Cost of Production

WHAT ARE COSTS?

Cost of an object or action require the payment
of (a specified sum of money) before it can be
acquired or done.

estimate the price of.

an amount that has to be paid or spent to buy or
obtain something

 The Firms Objective

The economic goal
of the firm is to
maximize profits.

Max
imu
mP
roft
s

The Firms Objective

Total Revenue, Total Cost, and

Profit

Total Revenue
The amount a firm receives for the sale of its
output.

Total Cost
The market value of the inputs a firm uses in
production.

Profit is the firms total revenue minus its total

cost.

Profit = Total revenue - Total cost

4

Opportunity cost
Opportunity cost: The cost of an alternative that must be
forgone in order to pursue a certain action. Put another
way, the benefits you could have received by taking an
alternative action.

Example

Opportunity cost of doing business

Opportunity cost of going to college
Opportunity cost of travelling on a 2 wheeler

Explicit costs

Explicit costs are opportunity costs that

involve direct monetary payment by producers
- The explicit opportunity cost of the factors
of production not already owned by a
producer is the price that the producer has
to pay for them.
- For instance, if a firm spends $100 on
electrical power consumed, its explicit
opportunity cost is $100.This cash
expenditure represents a lost opportunity to
purchase something else with the $100.
6

Implicit costs.
Implicit costs are the opportunity costs not
reflected in cash outflow but implied by the
failure of the firm to allocate its existing
resources, or factors of production to the best
alternative use.
For example: a manufacturer has previously
purchased 1000 tons of steel and the
machinery to produce hammers . The implicit
part of the opportunity cost of producing the
hammers is the revenue lost by not selling the
steel and not renting out the machinery instead
of using them for production.
7

Sunk Cost
Sunk Cost

asunk cost is a cost that has already been incurred

and cannot be recovered
A company budget may allow for investing money in
employee salaries, inventory, office space or any
other cost of doing business. Once the company's
money is spent, that money is considered a sunk
cost. Regardless of what money is spent on, sunk
costsare dollars already spent and permanently lost.
Sunk costs cannot be refunded or recovered. For
example, once rent is paid, that dollar amount is no
longer recoverable - it is 'sunk.'

Economic Profit versus

Accounting Profit

Economists measure a firms economic profit as

total revenue minus total cost, including both
explicit and implicit costs.
Economiccosts=totalimplicitcosts+total
explicitcosts

Accountants measure the accounting profit as

the firms total revenue minus only the firms
explicit costs.
Accountingcosts=totalexplicitcosts

Economic Profit versus

Accounting Profit

When total revenue exceeds both explicit and

implicit costs, the firm earns economic profit.

Economic profit is smaller than accounting profit.

10

Figure 1 Economists versus

Accountants
HowanEconomist
HowanAccountant
ViewsaFirm

ViewsaFirm

Economic
profit
Accounting
profit
Revenue

Implicit
costs

Explicit
costs

Revenue
Total
opportunity
costs

Explicit
costs

11

THE VARIOUS MEASURES OF

COST
Costs of production may be divided into fixed
costs and variable costs.
Fixedcosts are those costs that do not vary
with the quantity of output produced.
Variablecosts are those costs that do vary
with the quantity of output produced.

12

Total Costs
Total Costs
Total Fixed Costs (TFC)
Total Variable Costs (TVC)
Total Costs (TC)
TC = TFC + TVC

13

Table 1 A Production Function and Total Cost

14

Total
Cost

Figure 2 Cookie business TotalCost Curve

Quantity
ofOutput
(cookiesperhour)

15

Average Costs
Average Costs
Average costs can be determined by dividing

the firms costs by the quantity of output it

produces.
The average cost is the cost of each typical unit
of product.

16

Average Costs
Average Costs
Average Fixed Costs (AFC)
Average Variable Costs (AVC)
Average Total Costs (ATC)
ATC = AFC + AVC

17

Average Costs
Fixed cost FC
AFC

Quantity
Q
Variable cost VC
AVC

Quantity
Q
Total cost TC
ATC

Quantity
Q

18

Average and Marginal Costs

Marginal Cost
Marginal cost (MC) measures the increase in

total cost that arises from an extra unit of

production.
Marginal cost helps answer the following
question:
- How much does it cost to produce an additional
unit of output?

19

Average and Marginal Cost

(change in total cost) TC

MC

(change in quantity)
Q

20

Table 2 The Various Measures of Cost:

Lemonade Stand

21

Figure 3 Total-Cost Curves

TotalCost
Total-cost curve

$15.00
14.00
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0

Quantity
ofOutput
(glassesoflemonadeperhour)
8

10

22

Figure 4 Average-Cost and MarginalCost Curves of the Lemonade Stand

Costs
$3.50
3.25
3.00
2.75
2.50
2.25

MC

2.00
1.75

ATC

1.50
1.25
1.00
0.75
0.50

AFC

0.25
0

Quantity
ofOutput
(glassesoflemonadeperhour)
9

10

23

Marginal Cost Curve and shapes

Marginal cost rises with the amount of output
produced and is u shaped because of the law
of diminishing marginal returns.

For most production processes the marginal product

of labor initially rises, reaches a maximum value and
then continuously falls as production increases. Thus
marginal cost initially falls, reaches a minimum value
and then increases.
The marginal cost curve intersects both the average
variable cost curve and (short-run) average total cost
curve at their minimum points.

24

Marginal Cost
Curve and shapes
When the marginal cost
curve is above an average
cost curve the average curve
is rising.
When the marginal costs
curve is below an average
curve the average curve is
falling. This relation holds
regardless of whether the
marginal curve is rising or
falling.
25

Average Cost Curves and Their

Shapes
The average total-cost curve is U-shaped
because of law of diminishing returns. The
shape of MC determines the shape of average
cost curve.

At very low levels of output average total cost is

high because fixed cost is spread over only a
few units.

Average total cost declines as output increases.

Average total cost starts rising because average
variable cost rises substantially.
26

Efficient scale
The bottom of the U-shaped ATC curve occurs
at the quantity that minimizes average total cost.
This quantity is sometimes called the efficient
scale of the firm.

The marginal-cost curve crosses the averagetotal-cost curve at the efficient scale.
- Efficient scale is the quantity that minimizes
average total cost.

27

Figure 5 Cost Curves for a

Typical Firm

NotehowMChitsbothATCandAVCattheir
minimumpoints.
MarginalCostdeclinesatfirstandthen
Costs
increasesduetodiminishingmarginalproduct.
AFC,ashort-runconcept,declinesthroughout.

$3.00
2.50

MC
2.00
1.50

ATC
AVC

1.00
0.50

AFC
0

10

12

14
QuantityofOutput
28

Typical Cost Curves

Three Important Properties of Cost Curves
Marginal cost eventually rises with the quantity

of output.
The average-total-cost curve is U-shaped.
The marginal-cost curve crosses the averagetotal-cost curve at the minimum of average total
cost.

29

COSTS IN THE SHORT RUN AND

IN THE LONG RUN
For many firms, the division of total costs
between fixed and variable costs depends on
the time horizon being considered.

In the short run, some costs are fixed.

In the long run, all fixed costs become variable costs.

Because many costs are fixed in the short run

but variable in the long run, a firms long-run cost
curves differ from its short-run cost curves.

30

Long-Run Cost Curves

In the longrun, a firm has many sizes to choose
from.

The shortrun requires that scale be fixed

only one or a few resources can be changed.

31

The Envelope Relationship

Long-run costs are always less than or equal to short-run
costs because:
In the long run, all inputs are flexible
In the short run, some inputs are fixed
There is an enveloperelationshipbetween long-run and
short-run average total costs. Each short-run cost curve
touches the long-run cost curve at only one point.

In the short run all expansion must proceed by

increasing only the variable input
This constraint increases cost
32
13-32

The Envelope of
Short-Run Average Total
Cost Curves
Costs
perunit

LRATC
SRMC1

SRATC4
SRMC4

SRATC1
SRMC2

SRATC2
SRMC3

The long-run average

total cost curve (LRATC)
is an envelope of the
short-run average total
cost curves (SRATC1-4)

SRATC3

Q
33
13-33

Short-Run
and
Long-Run
AverageCost Curves

34

Determinants of the Shape of

the Long-Run Cost Curve

The law of diminishing marginal productivity

does not hold in the long run.

All inputs are variable in the long run.

The shape of the long-run cost curve is due to
the existence of economies and diseconomies of
scale.

35

Technical Efficiency and

Economic Efficiency

Technical efficiency as few inputs as

possible are used to produce a given output.

Technical efficiency is efficiency that does not
consider cost of inputs.

Economically efficient the method that

produces a given level of output at the lowest
possible cost.
It is the least-cost technically efficient process.

36

Economics of Scale
Scale means size.
Economiesofscale: the decrease in per unit
costs as the quantity of production increases
and all resources are variable

Diseconomiesofscale: the increase in per unit

costs as the quantity of production increases
and all resources are variable

Constantreturnstoscale: unit costs remain

constant as the quantity of production is
increased and all resources are variable
37

A Typical Long-Run Average

Total Cost Table
Total Costs
Quantity of Labor

11
12
13
14
15
16
17
18
19
20

$381
390
402
420
450
480
510
549
600
666

Total Cost Total Costs = Average Total

of Machines TCL + TCM Costs = TC/Q

$254
260
268
280
300
320
340
366
400
444

$635
650
670
700
750
800
850
915
1,000
1,110

$58
54
52
50
50
50
50
51
53
56
38

A Typical Long-Run Average Total Cost

Curve

Costs per unit

$64
62
60
58
56
54
52
50
48

Average
total cost
Minimum efficient
level of production

11 12 13 14 15 16 17 18 19 20 Quantity
39

Economies of Scale cannot be

obtained at lower production

An indivisible setup cost is the cost of an

indivisible input for which a certain minimum

amount of production must be undertaken
before the input becomes economically feasible
to use.

The cost of a blast furnace or an oil refinery is

an example of an indivisible setup cost.

40

Economies of Scale
The minimumefficientlevelofproductionis the
amount of production that spreads setup costs out
sufficiently for firms to undertake production profitably

The minimum efficient level of production is reached

once the size of the market expands to a size large
enough for firms to take advantage of all economies of
scale

In the longer run all inputs are variable, so only

economies of scale can influence the shape of the longrun cost curve.

41

Economies of Scale - reasons

Specializationanddivisionoflabour:
In large scale operations workers can do more specific tasks. With little
training they can become very proficient in their task, this enables greater
efficiency. A good example is an assembly line with many different jobs.

Technical
Some production processes require high fixed costs e.g. building a large
factory. If a car factory was then only used on a small scale it would be very
inefficient to run. By using the factory to full capacity average costs will be
lower.

Bulkbuying
If you buy a large quantity then the average costs will be lower. This is
because of lower transport costs and less packaging. This is why
supermarkets get lower prices from suppliers than local corner shops.

Spreadingoverheads.
If a firm merged it could rationalise its operational centres. E.g. it could have
one head office rather than two.
42

Economies of Scale - reasons

RiskBearingeconomies.
Some investments are very expensive and perhaps risky, therefore only a
large firm will be able and willing to undertake the necessary investment.
E.g. pharmaceutical industry needs to take risks in developing new drugs

MarketingEconomiesofscale.
There is little point a small firm advertising on a national TV campaign
because the return will not cover the high sunk costs

Financialeconomies.
A bigger firm can get a better rate of interest than small firms

Externaleconomiesofscale:
This occurs when firms benefit from the whole industry getting bigger. E.g.
firms will benefit from better infrastructure, access to specialized labour and
good supply networks. E.g. micro chip producers often set up in Silicon
valley

43

Diseconomies of Scale
Diseconomies of scale refer to decreases in
productivity which occur when there are equal
increases of all inputs (no input is fixed).

Diseconomies of scale occur on the right

side of the long-run average cost curve
where it is upward sloping, meaning that
average cost is increasing.
44

Diseconomies of Scale - Reason

Poorcommunicationin a large firm
Alienation: Working in a highly specialized assembly line can be very
boring, if workers become de-motivated. In a large firm there is an increased
gap between top and bottom e.g. call centres

Lackofcontrol: when there is a large number of workers it is easier to

escape with not working very hard because it is more difficult for managers
to notice shirking.

Monitoring costs are those incurred by the organizer of production in

seeing to it that the employees do what they are supposed to do.

45

Constant Returns to Scale

Constant returns to scale is where long-run
average total costs do not change as output
increases.

It is shown by the flat portion of the LRATC

curve.

46

Long-Run and
Short-Run Cost Curves (1)

47

A Typical Long-Run Average Total

Cost Curve
Costs
perunit
$60

$55

Minimum
efficient
level of
production

Long-run
averagetotal
cost(LRATC)

$50

11
14
17
20
ATCfallsbecause
ATCrisesbecause
ATCisconstant
ofeconomies becauseofconstant ofdiseconomies
ofscale
ofscale
returnstoscale
48
13-48

Importance of Economies and

Diseconomies of Scale

The long-run and the short-run average cost

curves have the same U-shape, but the
underlying causes of these shapes differ.

Economies and diseconomies of scale account

for the shape of the long-run total cost curve.

49

 Implicit costs are:

A) equal to total fixed costs.
B) comprised entirely of variable costs.
C) "payments" for self-employed resources.
D) always greater in the short run than in the long
run.

CHAPTER13 THE COSTS OF PRODUCTION

50

 Which would be an implicit cost for a firm? The

cost:
A) of worker wages and salaries for the firm.
B) paid for leasing a building for the firm.
C) paid for production supplies for the firm.
D) of wages foregone by the owner of the firm.

CHAPTER13 THE COSTS OF PRODUCTION

51

 If a firm's revenues just cover all its opportunity

costs, then:
A) normal profit is zero.
B) economic profit is zero.
C) total revenues equal its explicit costs.
D) total revenues equal its implicit costs.

CHAPTER13 THE COSTS OF PRODUCTION

52

 Suppose a firm sells its product at a price lower

than the opportunity cost of the inputs used to
produce it. Which is true?
A) The firm will earn accounting and economic profits.
B) The firm will face accounting and economic losses.
C) The firm will face an accounting loss, but earn economic
profits.
D) The firm may earn accounting profits, but will face
economic losses.

CHAPTER13 THE COSTS OF PRODUCTION

53

 Suppose that a firm produces 200,000 units a

year and sells them all for $10 each. The explicit
costs of production are $1,500,000 and the
implicit costs of production are $300,000. The
firm has an accounting profit of:
A) $500,000 and an economic profit of $200,000.
B) $400,000 and an economic profit of $200,000.
C) $300,000 and an economic profit of $400,000.
D) $200,000 and an economic profit of $500,000.

CHAPTER13 THE COSTS OF PRODUCTION

54

 Variable costs are:

A) sunk costs.
B) multiplied by fixed costs.
C) costs that change with the level of production.
D) defined as the change in total cost resulting
from the production of an additional unit of output.

CHAPTER13 THE COSTS OF PRODUCTION

55

 If you know that with 8 units of output, average

fixed cost is $12.50 and average variable cost is
$81.25, then total cost at this output level is:

A) $93.75.
B) $97.78.
C) $750.
D) $880.

CHAPTER13 THE COSTS OF PRODUCTION

56

 The reason the marginal cost curve eventually

increases as output increases for the typical firm
is because:
A) of diseconomies of scale.
B) of minimum efficient scale.
C) normal profit exceeds economic profit.
D) of the law of diminishing returns.

CHAPTER13 THE COSTS OF PRODUCTION

57

 If the short-run average variable costs of

production for a firm are rising, then this
indicates that:
A) average total costs are at a maximum.
B) average fixed costs are constant.
C) marginal costs are above average variable
costs.
D) average variable costs are below average fixed
costs.
CHAPTER13 THE COSTS OF PRODUCTION

58

 If a more efficient technology was discovered by

a firm, there would be:
A) an upward shift in the AVC curve.
B) an upward shift in the AFC curve.
C) a downward shift in the AFC curve.
D) a downward shift in the MC curve.

CHAPTER13 THE COSTS OF PRODUCTION

59

 The firm's short-run marginal-cost curve is

increasing when:

A) marginal product is increasing.

B) marginal product is decreasing.
C) total fixed cost is increasing.
D) average fixed cost is decreasing.

CHAPTER13 THE COSTS OF PRODUCTION

60

 A firm encountering economies of scale over

some range of output will have a:

A) rising long-run average cost curve.

B) falling long-run average cost curve.
C) constant long-run average cost curve.
D) rising, then falling, then rising long-run
average cost curve.

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61

 The larger the diameter of a natural gas pipeline,

the lower is the average total cost of transmitting
1,000 cubic feet of gas 1,000 miles. This is an
example of:

A) economies of scale.
B) normative economies.
C) diminishing marginal returns.
D) an increasing marginal product of labor.

CHAPTER13 THE COSTS OF PRODUCTION

62

 Economies and diseconomies of scale explain

why the:
A) short-run average fixed cost curve declines so long as
output increases.
B) marginal cost curve must intersect the minimum point of
the firm's average total
cost curve.
C) long-run average total cost curve is typically U-shaped.
D) short-run average variable cost curve is U-shaped.

CHAPTER13 THE COSTS OF PRODUCTION

63

 Whenthepriceislessthantheaverage
variablecost,thefirmshould.

(a) Continue to operate till the market recover ;

(b) Shut down its operation for the time being
(c) Retrench workers and pay them
compensation;

(d) Clear the existing stock at a price less than

the prevailing price to beat the competitors

CHAPTER13 THE COSTS OF PRODUCTION

64

An explicit cost is
a. the cost of giving up an alternative
b. the cost of a chosen alternative
c. calculated by subtracting the monetary cost of
an alternative by the time invested

d. none of the above

CHAPTER13 THE COSTS OF PRODUCTION

65

 The total fixed cost curve is parallel to the x axis

because
(a) expenditure on fixed factors increases as output
increases
(b) expenditure on fixed factors is zero at zero level of
output & increases
thereafter
(c) expenditure on fixed factors is same throughout the
production process
(d) none of the above.

CHAPTER13 THE COSTS OF PRODUCTION

66

 The average fixed cost curve is a rectangular

hyperbola because
(a) TFC remains constant during production in the
short run
(b) TFC decreases as more units are producer
(c) TFC is zero at zero level of output
(d) none of the above.

CHAPTER13 THE COSTS OF PRODUCTION

67

TVC curve will increase at decreasing rate when

(a) AFC increases
(b) Marginal product increases
(c) Total product increases at decreasing rate
(d) None of the above.

CHAPTER13 THE COSTS OF PRODUCTION

68

 In the above figure, the total fixed cost curve is

curve

A) B. B) A.
C) C. D) none of the curves in the figure

CHAPTER13 THE COSTS OF PRODUCTION

69

 In the above figure, the total variable cost curve

is curve

A) A. B) B.
C) C. D) none of the curves in the figure

CHAPTER13 THE COSTS OF PRODUCTION

70

 In the above figure, the total cost curve is curve

A) A. B) B.
C) C. D) none of the curves in the figure

CHAPTER13 THE COSTS OF PRODUCTION

71

 In the above figure, the relationship between

costs indicates that the distance between curves
A) B and C is equal to the average total cost.
B) A and B is equal to the variable cost.
C) A and B is equal to the fixed cost.
D) B and C is equal to the fixed cost.

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72

The marginal cost (MC) curve intersects the

A) AVC and AFC curves at their minimum points.
B) ATC and AFC curves at their minimum points.
C) ATC and AVC curves at their minimum points.
D) ATC, AVC, and AFC curves at their minimum
points.

CHAPTER13 THE COSTS OF PRODUCTION

73

In the figure, the marginal cost curve is curve

A) A.
B) B.
C) C.
D) D.

CHAPTER13 THE COSTS OF PRODUCTION

74

 In the above figure, the average fixed cost curve

is curve

A) A.
B) B.
C) C.
D) D.

CHAPTER13 THE COSTS OF PRODUCTION

75

 In the above figure, the average variable cost

curve is curve

A) A.
B) B.
C) C.
D) D.

CHAPTER13 THE COSTS OF PRODUCTION

76

 In the above figure, the average total cost curve

is curve

A) A.
B) B.
C) C.
D) D.

CHAPTER13 THE COSTS OF PRODUCTION

77

 In the above figure, curve D slopes downward

because
A) there are diminishing returns.
B) Spread of fixed cost.
C) all costs decrease as output increases.
D) there are decreasing marginal costs.

CHAPTER13 THE COSTS OF PRODUCTION

78

 Average variable cost is at a minimum at the

same amount of output at which

A) average product is at a minimum.

B) marginal product is at a minimum.
C) marginal product is at a maximum.
D) average product is at a maximum.

CHAPTER13 THE COSTS OF PRODUCTION

79

CHAPTER13 THE COSTS OF PRODUCTION

80