Lecture: Production & Costs
Lecture script · about 15–20 minutes spoken · Week 9
Opening
Picture a small bakery early in the morning. There's one kitchen, one oven, and a few people rolling dough. The owner is wondering whether to hire one more person. Down the street, a furniture maker is wondering something that sounds different but isn't: why does the sixth chair of the day cost 48 dollars to make, three times what the third chair costs?
Those are the questions this week answers. A bakery owner weighs them before every hire. A furniture maker or a home-based caterer weighs them before taking one more order.
Here's where we are. In Week 1 you met opportunity cost, the value of the best thing you give up. Weeks 3 through 7 built the supply-and-demand model and used it to measure surplus, price controls, and taxes. And in Week 8 you picked up the habit of thinking at the margin: do one more unit while its extra benefit is at least its extra cost.
Up to now, the supply curve was a line someone handed you. In this lecture we open up the business behind it. I'll start with the difference between the short run and the long run. Then we'll watch the bakery's output grow, and see why each new worker eventually adds less. After that we'll take a chair workshop's costs apart, one kind at a time. And we'll finish with a question every small-business owner should ask: is the business really beating the owner's next-best job?
1. The short run and the long run
Think about how fast a bakery can change. It can call in another worker by tomorrow morning. It can't build a second kitchen by tomorrow. Some inputs change fast, and some take a long time.
Economists sort time by exactly that difference. The short run is a period in which at least one of a firm's inputs, such as the size of its kitchen or workshop, is fixed and cannot be changed. The long run is a period long enough that a firm can change every input, including the size of its building.
So for the bakery, the kitchen and the oven are fixed, and workers are the input that can change. For the chair workshop, the room and the tools are fixed, and the wood and the paid hours can change. Everything in this lecture happens in the short run.
Pause and try this. A coffee cart can add a second barista this week, but it can't get a bigger cart for a year. Which input is fixed in its short run?
Think about which input can't move yet.
Here's the answer. The cart itself is fixed, because it can't change until the long run, while the number of baristas can change right away.
2. Total, marginal, and average product
Now let's watch the bakery work. The owner keeps a simple record of how many loaves come out each day with different numbers of workers. These numbers are built for this course, not taken from a real bakery.
With no workers, it makes nothing. With 1 worker, 10 loaves. With 2, 25. With 3, 45. With 4, 60. With 5, 70. And with 6, 75 loaves a day. That row is called total product: the total output a firm makes with a given amount of a variable input.
The more useful question is what each new worker adds. That's marginal product: the extra output from adding one more unit of a variable input, such as one more worker. You find it by subtracting. The first worker adds 10 loaves. The second adds 15. The third adds 20. Then the fourth adds 15, the fifth adds 10, and the sixth adds 5.
There's a third measure, average product, which is output per worker. You find it by dividing. With 3 workers, 45 loaves divided by 3 is 15 loaves per worker.
Pause and try this. With 4 workers the bakery makes 60 loaves. Is the 4th worker's marginal product 15 or 60?
Think about whether you subtract or divide.
Here's the answer. It's 15, because 60 minus the 45 loaves made by three workers leaves 15 extra loaves from the newest worker.
3. The law of diminishing marginal returns
Look again at what each worker adds: 10, 15, 20, and then 15, 10, 5. It climbs, and then it falls. Why?
The first few workers can split the jobs. One mixes, one shapes, one watches the oven. That's specialization, the idea from Week 2. But the kitchen doesn't grow. By the fourth worker, people are sharing one counter and waiting on one oven. Each new person has less room and less oven time than the one before.
That pattern has a name. The law of diminishing marginal returns says that as more of a variable input is added to a fixed input, the marginal product of the variable input eventually falls. In this bakery, diminishing returns set in with the fourth worker.
Two things to notice. First, the extra worker isn't lazy. In this model every worker is equally good. The sixth adds only 5 loaves because the kitchen is full. Second, total output never falls. It keeps rising, from 60 to 70 to 75 loaves. It rises more slowly, that is all.
Here's a picture to hold. Imagine a group project with one laptop. Two people can trade off. A third can take notes. A sixth person mostly watches.
Pause and try this. A classmate says diminishing returns at the bakery start with the first worker. What would you point to?
Think about where the extra loaves first get smaller.
Here's the answer. Marginal product rises from 10 to 15 to 20 before it falls, so diminishing returns begin with the fourth worker, not the first.
4. Fixed, variable, and total cost
Now let's move from loaves to dollars, and from the bakery to a chair workshop. Again, these numbers are built for this course.
Some of the workshop's bills arrive no matter what. The rent and the tools cost 60 dollars a day, whether it makes no chairs or 6. That's fixed cost: a cost that doesn't change with how much a firm produces in the short run.
Other bills grow with every chair: the wood and the paid hours. That's variable cost, a cost that rises and falls with output. For 1 to 6 chairs, variable cost is 30, 50, 66, 88, 120, and 168 dollars.
Put them together and you get total cost: fixed cost plus variable cost. So total cost runs 60 with no chairs, then 90, 110, 126, 148, 180, and 228 dollars for 6 chairs.
Notice that a day with no chairs still costs 60 dollars. That's what makes a cost fixed.
Pause and try this. If the workshop made zero chairs one day, what would its total cost be?
Think about which bills still arrive.
Here's the answer. It would be 60 dollars, because the fixed cost of rent and tools is paid whether or not any chairs get made.
5. Marginal cost
The question an owner asks most often isn't "what did everything cost?" It's "what will one more chair add?" That's the marginal question from Week 8, now asked about costs.
Marginal cost is the change in total cost from producing one more unit of output. You find it by subtracting each total from the next. The first chair adds 30 dollars. The second adds 20. The third adds 16. Then the fourth adds 22, the fifth adds 32, and the sixth adds 48.
So marginal cost falls for a while, then climbs. And the climb is diminishing returns showing up in dollars. Once the room is crowded, each chair takes more paid work, so each chair costs more.
Here's something worth seeing. The 60 dollars of fixed cost never shows up in marginal cost. It's inside every total, so it cancels out of every subtraction. You'd get the same six numbers by subtracting variable cost alone.
Pause and try this. A friend says the first chair costs 90 dollars, since total cost at one chair is 90. What's the slip?
Think about what happens to the rent either way.
Here's the answer. The 60 dollars of rent is paid with or without that chair, so the first chair adds only 90 minus 60, which is 30 dollars.
6. The three averages
Marginal cost looks at the next chair. Averages share the whole bill out evenly. Each average is a cost divided by the number of chairs.
Average fixed cost is fixed cost divided by the number of units. It falls every time: 60, 30, 20, 15, 12, and 10 dollars, because the same rent gets spread over more chairs. Average variable cost is variable cost divided by the number of units. It runs 30, 25, 22, 22, 24, and 28 dollars, lowest at 22 for 3 and 4 chairs. Average total cost is total cost divided by the number of units. It runs 90, 55, 42, 37, 36, and 38 dollars, lowest at 36 for 5 chairs.
Let me describe the picture these numbers make. Put chairs along the bottom and dollars per chair up the side. Average fixed cost slides downward the whole way. Average variable cost dips to 22 and climbs. Average total cost sits above it, dips to 36 at 5 chairs, and climbs again.
Pause and try this. At 5 chairs, is the cost of the 5th chair 32 dollars or 36 dollars?
Think about whether the question is about one chair or all five.
Here's the answer. The 5th chair adds 32 dollars; 36 is the average total cost of all five chairs together.
7. Why marginal crosses the averages at their lowest points
Here's a pattern worth slowing down for. Think about your quiz average. If you've been averaging 80 and your next quiz is a 70, your average drops. If the next one is a 95, it rises. A new score below your average pulls it down, and a new score above it pulls it up.
Costs work the same way. A marginal value below an average pulls the average down, and one above it pulls the average up. The 5th chair's marginal cost is 32 dollars, below the average of 37 at 4 chairs, so average total cost falls to 36. The 6th chair's 48 is above 36, so the average rises to 38.
That's why the marginal-cost curve passes through each average near its lowest point. While new chairs cost less than the average, the average keeps falling. Once a new chair costs more, it turns up.
One caveat. Marginal cost starts rising at the 4th chair, but average total cost keeps falling until 5 chairs. Why? The 4th and 5th chairs, at 22 and 32 dollars, still cost less than the average.
Pause and try this. The 3rd chair's marginal cost is 16 dollars and average variable cost at 2 chairs is 25. Which way does average variable cost move?
Compare the new chair with the average so far.
Here's the answer. It falls to 22, because 16 is below 25, and a new value below the average pulls the average down.
8. Explicit and implicit costs
So far every cost was a bill. But some costs never arrive as a bill at all.
Picture a mechanic who quits a job at a garage to open her own shop. Nobody bills her for the salary she gave up. Yet she gave it up. That's opportunity cost from Week 1, now inside a business.
An explicit cost is a cost a firm pays out in money, such as rent, wages, or materials. An implicit cost is the opportunity cost of resources the owner supplies without a money payment, such as the earnings the owner gives up to run the business and the return the owner's savings could have earned elsewhere.
Pause and try this. A shop owner uses a building she already owns and pays no rent. Does the building cost her anything?
Think about what else she could do with it.
Here's the answer. Yes, it carries an implicit cost, because she gives up the rent a tenant would have paid her for it.
9. Accounting profit and economic profit
Two kinds of cost give two kinds of profit. Accounting profit is revenue minus explicit costs, the profit on a firm's books. Economic profit is revenue minus both explicit and implicit costs.
Here's a case built for this course. A phone-repair stand brings in 80,000 dollars a year and pays 50,000 dollars in explicit costs. So its accounting profit is 30,000 dollars. But its owner left a job paying 36,000 dollars, and her savings could have earned 1,000 dollars in interest. Her implicit costs are 37,000 dollars. Take those away too, and her economic profit is negative 7,000 dollars, an economic loss.
So the books say profit, and the owner is still 7,000 dollars behind her next-best choice. Both are true.
What would zero economic profit mean? It doesn't mean she earns nothing. It means she earns exactly what her time and money would earn in their next-best use. If the stand had brought in 87,000 dollars, she'd be right at zero.
Pause and try this. Someone calls the stand's 30,000 dollars its economic profit. What label should it carry?
Ask which costs were taken away.
Here's the answer. It's accounting profit, because only the explicit costs were subtracted, and the owner's forgone salary and interest were left out.
10. The classic wrong turns
Most slips this week are small and fixable. Let me name the four I see most.
First, marginal versus average. Marginal comes from subtracting one row from the next. Average comes from dividing by the quantity. The 5th chair adds 32 dollars; the average of five chairs is 36.
Second, where diminishing returns start. Look for the first marginal product smaller than the one before. At the bakery that's the fourth worker.
Third, fixed cost in a marginal decision. It's in total cost and average total cost, but never in marginal cost.
Fourth, which profit. Accounting profit subtracts explicit costs. Economic profit subtracts implicit costs too.
Pause and try this. A chatbot tells you that because average total cost is lowest at 5 chairs, marginal cost must be lowest there too. Where would you look to check?
Look back at the marginal-cost row.
Here's the answer. Marginal cost is lowest at the 3rd chair, at 16 dollars, so the two lows land at different quantities.
Closing
Let's pull it together. In the short run at least one input is fixed, and in the long run every input can change. At the bakery, marginal product rose to 20 and then fell, so diminishing returns set in with the fourth worker. At the chair workshop, total cost is fixed cost plus variable cost, and marginal cost fell to 16 and then climbed to 48. The averages bottomed out at 22 for average variable cost and 36 for average total cost, and marginal cost crossed each one near its low. And at the phone-repair stand, an accounting profit of 30,000 dollars hid an economic loss of 7,000.
Next in this module, look through the slide deck, then the Readings and Resources page, and then work the lecture tutorial, the practice set, and the quiz. Next week, in Week 10, Perfect Competition, a market price meets this cost table, and the workshop decides how many chairs to make.
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