THE COST OF PRODUCTION

CHAPTER OUTLINE
 Measuring Cost: Which Costs Matter?
 Cost in the Short Run

 Cost in the Long Run

 Long-Run versus Short-Run Cost Curves

 Production with Two Outputs—Economies of

Scope

2
MEASURING COST: WHICH ONE MATTERS
 Economic Cost versus Accounting Cost
● accounting cost: Actual expenses plus
depreciation charges for capital equipment.
● 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:
3
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
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
 total cost (TC) Fixed costs plus variable costs.
 total fixed costs (TFC) The total of all costs that do not change with output,
even if output is zero.
 average fixed cost (AFC) Total fixed cost divided by the number of units of
output; a per-unit measure of fixed costs.
 total variable cost (TVC) The total of all costs that vary with output in the short
run.
 total variable cost curve A graph that shows the relationship between total
variable cost and the level of a firm’s output.
 marginal cost (MC) The increase in total cost that results from producing one
more unit of output. Marginal costs reflect changes in variable costs.
 average variable cost (AVC) Total variable cost divided by the number of units
of output.
 average total cost (ATC) Total cost divided by the number of units of output.
 total revenue (TR) The total amount that a firm takes in from the sale of its
product: the price per unit times the quantity of output the firm decides to
produce (P x q).
 marginal revenue (MR) The additional revenue that a firm takes in when it
increases output by one additional unit. In perfect competition, P = MR.
MEASURING COST: WHICH ONE MATTERS
 marginal cost (MC): Increase in cost resulting
from the production of one extra unit of output.

 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

7
COST CURVES

8
Average and Marginal 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.
 What is the firm’s total cost function? Average
cost?

10
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?
 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:
C = wL + rK

12
 COST IN THE LONG RUN

Choosing Inputs

Recall that in our analysis of production technology, we showed

that the marginal rate of technical substitution of labor for
capital (MRTS) is the negative of the slope of the isoquant and
is equal to the ratio of the marginal products of labor and
capital:

It follows that when a firm minimizes the cost of producing a particular

output, the following condition holds:

We can rewrite this condition slightly as follows:

 Long-Run Costs
 Long-run total cost (LTC) for a given level of
output is given by:
LTC = wL* + rK*
Where w & r are prices of labor & capital,
respectively, & (L*, K*) is the input combination on
the expansion path that minimizes the total cost of
producing that output

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 Long-Run Costs
 Long-run average cost (LAC) measures the cost per unit of output
when production can be adjusted so that the optimal amount of each
input is employed. The long-run average cost curve shows the
relationship between the lowest attainable average total cost and
output when both the plant and labor are varied.
 LAC is U-shaped
 Falling LAC indicates economies of scale
 Rising LAC indicates diseconomies of scale
 Long-run marginal cost (LMC) measures the rate of change in long-
run total cost as output changes along expansion path
 LMC is U-shaped
LTC
LAC 
Q
Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 Derivation of a Long-Run Cost
Schedule (Table 9.1)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 Economies of Scope
 Exist for a multi-product firm when the joint
cost of producing two or more goods is less
than the sum of the separate costs of
producing the two goods
 For two goods, X & Y, economies of scope
exist when:
C(X, Y) < C(X) + C(Y)
 Diseconomies of scope exist when:
C(X, Y) > C(X) + C(Y)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 SHORT RUN VS LONG RUN COST
 In the short-run one
input or factor of
production (usually
capital) is constant.
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
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. 19
LONG RUN VS SHORT RUN COST CURVES
 The long-run average
cost curve LAC is the
envelope of the short-

Managerial Economics
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. 20
Long – Run Average Total Cost Curve
• Long Run Average Total Cost Curve shows
the lowest unit cost at which the firm can
produce any given level of output.
 How ATC Changes as
the Scale of Production Changes
Economies of scale: Situation in
which output can be doubled for
less than a doubling of cost. ATC
ATC
falls as Q increases.

Constant returns to scale: ATC

stays the same LRATC
as Q increases.

Diseconomies of scale: ATC

rises as Q increases. Situation in
which a doubling of output
requires more than a doubling of
cost.

Increasing Returns to Scale:

Output more than doubles when Q
the quantities of all inputs are
doubled.

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ECONOMIES OF SCALE
 economies of scale Situation in which output can
be doubled for less than a doubling of cost.

Managerial Economics
 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
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. 24
 APPLICATION OF LEARNING CURVE
 A firm’s average cost of
production can decline
over time because of
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). 25
FEW MATHEMATICAL WORKS

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

TC = Q2 + 3Q + 36.
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
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.
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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 Cost Minimization
 Marginal product per dollar spent should be
equal for all inputs:

MPL MPK

w r
 Expressed differently

w
MRTS KL 
r
 Cost Minimization

Point of Cost
Slope of
Minimization
Isocost
=
Slope of
Isoquant

L
 Example

 A micro-entrepreneur produces caps and hats

for women. The output-cost data of the business
is reproduced below:
Output Total a. Estimate the total cost function and then use that
Cost equation to determine the average and marginal
50 870 cost functions. Assume a cost function.
b. Determine the output rate that will minimize
100 920 average cost and the per-unit cost at that rate of
150 990 output.
200 1240 c. The current market price of caps and hats per unit
is Tk. 6.00 and is expected to remain at that level
250 1440 for the foreseeable future. Should the firm continue
300 1940 its production?
350 2330
 Estimate of Example
 First we assume the cost function as
TC = c0+c1Q + c2Q2 +c3Q3
 Results
TC= 954.29 -2.46Q +0.02Q2 -.0002Q3
(5.9) (-0.75) (1.04) (-0.07)
R2 = 0.99 F = 197.78
 Comments: t-statistics are not acceptable though R2 and F are good.
 Second, we assume the cost function as
TC = c0+c1Q + c2Q2
Results
 TC = 944.29 -2.24Q + 0.02Q2
t Stat (12.51) (-2.58) (8.45)
R2 = 0.99 F = 394.86
 Comments: t-statistics are acceptable and R2 and F are good.
Answer (a) contd.
 Answer (b) contd.
Sign mistake
 Answer (c)
 Because the lowest possible cost is Tk. 6.45 per
unit, which is above the market price of Tk. 6.00,
the production should not be continued.
 Assignment

Output Total Cost

25 700
100 920
150 990
200 1240
280 1440
360 1940
460 2330
600 3500
 Few mathematical works
The total cost function of a good is given by
TC = Q2 + 3Q + 36.
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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