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Chapter Six

Cost of Production
Factors

 Fixed Factor
 Variable Factor
 Time Factor
Fixed Factors

 Factors which do not increase or decrease


with amount of output of good that firm is
producing.
 Example: Factory building, plant, equipment,
permanent staff etc
 Whether output is zero or increasing some of
the fixed factors are used
Variable Factor

 Factors which increase or decrease with the


output level of good produced.
 Example: Raw material, Labor
 It increases with the level of output
increases. When there is no good produced
there is no usage of variable factor.
Time factor

 Short-run
 Long-run
Short-Run Production Relationship

Labor-Output relationship
Given fixed plant capacity

Total Product (TP): Total Quantity or output of a


particular product.

Marginal Product (MP): Additional Output associated


to adding additional input.
MP = Changes in TP / Changes in Labor input
Short-Run Production Relationship

Marginal Product (MP): Additional Output


associated to adding additional input.
MP = Changes in TP / Changes in Labor input

Average Product (AP): labor productivity, output


per unit of labor input
AP = TP / Units of Labor
Short-Run Production Relationship
(1) (2) MP, Changes in AP,
Units of TP (2) / Changes in (2)/(1)
(1)
labor
0 0 -- --
1 10 10 10
Increasing
2 25 15 12.5
Marginal
3 45 20 Returns 15
4 60 15 15
5 70 10 Diminishing 14
Marginal
6 75 5 Returns 12.5
7 75 0 10.71
Law of Diminishing Returns

 Assume
• Technology is fixed.
• Techniques of production do not change.
• All units of labor are of equal quality.
 It refers to how the marginal contribution of a factor
of production usually decreases as more of the factor
is used
 Each additional unit of the variable input (Labor)
yields smaller and smaller increases in output.
 First labor employed gives more productivity as
compared to next last.
Law of Diminishing Returns

 When workers cause more congestions then


marginal productivity would become
negative.
TP

Total
Products

Quantity of Labor
TP
Relationship between MP and AP:
Total
Products When MP exceeds AP, AP rises, when
MP is less than AP, then AP declines.

Quantity of Labor

Increasing Diminishing Negative


Marginal Marginal Marginal
Returns Return Return
Marginal
product

AP
Quantity of Labor / marginal and
average products
MP
Short-Run Production Cost:

 Fixed cost
 Variable Cost
 Total Cost (FC+VC)
 Variable cost can be controlled or altered in
short run but not Fixed cost.
Short-Run Production Cost:

Per Unit or Average cost;


Average Fixed Cost
AFC = Total Fixed Cost (TFC) / Q

Average Variable Cost


AVC = Total Variable Cost (TVC) / Q
AFC

ATC

AVC

AFC
Short-Run Production Cost:

 At low level of output, production is


relatively inefficient

ATC = AVC + AFC

Marginal Cost (MC):


MC = change in TC / change in Q
MC

ATC

AVC

AFC
Minimum Efficient Scale (MES)

 Which is lowest level of output at which a


firm can minimize its long-term average
cost.
 Given demand curve efficient production will
be achieved with large scale producer. Small
scale firms can not realize minimum efficient
scale.
 Natural monopoly: average total cost is
minimized when only one firm produces
particular goods and services
Applications
Rising cost of Insurance companies

 9/11 terrorist attack


 Increase cost of security and cameras
 Increase premiums of insurance
Successful Start-Up Firms

 These firms reduce their cost by moving high


to low point on their short-run cost
 Their ability to spread huge product
development and advertising cost over large
number of goods.
Daily Newspaper

 Resources to produce newspaper: reporters,


delivery people, photographers, editors,
management, printing press, ink makers,
loggers, loggers truck delivery, and so on.
 Yet sell for $0.50 per newspapers.
 They are achieving economies of scale.
The End