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CHAPTER-6

THE COST OF PRODUCTION


MANAGERIAL ECONOMICS (BUS-525)

COURSE CONVENER:
DR. TAMGID AHMED CHOWDHURY
CHAPTER OUTLINE
 Measuring Cost: Which Costs Matter?
 Cost in the Short Run

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 Cost in the Long Run

 Long-Run versus Short-Run Cost Curves

 Production with Two Outputs—Economies of


Scope

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MEASURING COST: WHICH ONE MATTERS
 Economic Cost versus Accounting Cost
● accounting cost: Actual expenses plus
depreciation charges for capital equipment.

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● economic cost: Cost to a firm of utilizing
economic resources in production, including
opportunity cost.
 Opportunity Cost

Cost associated with opportunities that are


forgone when a firm’s resources are not put to
their best alternative use. It is the next best
alternative:
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MEASURING COST: WHICH ONE MATTERS
 Sunk cost: Expenditure that has been made
and cannot be recovered. Such as R&D costs.
Because a sunk cost cannot be recovered, it should

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not influence the firm’s decisions.
 fixed cost (FC): Cost that does not vary with
the level of output and that can be eliminated
only by shutting down. Such as, machinery cost,
rent, fixed utility bills etc.
 variable cost (VC): Cost that varies as output
varies. Example, labor wages, input costs
 Total cost (TC): It’s the summation of fixed and
variable cost. 4
MEASURING COST: WHICH ONE MATTERS
 marginal cost (MC): Increase in cost resulting
from the production of one extra unit of output.

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 average total cost (ATC): Firm’s total cost
divided by its level of output.
 average fixed cost (AFC): Fixed cost divided by
the level of output.
 average variable cost (AVC): Variable cost
divided by the level of output.
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TYPES OF COSTS: A NUMERICAL EXAMPLE

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COST CURVES
MATHEMATICAL EXAMPLE
3. A firm has a fixed production cost of $5,000
and a constant marginal cost of production
of $500 per unit produced.

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 What is the firm’s total cost function?
Average cost?

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The short-run cost function of a company is given by the
equation TC = 200 + 55q, where TC is the total cost
and q is the total quantity of output, both measured
in thousands.
 What is the company’s fixed cost?

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 If the company produced 100,000 units of goods, what
would be its average variable cost?
 What would be its marginal cost of production?
 What would be its average fixed cost?
 Suppose the company borrows money and expands its
factory. Its fixed cost rises by $50,000, but its
variable cost falls to $45,000 per 1000 units. The cost
of interest (i) also enters into the equation. Each 1-
point increase in the interest rate raises costs by
$3,000. Write the new cost equation.
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FINDING COST MINIMIZING BUNDLE OF INPUT

 Iso-cost line is similar


to budget line with
equation of:

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C = wL + rK

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SHORT RUN VS LONG RUN COST
 In the short-run one
input or factor of
production (usually
capital) is constant.

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And thus in the short
run we can’t make
choice between
different combinations
of labor and capital to
produce a specific
quantity. When Labor
become costly we can
chose capital and thus
move to point B. In the
long run, that’s
possible.
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INFLEXIBILITY OF SHORT-RUN
 Output is initially at
level q1. In the short
run, output q2 can be

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produced only by
increasing labor from
L1 to L3 because capital
is fixed at K1. In the
long run, the same
output can be produced
more cheaply by
increasing labor from
L1 to L2 and capital
from K1 to K2. 12
LONG RUN VS SHORT RUN COST CURVES
 The long-run average
cost curve LAC is the
envelope of the short-

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run average cost curves
SAC1, SAC2, and
SAC3.
 With economies and
diseconomies of scale,
the minimum points of
the shortrun average
cost curves do not lie on
the long-run average
cost curve. 13
ECONOMIES OF SCALE
 economies of scale Situation in which output can
be doubled for less than a doubling of cost.

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 diseconomies of scale Situation in which a
doubling of output requires more than a doubling
of cost.

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LEARNING CURVE
 learning curve
Graph relating
amount of inputs

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needed by a firm to
produce each unit of
output to its cumulative
output.
 Firm’s production cost
may fall over time as
managers and workers
become more
experienced and more
effective at using the
available plant and
equipment. 15
APPLICATION OF LEARNING CURVE
 A firm’s average cost of
production can decline
over time because of

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growth of sales when
increasing returns are
present (a move from A
to B on curve AC1),
 or it can decline
because there is a
learning curve (a move
from A on curve AC1 to
C on curve AC2). 16
FEW MATHEMATICAL WORKS

1. The total cost function of a good is given by


TC = Q2 + 3Q + 36.

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Calculate the level of output that minimizes
average cost. Find AC and MC at this value of
Q.
2. A firm’s short run production function is given by
Q = 30L2 – 0.5 L3
Find the value of L which maximizes APL and
verify that MPL = APL at this point.

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ANOTHER EXAMPLE
 Suppose that a firm’s production function is q =
10L1/2K1/2. The cost of a unit of labor is $20 and
the cost of a unit of capital is $80.
a. The firm is currently producing 100 units of

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output and has determined that the cost-
minimizing quantities of labor and capital are
20 and 5, respectively. Graphically illustrate
this using isoquants and isocost lines.
b. The firm now wants to increase output to 140
units. If capital is fixed in the short run, how
much labor will the firm require? Illustrate this
point graphically and find the firm’s new total
cost.
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CONTINUES......
c. Graphically identify the cost-minimizing level of
capital and labor in the long run if the firm wants
to produce 140 units.

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d. If the marginal rate of technical substitution is
K/L , find the optimal level of capital and labor
required to produce the 140 units of output.

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