Cost of Production

Dr. S P Singh
 Introduction

• Business decisions are generally taken based

on the monetary values of inputs and outputs.

• The quantity of inputs multiplied by their

respective unit prices will give the monetary
value or the cost of production.

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 Economic cost versus Accounting cost
• Accounting costs account only for the explicit costs incurred in
conducting a business and not the implicit costs. The explicit
costs include the direct costs to the company, such as employee
wages, utility bills (water, electricity, etc.), raw material cost,
premises cost, transportation and storage costs, etc.

• Economic costs, on the other hand, account for both explicit and
implicit costs. Implicit costs is the opportunity cost in terms of
revenue lost by forgoing the next best alternative, say renting out
premises instead of conducting the business there. For example,
a business that operates from a building it owns forfeits the rent
that it would have otherwise received if it rented out the building

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 Sunk Costs
• Sunk costs are the costs that you have already incurred. This is
the money that you have put into some particular endeavor and
which you can not recoup. For example, if you buy machinery
to produce a certain product, the price of that machinery is
sunk. You have already paid for it and cannot get that money
back.

• Because it cannot be recovered, it should not influence the

firm’s decisions. For example, consider the purchase of
specialised equipment, designed for a plant. We assume that the
equipment can be used to do only what it was originally
designed for and can’t be converted for alternative use.
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 Sunk Costs
• The expenditure is therefore a sunk cost, because it has no
alternative use, its opportunity cost is zero. Thus it should not
be included as part of the firm’s costs.

• If on the other hand, the equipment could be put to other use,

or be sold or rented to antoher firm, its current economic cost
would be measured by the value of its next most profitable
use.

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 Fixed and Variable Costs
• Costs that are fixed in volume for a certain level of
output. They do not vary with output. They remain
constant regardless of the level of output. Fixed costs
include:

• (i)Cost of managerial and administrative staff; (ii)

Depreciation of machinery; (iii) Land, maintenance.
Fixed costs are normally short-term concepts because, in
the long-run, all costs must vary.

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 Variable Costs

• Variable Costs are those that vary with variations in output. It

includes: (i) Cost of raw materials; (ii) Running costs of fixed
capital, such as fuel, repairs, routine maintenance expenditure,
direct labour charges associated with output levels; and (iii)
The Costs of all other inputs that may vary with the level of
output.

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 Total, Average, and Marginal Costs
• The Total Cost (TC) refers to the total expenditure on the
production of goods and services.

• It includes both explicit and implicit costs.

• The explicit costs themselves are made up of fixed and

variable costs.

• The Average cost (AC) is obtained by dividing total cost (TC)

by total output (Q). AC = TC/Q

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 Marginal Costs

• Marginal Cost (MC) is the addition to total cost on account of

producing one additional unit of a product. It is the cost of the
marginal unit produced. MC = Change in TC/ Change in Q =
ΔTC/ ΔQ

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 Short-Run and Long-Run Costs

• Short-Run Costs are costs which change as desired output

changes, size of the firm remaining constant. These costs are
often referred to as variable costs. Long-Run costs, on the
other hand are costs incurred on the firm’s fixed assets, such as
plant, machinery, building, and the like.

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 Historical and Replacement Costs

• Historical cost refers to the cost an asset acquired in the past,

whereas, replacement cost refers to the outlay made for
replacing an old asset. These concepts derive from the
unstable nature of price behaviour. When prices become stable
over time, other things being equal, historical and replacement
costs will be at par with each other.

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 Cost in the short run
• Total Cost (TC): The total cost of production has two
components: the fixed cost, which is borne by the firm whatever
level of output it produces and the Variables cost (VC) which
varies with the level of output.

• To decide, how much to produce, managers of firms need to

know how variable cost increases with the level of output. To
address this, we need to examine additional cost measures.

• Marginal cost (MC) sometimes called incremental cost is the

increase in cost that results from producing one extra unit of
output.

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 Cost in the short run
• Because, fixed cost does not change as the firm’s level of
output changes, marginal cost is just the increase in variable
costs that result from an extra unit of output.

• MC= ∆ VC/ ∆ Q

• Average Cost (AC) Average Cost in the cost per unit of output.

• Average Total Cost (ATC) is the firm’s total cost divided by its
level of output TC/Q.

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 Cost in the short run
• ATC has two components - Average Fixed Cost (AFC) and
Average Variable Cost (AVC)

• AFC is the fixed cost divided by the level of output, FC/Q

• AVC is variable cost divided by the level of output, VC/Q

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 Table: A Firm’s Short-Run Costs
Rate of Fixed Variable Total Cost Marg Average Average Average
Output Cost (FC) Cost (VC (TC) inal Fixed Variable Total
cost Cost Cost (AVC) Cost
(MC) (AFC) (ATC)

0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8

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Graphical representation and implications
• - P.202; Figure 7.1 (Pindyck and Rubinfield)

• Fixed cost does not vary with output

• VC is zero when output is zero as increases as output increases

• As more is produced the AFC declines

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 Implications
• Whenever marginal costs lies below the average cost, the
average cost falls.

• Whenever the marginal cost lies above the average cost, the
average cost rises.

• When average cost is at a minimum, marginal cost equals

average cost

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 Determinants of Short-Run Cost
• The table shows that variable and total costs increase with
output.

• The rate at which these costs increase depends on the nature

of the production process, and in particular on the extent to
which the production involves diminishing returns to
variable factors.

• Diminishing returns to labour occur when the marginal

product of labour is decreasing. This means that total output
will be increasing at a decreasing rate.

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 Determinants of Short-Run Cost
• Beyond a certain point, new workers will not have as much
capital equipment to work with so it becomes diluted among a
larger workforce.

• If labour is the only variable factor, what happens as we increase

the firm’s rate of output?. To produce more output, the firm has
to hire more labour.

• If the marginal product of labour decreases rapidly as the amount

of labour hired is increased (owing to diminishing returns),
greater expenditure must be incurred to produce output at a faster
rate.

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 Determinants of Short-Run Cost
• As a result, variable and total costs increase
rapidly as the rate of output is increased.

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Relationship between production and costs

• A firm can hire as much labour as it wishes at

a fixed wage w.

• Marginal cost is the change in variable cost for

a one unit change in output (ΔVC/ΔQ).

• Variable cost is the per unit cost of the extra

labour w times the amount of extra labour Δ L
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Relationship between production and costs

VC wL
MC  
q q

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 Marginal Product of Labour
• The marginal product of a factor of production
is generally defined as the change in output
associated with a change in that factor,
holding other inputs into production constant.
The marginal product of labor is then the
change in output (Y) per unit change in labor
(L).

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Relationship between production and costs

Q
MPL 
L

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Relationship between production and costs

We can conclude that:

w
MC 
MPL
and a low marginal product (MPL)
leads to a high marginal cost
(MC) and vice versa 25
 Cost in the Long Run
• In the long run, the firm can change all its inputs.

• A firm’s long-run production function is of the form:

• Q = f(Ld, L, K, M, T, t)

• where Ld = land and building; L = labour; K = capital; M =

materials; T = technology; and, t = time.

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 Cost in the Long Run
• For the sake of convenience, economists have reduced the number of variables
used in a

• production function to only two: capital (K) and labour (L). Therefore, in the
analysis of

• input-output relations, the production function is expressed as:

Q = f(K, L)

• Increasing production, Q, will require K and L, and whether the firm can
increase both K and L or only L will depend on the time period it takes into
account for increasing production, that is, whether the firm is thinking in terms
of the short run or in terms of the long run.

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 Cost in the Long Run
• Economists believe that the supply of capital (K) is inelastic in
the short run and elastic in the long run.

• Thus, in the short run firms can increase production only by

increasing labour, since the supply of capital is fixed in the
short run. In the long run, the firm can employ more of both
capital and labour, as the supply of capital becomes elastic
over time.

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 Cost Minimising input choice

• Fundamental problem that all firms face: how to select inputs to

produce a given output at a minimum cost.

• For simplicity, let us work with two variable inputs , labour and
capital.

• Assume that labour and capital can be hired in competitive markets.

The price of labour is the wage rate, w and the price of capital is the
rental rate for machinery, r.

• Further it is assumed that capital is rented rather than purchased.

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 Cost Minimising input choice
• Since capital and labour inputs are hired in competitive factor
markets, we can take the prices of these factors as fixed.

• This allows us to focus on the firm’s optimal combination of

factors without worrying about whether large purchase will
cause the price of an input to increase.

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Thanks

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