents:
TC 0CDQ
VC 0BEQ
FC 0AFQ or BCDE
Why is the MC curve U-shaped?
12
11 MC
10
9
Costs (dollars)

8
7
6
5
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quantity
Why is the MC curve U-shaped?
• The MC curve falls and then rises because of diminishing marginal returns.
Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost
for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0
1 5
2 13
3 19
4 23
5 25
6 26
Why is the MC curve U-shaped?
• The MC curve falls and then rises because of diminishing marginal returns.
Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost
for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0 -
1 5 5
2 13 8
3 19 6
4 23 4
5 25 2
6 26 1
Why is the MC curve U-shaped?
• The MC curve falls and then rises because of diminishing marginal returns.
Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost
for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0 - $20
1 5 5 $30
2 13 8 $40
3 19 6 $50
4 23 4 $60
5 25 2 $70
6 26 1 $80
Why is the MC curve U-shaped?
• The MC curve falls and then rises because of diminishing marginal returns.
Example: Assume the fixed cost is $20 and the ONLY variable cost is the cost
for each worker ($10)

Workers Total Prod Marg Prod Total Cost Marginal Cost

0 0 - $20 -
1 5 5 $30 10/5 = $2
2 13 8 $40 10/8 = $1.25
3 19 6 $50 10/6 = $1.6
4 23 4 $60 10/4 = $2.5
5 25 2 $70 10/2 = $5
6 26 1 $80 10/1 = $10
Why is the MC curve U-shaped?
• The additional cost of the first 13 units produced falls because
workers have increasing marginal returns.
• As production continues, each worker adds less and less to
production so the marginal cost for each unit increases.
Workers Total Prod Marg Prod Total Cost Marginal Cost
0 0 - $20 -
1 5 5 $30 10/5 = $2
2 13 8 $40 10/8 = $1.25
3 19 6 $50 10/6 = $1.6
4 23 4 $60 10/4 = $2.5
5 25 2 $70 10/2 = $5
6 26 1 $80 10/1 = $10
Relationship between Production and Cost
Average product and
marginal product

Why is the MC curve U-shaped?

• When marginal product is increasing,
marginal cost falls
MP • When marginal product falls, marginal
Quantity of labor costs increase.
MC
Costs (dollars)

MP and MC are mirror images of each

other.

Quantity of output
Average produc
marginal prod

Relationship between
MP Production and Cost
Quantity of labor
MC Why is the ATC curve U-shaped?
Costs (dollars)

When the marginal cost is below the average, it

pulls the average down.
ATC •When the marginal cost is above the average,
it pulls the average up.
Quantity of output

The MC curve intersects the ATC curve at its lowest point.

Example:
•The average income in the room is $50,000.
•An additional (marginal) person enters the room: Bill Gates.
•If the marginal is greater than the average it pulls it up.
•Notice that MC can increase but still pull down the average.
Intersection of MC and ATC
• MC crosses ATC at the lowest point of
ATC
• In the figure on the right it is at $7 and
75 units of output
• If MC is below ATC then cost of
producing one more unit will reduce
ATC (downward sloping ATC curve)
• Conversely, if MC is above ATC, then
cost of producing one more unit will
increase the ATC (upward sloping ATC
curve)
ATC, AVC, MC – sample problem
ATC, AVC, MC - solution
Shifting
Cost
Curves
Shifting Costs Curves
TP VC FC TC MC AVC AFC ATC
0 0 What if Fixed
100 100 - - - -
1 10 100 110 10 10 100 110
2 16
Costs increase to
100 116 6 8 50 58
3 21 100 $200
121 5 7 33.3 30.3
4 26 100 126 3 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Shifting Costs Curves

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 100 - - - -
1 10 200 110 10 10 100 110
2 16 200 116 6 8 50 58
3 21 200 121 5 7 33.3 30.3
4 26 200 126 5 6.5 25 31.5
5 30 200 130 4 6 20 26
6 36 200 136 6 6 16.67 22.67
7 46 200 146 10 6.6 14.3 20.9
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 100 110
2 16 200 216 6 8 50 58
3 21 200 221 5 7 33.3 30.3
4 26 200 226 5 6.5 25 31.5
5 30 200 230 4 6 20 26
6 36 200 236 6 6 16.67 22.67
7 46 200 246 10 6.6 14.3 20.9
Which Per Unit Cost Curves Change?
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 100 110
2 16 200 216 6 8 50 58
3 21 200 221 5 7 33.3 30.3
4 26 200 226 5 6.5 25 31.5
5 30 200 230 4 6 20 26
6 36 200 236 6 6 16.67 22.67
7 46 200 246 10 6.6 14.3 20.9
ONLY AFC and ATC Increase!
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 110
2 16 200 216 6 8 100 58
3 21 200 221 5 7 66.6 30.3
4 26 200 226 5 6.5 50 31.5
5 30 200 230 4 6 40 26
6 36 200 236 6 6 33.3 22.67
7 46 200 246 10 6.6 28.6 20.9
ONLY AFC and ATC Increase!
Shifting Cost Curves
If fixed costs change ONLY AFC and ATC Change!
TP VC FC TC MC AVC AFC ATC
0 0 200 200 - - - -
1 10 200 210 10 10 200 210
2 16 200 216 6 8 100 108
3 21 200 221 5 7 66.6 73.6
4 26 200 226 5 6.5 50 56.5
5 30 200 230 4 6 40 46
6 36 200 236 6 6 33.3 39.3
7 46 200 246 10 6.6 28.6 35.2
MC and AVC DON’T change!
Shift from an increase in a Fixed Cost
MC
ATC1

ATC
Costs (dollars)

AVC

AFC1
AFC
Quantity
Shift from an increase in a Fixed Cost
MC
ATC1
Costs (dollars)

AVC

AFC1

Quantity
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 What if the cost for
100 110 10 10 100 110
2
3
16
21
variable resources
100
100
116
121
6
5
8
7
50
33.3
58
30.3
4 26 100 increases?
126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 10 100 110 10 10 100 110
2 16 100 116 6 8 50 58
3 21 100 121 5 7 33.3 30.3
4 26 100 126 5 6.5 25 31.5
5 30 100 130 4 6 20 26
6 36 100 136 6 6 16.67 22.67
7 46 100 146 10 6.6 14.3 20.9
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 110 10 10 100 110
2 18 100 116 6 8 50 58
3 24 100 121 5 7 33.3 30.3
4 30 100 126 5 6.5 25 31.5
5 35 100 130 4 6 20 26
6 43 100 136 6 6 16.67 22.67
7 55 100 146 10 6.6 14.3 20.9
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 10 10 100 110
2 18 100 118 6 8 50 58
3 24 100 124 5 7 33.3 30.3
4 30 100 130 3 6.5 25 31.5
5 35 100 135 4 6 20 26
6 43 100 143 6 6 16.67 22.67
7 55 100 155 10 6.6 14.3 20.9
Which Per Unit Cost Curves Change?
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 10 100 110
2 18 100 118 7 8 50 58
3 24 100 124 6 7 33.3 30.3
4 30 100 130 6 6.5 25 31.5
5 35 100 135 5 6 20 26
6 43 100 143 8 6 16.67 22.67
7 55 100 155 12 6.6 14.3 20.9
MC, AVC, and ATC Change!
Shifting Cost Curves
TP VC FC TC MC AVC AFC ATC
0 0 100 100 - - - -
1 11 100 111 11 11 100 110
2 18 100 118 7 9 50 58
3 24 100 124 6 8 33.3 30.3
4 30 100 130 6 7.5 25 31.5
5 35 100 135 5 7 20 26
6 43 100 143 8 7.16 16.67 22.67
7 55 100 155 12 7.8 14.3 20.9
MC, AVC, and ATC Change!
Shifting Cost Curves
If variable costs change MC, AVC, and ATC Change!

TP VC FC TC MC AVC AFC ATC

0 0 100 100 - - - -
1 11 100 111 11 11 100 111
2 18 100 118 7 9 50 59
3 24 100 124 6 8 33.3 41.3
4 30 100 130 6 7.5 25 32.5
5 35 100 135 5 7 20 27
6 43 100 143 8 7.16 16.67 23.83
7 55 100 155 12 7.8 14.3 22.1
Shift from an increase in Variable Costs
MC1
MC
ATC1
AVC1
ATC
Costs (dollars)

AVC

AFC
Quantity
Shift from an increase in Variable Costs
MC1

ATC1
AVC1
Costs (dollars)

AFC
Quantity
Taxes and Shifting cost curves
• Per-unit taxes: is a tax on each additional unit of output produced. It
is a variable cost not a fixed cost. E.g. Excise tax per unit
• Shifts MC, ATC, and AVC curves upwards but not AFC

• Lump-sum taxes: is a fixed and unchanging tax regardless of quantity

produced.
• Shifts AFC and ATC upwards, not MC or AVC

Type of Tax Cost curves affected

Per-unit tax (excise tax) Marginal cost (MC), average total cost (ATC), average variable cost (AVC)
Lump-sum tax Average fixed cost (AFC), average total cost (ATC)
LONG
RUN
COSTS
Definition and Purpose of the Long Run
In the long run, all resources are variable. Plant capacity/size
can change.
Why is this important?
Long run is used for planning. Firms use it to identify which plant size results in
lowest per-unit cost
Ex: Assume a firm is producing 100 bikes with a fixed number of resources
(workers, machines, etc.)
If this firm decides to DOUBLE the number of resources, what will happen to
the number of bikes it can produce?
There are only three possible outcomes:
1. Number of bikes will double (constant returns to scale)
2. Number of bikes will more than double (economies of scale)
3. Number of bikes will less than double (diseconomies of scale)
Long Run ATC
What happens to the average total costs of a product when a
firm increases its plant capacity?
Example of various plant sizes:
•I make looms out of my garage with one saw
•I rent out a building, buy 5 saws, hire 3 workers
•I rent a factory, buy 20 saws and hire 40 workers
•I build my own plant and use robots to build looms.
•I create plants in every major city in the U.S.

Long Run ATC curve is made up of all the different short run ATC
curves of various plant sizes.
Economies of Scale
Why does economies of scale occur?
• Firms that produce more can better use Mass Production
Techniques and Specialization.
Example:
• A car company that makes 50 cars will have a very high average cost per
car.
• A car company that can produce 100,000 cars will have a low average
cost per car.
• Using mass production techniques, like robots, will cause total cost to be
higher but the average cost for each car would be significantly lower.
Long Run AVERAGE Total Cost
Costs MC1
ATC1

$9,900,000

$50,000

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

Quantity Cars
Long Run AVERAGE Total Cost
Economies of Scale- Long
Costs MC1 Run Average Total Cost
ATC1 falls because of the use of
MC2 mass production
$9,900,000 techniques.
ATC2
$50,000

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

Quantity Cars
Long Run AVERAGE Total Cost
Economies of Scale- Long
Costs MC1 Run Average Total Cost falls
ATC1 because of the use of mass
MC2 production techniques.
$9,900,000
MC3

ATC2
$50,000 ATC3

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

Quantity Cars
Long Run AVERAGE Total Cost
Constant Returns to Scale-
Costs MC1 The long-run average total
ATC1 cost is as low as it can get.
MC2
$9,900,000
MC3
MC4
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

0 1 100 1,000 100,000 1,000,0000

Quantity Cars
Long Run AVERAGE Total Cost
Diseconomies of Scale-
Costs MC1 Long run costs increase as
ATC1 the firm gets too big and
MC2
difficult to manage.
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

Quantity Cars
Long Run AVERAGE Total Cost
Diseconomies of Scale- The
Costs MC1 LRATC is increasing as the
ATC1 firm gets too big and
MC2
difficult to manage.
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

Quantity Cars
Long Run AVERAGE Total Cost
These are all short run
Costs MC1 average cost curves. Where
ATC1 is the Long Run Average
MC2
Cost Curve?
$9,900,000 MC5
MC3
MC4 ATC5
ATC2
$50,000 ATC3 ATC4

$6,000

$3,000

Quantity Cars
Long Run AVERAGE Total Cost
Costs
Economies of Constant Diseconomies
Scale Returns to of Scale
Scale

Quantity Cars
LRATC Simplified
The law of diminishing marginal returns doesn’t apply in the long run
because there are no FIXED RESOURCES.
Costs
Economies of Constant Diseconomies
Scale Returns to Scale of Scale

Long Run
Average Cost
Curve

Quantity
Difference between economies of scale and
diminishing marginal returns
• Diminishing marginal returns refers only to short-run average cost
curve, where one variable input is increasing but other inputs are
fixed
• Economies of scale refers to long-run average cost curve where all
inputs are allowed to increase together
• It is possible and common for an industry to have both diminishing
marginal returns when only one input is allowed to change and
economies of scale when all inputs change together to produce a
large-scale operation