MBA, SEM 1 COST OF PRODUCTION

MANAGERIAL ECONOMICS
DR. SUBHENDU DUTTA

Subhendu Dutta
COST OF After attending this session, you will be able to understand:
PRODUCTION ▪ meaning of cost, and different cost concepts

▪ the difference between short run and long run costs

▪ the concepts of economies and diseconomies of scale

▪ the significance of economies of scope and learning by doing ( the
learning curve)
Key terms
▪ Implicit costs, explicit costs
▪ Economic cost & accounting cost
▪ Sunk cost & opportunity costs
▪ Total , Fixed and variable costs
▪ Marginal cost and average cost
▪ Break-even point

Subhendu Dutta ▪ economies of scale and economies of scope

 Average
Sunk
Fixed cost
Implicit
Explicit total
Opportunity
The Costs
Accounting
Economic costs cost
isand
the
cost
Average-Marginal
Marginal and
costs
costs or
isare
the
Average
refer AC
expenditureisexplicit
cost
costs
Variable
include
to the
value
the the
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that
Costs
the
the
actual has
associated total
costsbeen
with
ofRelationship
explicit cost
made
of owned
inputs the
expenditures divided
or firm. and
opportunities bythat
its
by level
cannot
out-of-pocket
ofandThese
the used
firm are
on
of
be
are output
recovered.
forgone
theitsbyofItnotisproduction
ignored
putting to the when firm’s making hirefuture
resources to economic
is their best
COST OF used
expenditures
the
inputs forsuch
firm
decisions.
alternative
in firm’s
use.
own
as the financial
wages,
Though
firm
an
rent,purchase
reporting
AC
activity.Calculate
interest
=
opportunityTC/Q
to
orwhich
stock
cost is
itMC,
inputs
holders
often
AFC,
andandalso
paying
hidden,
for
to
The
• Marginal
Total
tax
the marginal
costcost
purposes.
implicit
outsiders. (TC) iscost
costsofthe curve the(MC)
production
orincrease valueinintersects
consists
cost of the
that
(imputed average
results
fixed
from and
from bestit cost
variable
variable
their producing
PRODUCTION IN THE should
curve be
and taken
the ofaverage intototal account
cost curve
AVC
when and AC from
making
at their economicthe
one
costs.extra
alternative unit
use) output.
of inputs owned and used by minimum
the firm inpoints.
its
• Example:
decisions.
When Suppose
marginal a specialized
cost is(TFC):
less athan table.
equipment
average iscost,
designed
notaveragethefor a ofis
cost
SHORT RUN production
•
▪ Total
specific
decreasing,
Incremental
processes.
Average
use
theoutput.
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leveland
cost
fixed
of cannot
Economic
and
cost
cost
is the cost
output be
(AFC)
andconverted
total
cost
is
=increase
that
thethat
can for
Opportunity
TFCdoes
divided
bealternative
in costresulting
costs
eliminated
vary
by
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with
level
The
onlyfrom
by the
expenditure
When
• implementation
going out
▪ Average onofthis
marginal of a equipment
cost
business
variable exceeds
particular
cost[shutting is average
aisdown].
sunk
managerial
(AVC) the TVCcost.
cost, Asaverage
decision,
(Eg.divided it such
has
expenditures
by thenocost
as theis
level
alternative
increasing.
introduction
for of use,
plant aitsnew
opportunity
of maintenance,
output. cost
product,insurance,
enteringis zero. Thus
aheat
new andit should
market, not
electricity
improving
be included
the etc) ofasthe
quality part of the
firm’s firm’s etc.
product, economic costs.
• Total Variable cost (TVC): a cost that varies as output
We can amortize sunkrecover
costsΔ𝑇𝑉𝐶 by spreading them out over
varies.(Eg. Can you
expenditures sunk
for costs?
wages, Δ𝑇𝐶salaries, and raw
many years and treating
Materials etc)
𝑀𝐶 as= fixed cost. =
Δ𝑄 Δ𝑄

Subhendu Dutta
 TheInLearning
Long-run
Economies
Long-Run
Economies Cost
the long Curve
With
run,
of the Economies
Average
and firm’s
Scope And
Costplanning Diseconomies
horizon
& Marginal
Diseconomies of Scale is long
Cost
enough to allow for a change in plant size. This added
COST OF of Scale
Asflexibility
However, at A some
FIRM’S
a result,Inaallows
the
firmlong
therun,
“learns” EXPANSION
atofirm
firmover
point AC begins toPATH
canasexpand
time
produce at its average
cumulative
a lower rise withAND LONG-
output:
PRODUCTION IN THE cost
The
output
Aslong-run
output
than
mostRUN in
increases.
Long-run
Long-run
TOTAL
capacity
the
important byCOST
short expanding
Managers
marginal
average
run.
cost
cost
CURVE
determinant
can existing
curve
curve
useof thefactories
this
(LMC)
(LAC)
shape
learning
shows
relates to
ofthe
the
process
• TheAtchangeto increases,
or
help
a average
particular
inbuilding
average
plan
plant
long-run
thenew
and firm’s
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total ones;
(i.e,
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cost
begins
itasshort
the cancostto decline
expand
forecast
output curves
run),
is or after
futureis space
factory
increased the
LONG RUN a economies
point. long-run
The
As
relationship
costs.
and machinery
incrementally of
cost
reasons
contract
long as
between
scope
of
average
may
are:
its
the
production
labor
arethe
make
by 1 unit.
cost
use of
force,
scale
present
it
to
curve
both
moreof
output
and
when
(LAC)
labor
the in
the
difficult
when
and
firm’sis operation
some
for
the
capital
workers to
envelopeall inputs,
of the including
short-run capital,
average are variable.
cost curves.
and
joint the
do their increases
cases,
inputs
output ita with
ofthat canarechange
single
jobs effectively. output,
firm the
required the design
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istogreater
minimize of itspath
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larger scale bemakes workers specialize
For
• than instance,
the
Management output of aor
slope
introduce
could
larger upward.
firm new We
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in
two the activities
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firmswhich
the each they
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producing productive.
a input prices
and
1. In inefficient.
case of Constant returns to scale:
firms product.
• single can organize
Therefore, all the production process more
The advantages
• remain unchanged as factors
of buying output become
in bulk may have
increases, variable
ACdisappeared
remains
effectively.
forinallthe
same certain
once longofrun.
quantities
levels are reached.
output.
• Firms can achieve financial economies
2. Increasing returns to scale: In this case, AC falls
with output
3. Decreasing returns to scale: AC increases with
output.

long-run
In the average costthe
long run, mayfirmdecline
Theover
LRACtimecurve
because workers and
exhibits
managers absorb
can change thenew
size technological
of its economiesinformation
of scale as they become
initially
plant.
more In doing at
experienced so,their jobs.but
it will As exhibits diseconomies
management and labor gain
always choose
experience the plantthe at
with production, higher
firm’s output levels.
marginal and average costs
that minimizes
of producing AC.level of output fall.
a given

Subhendu Dutta
 Break Even Point Analysis
BREAK EVEN POINT
BE Point : TR = TC

Total Revenue: TR = (P)(Q)

Total Cost: TC = TFC + (AVC)(Q) P = 10
TFC
We will substitute TR and TC in ‘TR= TC’ to get = 200
break even quantity
AVC = 5
(P)(Q) = TFC + (AVC)(Q)
QBE = 40
Or, (P)(Q) - (AVC)(Q) = TFC

Or, Q(P - AVC) = TFC

therefore, Q BE = TFC/(P - AVC)

Calculate breakeven output if AVC = 5/-, P = 10/- and TFC =

200/-. And show BE point in a graph.
Subhendu Dutta
 The short-run
• Average marginal
Total Cost = ATCcost curve increases beyond a certain point, and
= TC/Q
SUMMARY • cuts both average
Managers,
Average
cost curves
Fixedinvestors,
Cost = AFC
from belowmust
and= economists
TFC/Q
at their minimum
take points. the
into account
• Inopportunity
the long run,costall inputs towith
associated thethe
production process
use of a firm’s are variable. As a
resources.
• result,
Average the choice
Variable
opportunity costCostofis=
inputs
AVC depends
=
the cost TVC/Q both onwith
associated the the
relative costs of the
opportunities
factors of production and on the extent to which the firm can substitute
ATCforgone
= AFCwhen+ AVC the firm uses its resources in its next best alternative.
• A sunk cost is its
among inputs in an production
expenditure process.
that has been made and cannot be
The
• Marginallong-run
Cost = TC/Q
average cost
= TVC/Q
curve
recovered. After it has been incurred, is the envelope
it shouldofbetheignored
firm’s short-run
when
average
making future economic decisions. Because an expenditure that is to
cost curves, and it reflects the presence or absence of returns
scale.
sunk has When there are use,
no alternative increasing returns cost
its opportunity to scale
is zero.initially and then
decreasing returns to scale, the long-run average cost curve is U-shaped.
• In the short run, one or more of a firm’s inputs are fixed. Total cost
• Acan firmbeenjoys
dividedeconomies
into fixed costof scale when it cost.
and variable can double its output at less
• than twice
A firm’s the cost.
marginal costCorrespondingly,
is the additionalthere are cost
variable diseconomies
associated of scale
with
when a doublingunit
each additional of ofoutput
output.requires more than twice the cost. Scale
• economies
The average and diseconomies
variable cost is the applytotaleven whencost
variable input proportions
divided by the are
variable; returns to scale apply only when input proportions are fixed.
number of units of output.
• • Economies
In the short of run,
scopewhenarisenot whenall the firmare
inputs canvariable,
producethe anypresence
combinationof of
the two outputs
diminishing more cheaply
returns determines thanthecould two independent
shape of the cost firms thatIn
curves. each
produced
particular,a single
there output.
is an inverse relationship between the marginal
• Aproduct
firm’s average cost of production
of a single variable input and can thefall over time
marginal costif of
the firm “learns”
production.
how to produce more effectively. The learning curve shows how much the
• The average variable cost and average total cost curves are U-
input
shaped.needed to produce a given output falls as the cumulative output of
the firm increases.
Subhendu Dutta
PRACTICE TEST 12

Subhendu Dutta
 Microeconomics (2012), 10th edition, M. Parkin, Pearson
REFERENCES Microeconomics ()7th edition, Pindyck, Rubinfeld & Mehta

Subhendu Dutta