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 CHAPTER 6
COST OF PRODUCTION

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 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
CONCEPTS OPPORTUNITY COST
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.
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 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

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 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 and  Example: Raw materials, labours,
etc. etc.

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 SHORT-RUN PRODUCTION 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

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 SHORT-RUN PRODUCTION 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
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 SHORT-RUN COST CURVES

COST TOTAL COST (TC)

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

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 SHORT-RUN COST CURVES (cont.)
MARGINAL COST (MC)
Change in total cost that results from a change in output
MC = TC
COST Q

MC ATC
AVERAGE TOTAL COST (ATC)
Total cost per output
ATC = TC ATC = AFC + AVC
Q
AVC
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
Q

AFC

QUANTITY

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 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

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 SHORT-RUN COST CURVES
COST

STAGE I STAGE II STAGE III

STAGE I
AFC begins to fall with an increase in output and AVC decreases.
SATC 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

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 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.

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 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

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 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

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 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.

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 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
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 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.

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 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.

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 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

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 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
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 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.

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 ECONOMIES OF SCALE

Economies of scale are benefits and advantages of a firm

as it expands its production.
• Reduce the average cost.
INTERNAL
Internal economies happen inside an EXTERNAL
organization Advantages of the industry as a whole

Labour Economies

Managerial Economies Economies of Government Action

Marketing Economies
Economies of Concentration
Technical Economies

Financial Economies
Economies of Information

Risk Bearing Economies

Economies of Marketing
Transport and Storage
Economies

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 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

Management Problem Wage Differential

Technical Difficulties
Concentration Problem

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Ch. 6: 23
 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.

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 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

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 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

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 CONCEPT OF REVENUE (cont.)

Case I: 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

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 CONCEPT OF REVENUE (cont.)

Case II: Under Imperfect Market

Quantity Price Total Average Marginal Revenue
Revenue (TR) Revenue (MR) AR equal to but MR is less than
(AR) price when price changes.
The graph shows the AR and MR
1 10 10 10 10
downward sloping and MR curve
2 9 18 9 8
lies below AR curve.
3 8 24 8 6
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

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 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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