Chapter 13: Costs of Production

Fixed costs, variable costs, and the curves that connect them

Section 1

Two Kinds of Cost

Economists count costs that accountants miss. There are two types: explicit costs — actual cash payments like wages and rent — and implicit costs — the value of what you gave up to do this instead.

What counts as an implicit cost?

Implicit costs

The value of what you gave up. If you quit your $40,000 job to start a business, that forgone salary is an implicit cost — no money left your wallet, but you're still $40,000 poorer in the economic sense.

Because of implicit costs, economists and accountants calculate profit differently:

Accounting profit Revenue − explicit costs
Economic profit Revenue − explicit costs − implicit costs

Mary opens a bakery. She left a $40,000/year office job to do it. In year one, the bakery brings in $50,000 in revenue and spends $30,000 on supplies and rent.

  • Accounting profit = $50,000 − $30,000 = $20,000 (the books look fine)
  • Implicit cost = the $40,000 salary she gave up
  • Economic profit = $50,000 − $30,000 − $40,000 = −$20,000

Her books show a profit, but she'd be $20,000 better off back at the office. That's the economic view.

Economists include both explicit and implicit costs; accountants include only explicit costs. True or False?

Section 2

Workers, Output, Diminishing Returns

Before you can talk about costs, you need to know how many workers it takes to make each unit. The MPL tells you exactly that.

MPL = ΔQ ΔL  (change in output ÷ change in workers)

The curve bends — each worker adds less output than the last. That's diminishing marginal product.

Early workers specialize — big output gains. Add more workers to a fixed factory and they crowd each other; each new hire adds less. When MPL falls, each unit needs more workers, so MC rises. MC and MPL are mirror images.

MPL (falling)

MPL Workers MPL

MC (rising)

MC Output (Q) MC ($)

MPL falls → MC rises. Mirror images.

In the Silph Co. table (next section), where do diminishing returns first appear?

Section 3

The Cost Table

Five formulas the exam will test:

Total Cost (TC) TC = FC + VC
Average Fixed Cost (AFC) AFC = FC / Q
Average Variable Cost (AVC) AVC = VC / Q
Average Total Cost (ATC) ATC = TC / Q = AFC + AVC
Marginal Cost (MC) MC = ΔTC / ΔQ

Silph Co. makes telescopes. The setup:

  • Factory costs $120/day regardless of output → FC = $120
  • Each worker earns $10/day
  • Each scope needs $20 in raw materials
  • So VC = (workers × $10) + (Q × $20)

Fill in the blank cells and check your work. Hover headers for full names. The dim. tag in the MPL column marks diminishing returns (MPL falling); the * next to Q marks efficient scale (min ATC).

Workers Q FC VC TC AFC AVC ATC MC MPL

Section 4

Reading Cost Curves

  • AFC always falls — fixed cost spreads over more units.
  • AVC U-shaped — falls early, then rises (diminishing returns).
  • ATC U-shaped — AFC pulls it down at low Q; AVC pushes it up at high Q.
  • MC U-shaped — crosses ATC and AVC at their minimums.

Drag the slider — the panel shows whether ATC is falling or rising and why.

4

At Q = 4

AFC —
AVC —
ATC —
MC —

Move the slider to explore.

Batting average analogy: MC is today's score; ATC is your season average. Score below average → average drops. Score above → average rises. Average is lowest exactly when today's score equals it. Same logic: ATC is lowest where MC = ATC.

If the marginal cost of the 10th unit is $2.50 and average total cost at Q=10 is $3.00, is ATC rising or falling?

Section 5

Returns to Scale

If a firm doubles its output, does each unit get cheaper, stay the same, or cost more? Depends on the firm. Three cases:

Firm Q = 1 Q = 2 Q = 3 Q = 4 Q = 5 What this shows
Firm A
Economies of scale 		$100 $100 $100 $100 $100 TC stays flat as Q grows — output outpaces cost. LRATC falls (from $100 to $20 per unit).
Firm B
Constant returns 		$100 $200 $300 $400 $500 TC rises in step with Q (doubles when Q doubles). LRATC flat at $100 per unit.
Firm C
Diseconomies of scale 		$100 $300 $600 $1,000 $1,500 TC triples when Q doubles — cost outpaces output. LRATC rises (from $100 to $300 per unit).

Which firm has constant returns to scale?

The Long-Run ATC Envelope

In the long run, a firm picks any plant size. Each plant has its own SRATC. The LRATC is the lowest ATC achievable at each output — it hugs the bottom of all possible SRATC curves.

Each SRATC (blue) = one plant size. The LRATC (green) traces the lowest possible cost at each output.

Section 6

Takeaways

Tap each to expand.

  • Accountants track cash only. Economists add the value of what you gave up. Mary's bakery showed $20,000 accounting profit but −$20,000 economic profit because she gave up a $40,000 salary.
  • In the Silph table, Q=2 through Q=4 each take just 1 extra worker — specialization means every new hire contributes a full telescope. But from Q=5 on, each extra scope needs more workers than the last: 3 extra at Q=5, then 4, 5, 6. MPL falls and MC rises — they're mirror images.
  • AFC = FC/Q always falls. AVC = VC/Q is U-shaped. ATC = TC/Q = AFC + AVC is U-shaped. MC = ΔTC/ΔQ — the cost of one more unit.
  • When MC < ATC, each new unit is cheaper than the average, pulling ATC down. When MC > ATC, each new unit is more expensive, pushing ATC up. ATC is lowest exactly where MC catches up to it. In the Silph table, MC hits ATC at Q=6: both equal $60, which is the minimum ATC — the efficient scale.
  • Constant returns: output and cost grow together (LRATC flat — Firm B). Diseconomies: output grows slower than cost (LRATC rises — Firm C). In the long run, a firm picks the plant size that minimizes ATC — the LRATC envelope.