Economics / Unit 4: Supply and Market Equilibrium
4.3 Costs of Production
Notes
Firms decide how much to produce by comparing costs and revenues.
- Fixed costs do not change with output (rent, insurance). Variable costs rise with output (materials, hourly wages).
- Total cost $=$ fixed cost $+$ variable cost. Average total cost $\displaystyle = \frac{\text{total cost}}{\text{quantity}}$.
- Marginal cost (MC) is the extra cost of producing one more unit. Marginal revenue (MR) is the extra revenue from selling one more unit.
- A firm maximizes profit by producing up to the point where $MR = MC$: keep making units while MR is at least MC.
- Diminishing marginal returns: after a point, adding more workers to fixed equipment raises output by smaller and smaller amounts, so marginal cost starts to rise.
| Output | Total cost | Marginal cost |
|---|---|---|
| 0 | $100 | |
| 1 | $130 | $30 |
| 2 | $150 | $20 |
| 3 | $180 | $30 |
| 4 | $230 | $50 |
| 5 | $300 | $70 |
- Worked example: fixed cost is $100 (cost at zero output). If each unit sells for $60, the firm makes 4 units, since the 5th unit's MC of $70 is more than $60. Profit at 4 units is $240 - 230 = 10$ dollars.
Practice
A t-shirt shop pays $500 a month in rent and $4 in materials for each shirt. If it makes 200 shirts in a month, its total cost is:
Fixed $500 plus variable $4 \times 200 = 800$ dollars equals $1,300.
A firm's total cost rises from $240 to $275 when it makes a 7th unit instead of 6. The marginal cost of the 7th unit is:
Marginal cost is the change in total cost: $275 - 240 = 35$.
Which cost is a fixed cost for a pizza restaurant?
Rent stays the same no matter how many pizzas are made.
Ready for more? Take the Unit 4 test.