Costs of Production

• Total Revenue (TR): The amount a firm receives for the sale of its output $TR = \text{Price} \times \text{Quantity}$
• Total Cost (TC): The market value of the inputs a firm uses in production.
• Profit: Total revenue minus total cost $Profit = TR - TC$ Explicit Costs: Input costs that require an outlay of money by the firm (e.g., paying wages, buying raw materials, paying rent).

Implicit Costs: Input costs that do not require an outlay of money (e.g., the value of the owner’s time, the interest income foregone by using personal savings to start the business).

Accounting Profit: Total Revenue minus only Explicit Costs. This is usually a higher number because it ignores “hidden” opportunity costs.

Economic Profit: Total Revenue minus all opportunity costs (Explicit + Implicit).

Marginal Product: This is the increase in output that arises from an additional unit of input.

*$Marginal\ Product = \frac{\Delta\ Output}{\Delta\ Input}$

Diminishing Marginal Product: This is the property whereby the marginal product of an input declines as the quantity of the input increases.

• Example: In a small kitchen, the first few workers are very productive. As you add more workers, they start getting in each other’s way or waiting for the oven, so each additional worker adds less to total output than the one before.

The production function and the total-cost curve are two sides of the same coin. As the production function gets flatter (due to diminishing marginal product), the total-cost curve gets steeper.

• Total-Cost Curve: A graph showing the relationship between the quantity of output produced and the total cost of production.
• The Logic: If each additional worker produces less output (diminishing marginal product), then producing additional units of output requires more and more labor. Therefore, the cost of producing those extra units rises.

Measure of Costs

• Fixed Costs (FC): Costs that do not vary with the quantity of output produced (e.g., rent, insurance, cost of machinery). Even if the firm produces zero, these costs remain.

• Variable Costs (VC): Costs that change as the firm alters the quantity of output produced (e.g., raw materials, wages for production workers).

• Total Cost (TC): The sum of fixed and variable costs.

  $TC = FC + VC$

Average costs tell us the cost of a typical unit of product.

• Average Fixed Cost (AFC): Fixed cost divided by the quantity of output. As production increases, AFC always declines (this is called “spreading the overhead”).

  $AFC = FC / Q$

• Average Variable Cost (AVC): Variable cost divided by the quantity of output.

  $AVC = VC / Q$

• Average Total Cost (ATC): Total cost divided by the quantity of output. It is also the sum of AFC and AVC.

  $ATC = TC / Q$

This is the most important measure for decision-making. It tells us the increase in total cost that arises from an extra unit of production.

$MC = \Delta TC / \Delta Q$