Teaching PowerPoint Slides - Chapter 6

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved
© Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 1

CHAPTER 6
COST OF PRODUCTION

COST CONCEPTS
IMPLICIT COST
Value of input services that are used in production but not purchased in a market.
EXPLICIT COST
Value of resources purchased for production.
COST OPPORTUNITY COST
CONCEPTS The value of a resource in its next best use.
SOCIAL COST
Total cost of production of a good that
includes direct and indirect costs.
SUNK COST
The cost that a firm cannot recover from the expenditure it has made.

COST OF PRODUCTION
SHORT RUN
A production period in which at least on

of the input is fixed*.
LONG RUN
A production period in which all the

inputs are variable**.
* A fixed input is an input which the quantity does not change
according to the amount of output. E.g. machinery
** A variable input is an input which the quantity varies according to
the amount of output. E.g. labour

SHORT-RUN PRODUCTION
COST
TOTAL COST (TC)

 The sum of cost of all inputs used to produce goods and services.
 Total cost (TC ) also defined as total fixed cost (TFC) plus
total variable cost (TVC).
TC = TFC + TVC
TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)

 The cost of inputs that are  The cost of inputs that changes
independent of output. with output.
 Examples: Factory, machinery  Example: Raw materials, labours,
and etc. etc.

COST (cont.)
AVERAGE TOTAL COST (ATC)
 The total cost per unit of output.
 The formula for average total cost (ATC) is the total
cost (TC) divided by the output (Q).
ATC = TC
Q
TC = TVC + TFC

COST (cont.)
AVERAGE FIXED COST (AFC)
Total fixed cost (TFC) divided by total output:
AFC = TFC
Q
AVERAGE VARIABLE COST (AVC)

Total variable cost (TVC) divided by total output:
AVC = TVC
Q
MARGINAL COST (MC)
The change in total cost that results from a change in output; the
extra cost incurred to produce another unit of output:
MC = TC
Q

SHORT-RUN COST CURVES
TOTAL COST (TC)

COST
TC The sum of cost of all inputs used to produce goods
and services.
Also defined as TFC plus TVC
TVC TC = TVC + TFC
TOTAL VARIABLE COST (TVC)

The cost of inputs that changes with output.
TFC
TOTAL FIXED COST (TFC)
The cost of inputs that is independent of output.
QUANTITY

(cont.)
MARGINAL COST (MC)
COST Change in total cost that results from a change in output
MC = TC
MC ATC Q
AVERAGE TOTAL COST (ATC)

Total cost per output
AVC ATC = TC ATC = AFC + AVC

Q
AVERAGE VARIABLE COST (AVC)

Total variable cost (TVC) divided by total output
AVC = TVC
Q
AVERAGE FIXED COST (AFC)

Total fixed cost (TFC) divided by total output
AFC = TFC
AFC Q
QUANTITY

Total costs Average costs
(1) (2) (3) (4) (5) (6) (7) (8)

Quantity Total Total Total Average Average Average Marginal
(Q) fixed variable cost fixed cost variable total cost cost (MC)
cost cost (TC) (AFC) cost (AVC) (ATC)
(TFC) (TVC) TC=TFC AFC = AVC = ATC = MC =
+TVC TFC/Q TVC/Q TC/Q TC/Q
(2)+(3) (2)/(1) (3)/ (1) (4)/(1) or (4) /(1)

(5)+(6)
0 20 0 20 - - - -
1 20 15 35 20 15 35 15
2 20 25 45 10 12.50 22.50 10
3 20 30 50 6.67 10 16.67 5
4 20 35 55 5 8.75 13.75 5
5 20 45 65 4 9 13 10

(cont.)
COST
STAGE III
STAGE I STAGE II
SATC STAGE I
AFC begins to fall with an increase in output
and AVC decreases.
As long as the falling effect of AFC is higher than the rising
effect of AVC, the ATC tends to decrease.
SAVC
STAGE II
AFC continuous to decline and SATC will become minimum.
ATC remains constant at this stage since the falling effect of
AFC and rising effect of AVC is balanced.
.
STAGE III
The falling effect of AFC is lower than rising effect of AVC,
therefore ATC begins to increase.
SAFC
QUANITTY
ATC curve is “U-Shaped” because of the combined influences of AFC and AVC.

RELATIONSHIP BETWEEN MC
AND ATC
Cost
MC
ATC
Quantity
ATC falling, MC curve lies below ATC curve.
ATC is at minimum point, ATC curve and MC curve are equal.
ATC starts to increase, MC curve lies above ATC curve.

RELATIONSHIP BETWEEN
PRODUCTIVITY AND COST
Production
When its AP is equal to MP,

MP AP curve is at maximum.
AP
When its AVC is equal to MC,
AVC curve is at minimum.
Labour
Cost
MC AVC
Quantity
ISOCOST
 An isocost line shows various combinations of two inputs,

capital and labour, which can be purchased with a given
amount of money for a given total cost.
 An isocost equation shows the relationship between the
inputs (capital and labour) used in the production and the
given total cost by a firm.
 The isocost equation can be written as:
TC = wL + rk
Where: TC = Total Cost
L = Labour
K = Capital (fixed)
w = Price of labour
r = Price of capital

ISOCOST (cont.)
Isocost Line
6
5
4
Capital
3
Isocost
2
1
0
1 2 3 4 5 Labour
Isocost line shows the various combinations of labour and

capital with given total cost for a firm in the production of shoes.

ISOCOST MAP
An isocost map is a number of isocost lines that
show different levels of total cost in one diagram.
Isocost Map
7
6
5
Capital
4
Isocost (RM100)
3
Isocost (RM120)
2
1
0
1 2 3 4 5 6 7 Labour
COST MINIMIZING
TECHNIQUES
The cost minimizing technique is selecting combinations of inputs
that minimize the total cost at the given level of output.
At point y, the slope of isoquant curve is equal to that of isocost line
and this is the most efficient technique for production.
7
6
5 Isocost (RM100)
Capital
4 x Isocost (RM120)
3 Isoquant
2 y
1 z
0 Labour
Points x and z are not efficient because the cost of production is exceeding RM120.

COST CURVES IN THE LONG
RUN
 Long run is a period where there are only
variable factors and no fixed cost involved.
 Long run total cost (LRTC) starts from origin
because of the absence of total fixed cost.
LONG RUN AVERAGE COST CURVE (LRAC)
 Shows the minimum cost of producing any
given output when all of the inputs are variable.
 Long run is a period where firms plan how to
minimize average cost.

LONG-RUN PRODUCTION
COST
LRAC curve are derived by a series of short run average cost curves
COST
SRAC1
SRAC5
SRAC2 SRAC4 LRAC

SRAC3
Tangential point of the SAC

are joined and made up the LRAC.
QUANTITY

LONG-RUN PRODUCTION COST
(cont.)
 Long run average cost curve (LRAC) is “U–Shaped”

due to the Law of Returns to Scale.
 Law of Returns to Scale states that as the firm expand
its size or scale of production, its long run average cost
(LRAC) will decrease and increase at later stage.
Cost
LRAC
Increasing Constant Decreasing

Return to Return to Return to
Scale Scale Scale
Quantity
LONG-RUN PRODUCTION
COST (cont.)
ECONOMIES OF SCALE
 Advantages and benefits of a firm as it becomes larger and
larger.
 Reduce long run average cost (LRAC).
 Marketing economies, financial economies, labour economies,
technical economies, managerial economics.
DISECONOMIES OF SCALE
 Problems faced by a firm as it becomes larger and larger.
 Decrease long run average cost (LRAC).
 Mismanagement, competition, labour diseconomies.

ECONOMIES OF SCALE
Economies of scale are benefits and advantages
of a firm as it expands its production.
• Reduce the average cost.
INTERNAL EXTERNAL
Internal economies happen inside an organization Advantages of the industry as a whole
Labour Economies
Economies of Government Action
Managerial Economies
Marketing Economies Economies of Concentration
Technical Economies
Economies of Information
Financial Economies
Risk Bearing Economies Economies of Marketing
Transport and Storage

Economies

ECONOMIES OF SCALE
(cont.)
Diseconomies of scale are problems and disadvantages
faced by a firm when it expands production.
• Increase the average cost.
INTERNAL EXTERNAL
Raise the cost of production of a firm as The disadvantages faced by the industry
the firm expands as a whole
Labour Diseconomies Scarcity of Raw Material
Wage Differential
Management Problem
Concentration Problem
Technical Difficulties

ECONOMIES AND
DISECONOMIES OF SCOPE
 Economies of scope appear when an individual
firm’s output for two different products is higher
than the output reached by two different firms
each produce a single product.
 The diseconomies of scope appear in the
productions of an individual firm’s because the
production of one product might inconsistent
with the production of another product.

CONCEPT OF REVENUE
TOTAL REVENUE (TR)

The total amount received from the sale of a firm’s goods and services
Total Revenue (TR) = Price (P) x Quantity (Q)
AVERAGE REVENUE (AR)

Average revenue is the total revenue per unit output sold.
 Average revenue (AR) is also equal to the price (P) of the good.
Average Revenue (AR) = Total Revenue (TR)

Quantity (Q)
AR = PxQ = PRICE
Q

CONCEPT OF REVENUE
(cont.)
MARGINAL REVENUE (MR)
The change in total revenue resulting from one unit increase in quantity sold.
Marginal Revenue (MR) = Change in Total Revenue

Change in Quantity
MR =  TR/  Q
(1) (2) (3) (4) (5)

Quantity Price Total Revenue Average Marginal Revenue
(1) x (2) Revenue (3) / (1)
(3) / (1)
10 50 500 50 50
20 45 900 45 40
30 40 1200 40 30
40 35 1400 35 20
50 30 1500 30 10
60 25 1500 25 0
70 20 1400 20 -10

CONCEPT OF REVENUE
(cont.)
Case 1: Under Perfect Market
Quantity Price Total Average Marginal
Revenue Revenue Revenue (MR)
(TR) (AR)
AR, MR and price are same when
1 10 10 10 10 the price is constant. The graph
2 10 20 10 10 Shows the horizontal line at price
3 10 30 10 10 of RM10 which indicates that
4 10 40 10 10 MR = AR = Price.
5 10 50 10 10
Quantity
Price
15
AP, MP
10
5 AR=MR=DD
0
10 20 30 40 50

CONCEPT OF REVENUE
(cont.)
Case 2: Under Imperfect Market
Quantity Price Total Average Marginal
Revenue Revenue Revenue (MR)
(TR) (AR) AR equal to but MR is less than
price when price changes.
1 10 10 10 10
The graph shows the AR and MR
2 9 18 9 8
downward sloping and MR curve
3 8 24 8 6
lies below AR curve.
4 7 28 7 4
5 6 30 6 2
Price
15
AP, MP
10
AR=DD
5
MR Quantity
0
10 20 30 40 50

CONCEPT OF REVENUE
(cont.)
Concept of Revenue by Equation
Given demand curve as:
P = a – bQ (b is the slope)
TR = P x Q
= (a – bQ) x Q
= aQ – bQ2
Derivation of MR from demand curve

MR = dTR/dQ
MR = a – 2bQ (MR is ½ of the slope of DD)


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PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

© Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 1

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

A production period in which at least on

A production period in which all the

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

TOTAL COST (TC)

TOTAL FIXED COST (TFC) TOTAL VARIABLE COST (TVC)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

AVERAGE VARIABLE COST (AVC)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

TOTAL COST (TC)

TVC TC = TVC + TFC

TOTAL VARIABLE COST (TVC)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

AVERAGE TOTAL COST (ATC)

AVC ATC = TC ATC = AFC + AVC

AVERAGE VARIABLE COST (AVC)

AVERAGE FIXED COST (AFC)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

(1) (2) (3) (4) (5) (6) (7) (8)

(2)+(3) (2)/(1) (3)/ (1) (4)/(1) or (4) /(1)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

When its AP is equal to MP,

 An isocost line shows various combinations of two inputs,

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Isocost line shows the various combinations of labour and

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

SRAC2 SRAC4 LRAC

Tangential point of the SAC

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

 Long run average cost curve (LRAC) is “U–Shaped”

Increasing Constant Decreasing

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Marketing Economies Economies of Concentration

Risk Bearing Economies Economies of Marketing

Transport and Storage

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Labour Diseconomies Scarcity of Raw Material

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

TOTAL REVENUE (TR)

AVERAGE REVENUE (AR)

Average Revenue (AR) = Total Revenue (TR)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Marginal Revenue (MR) = Change in Total Revenue

(1) (2) (3) (4) (5)

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

Derivation of MR from demand curve

PRINCIPLES OF ECONOMICS Third Edition All Rights Reserved

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