THE UNIVERSITY OF LUSAKA

ECF: 330 – INTRODUCTION TO MICROECONOMICS

UNIT 9

LECTURER: ELIAS
 OUTLINE
COST OF PRODUCTION
 Sunk costs
 Short run and the long run cost functions
 Economies of scale
 Supply curve of the firm and the market supply
 Pricing, revenues and profits of the firm

Readings: Mankiw Chp 13 McConnell Chp 8

 Cost Functions
 Every business has costs incurred in the production
process
 Some costs are recovered while others are not
 Costs that cannot be recovered are called sunk costs
 For example, if you want to start business and you
invest money in a market research to assess the
market for the product. If you find out that its not a
good business and decide to avoid it, the money
invested cannot be recovered and hence it’s a sunk
cost
 Cost Functions
 The cost function shows the relationship between the
outlay, factor inputs and the payments to those factor
inputs
 In a two factor (capital and labour) model, the simple
cost function can be expressed as follows

𝐶 = 𝑟𝐾 + 𝑤𝐿

 Where C is the total cost, r is the payment to capital,

w is the payment to labour, K is the capital units and
L is the labour units
 Short Run Cost: Fixed Cost
 Recall that the short run is a period in which the firm
is not able to adjust all its resources for the purpose of
expanding its production capacity
 In simpler terms, in the short run, a firm has some
inputs that are fixed and cannot be changed, while
some may vary
 Fixed costs are costs that in total do not change when
the firm changes its output
 They are cost incurred in acquiring the fixed
resources
 Short Run Cost: Fixed Cost
 Fixed costs include payment for the firms plant,
rental payments, interest on a firm’s debts, a portion
of depreciation on equipment and buildings, and
insurance premiums
 They are payments that the firm will have to make
even if output is zero
 In the short run, we assume that capital is fixed,
hence we label it as 𝐾
 Therefore, r𝐾 is the fixed cost and 𝑤𝐿 is the variable
cost and we write
 The firm cannot avoid paying these costs in the short
run
 Short Run Cost: Variable Cost
 Recall that even in the short run, inputs such as labour
vary and form part of the firms variable cost
 Variable costs are costs that in total increase when the
firm increases its output and decrease when it reduces
its output
 They include payments for materials, fuel, power,
transportation services, most labour, and similar
variable resources
 Variable costs increase as the firm increase
production (output)
 In a two factor short run model, 𝑤𝐿 is the variable
cost
 Short Run Cost: Total Cost
 In the short run, total cost is the sum of the fixed cost
plus the variable cost
 Hence,
𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡𝑠 + 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡𝑠
Or simply
𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
Example: Suppose the firm has fixed costs of K30,000
and variable costs of K45,000, then
𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶
𝑇𝐶 = 𝐾30,000 + K45,000
𝑇𝐶 = 𝐾75,000
 Short Run Cost
Cost Schedules
Output Fixed Cost Variable Cost Total Cost
(ZMW) (ZMW) (ZMW)
0 100 0 100
1 100 90 190
2 100 170 270
3 100 240 340
4 100 300 400
5 100 370 470
6 100 450 550
7 100 540 640
8 100 650 750
9 100 780 880
10 100 930 1030
 Short Run Cost
Relationship among Total, Fixed and Variable cost
TC
Total cost, Fixed cost

TVC
& Variable cost

100 TFC

Total Product (Q)

 Short Run Cost: Per Unit Costs
Average Fixed Costs
 The average fixed cost is the total fixed cost incurred
per unit of output produced
 It is the firm’s total fixed costs divided by the output
produced

𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄

 Average fixed costs declines along the entire AFC

curve
 Short Run Cost: Per Unit Costs
Average Variable Costs
 The average variable cost is the total variable cost
incurred per unit of output produced
 It is the firm’s total variable costs divided by the
output produced

𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄
 AVC initially falls because of increasing marginal
returns but then rises because of diminishing marginal
returns
 Short Run Cost: Per Unit Costs
Average Total Costs
 The average total cost is the total cost incurred per
unit of output produced
 It is the firm’s total costs divided by the output
produced

𝑇𝐶
𝐴𝑇𝐶 =
𝑄
 It is thus the sum of AFC and AVC

𝐴𝑇𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶

 Short Run Cost: Marginal Costs
 The firm’s marginal cost is the extra or additional cost
of producing one more unit of output
 It is equal to the change in total cost divided by the
change in output
∆𝑇𝐶 𝑑𝑇𝐶
𝑀𝐶 = or 𝑀𝐶 =
∆𝑄 𝑑𝑄
 In the short run, MC can also be found as

∆𝑇𝑉𝐶
𝑀𝐶 =
∆𝑄
Why is this the case?
 Short Run Cost
Cost Schedules
Q TFC TVC TC AFC AVC ATC MC
0 100 0 100 - - - -
1 100 90 190 100 90 190 90
2 100 170 270 50 85 135 80
3 100 240 340 33.33 80 113.33 70
4 100 300 400 25 75 100 60
5 100 370 470 20 74 94 70
6 100 450 550 16.67 75 91.67 80
7 100 540 640 14.29 77.14 91.43 90
8 100 650 750 12.5 81.25 93.75 110
9 100 780 880 11.11 86.67 97.78 130
10 100 930 1030 10 93 103 150
 Short Run Cost
Relationship among AFC, AVC, ATC AND MC
AFC,AVC,ATC,MC

MC
ATC
AVC

AFC
0 Total Product (Q)
 Short Run Cost: Marginal Costs
 Relationship among AFC, AVC, ATC AND MC
 The marginal cost (MC) curve cuts through the
average total cost (ATC) curve and the average-
variable cost (AVC) curve at their minimum points
 When MC is below average total cost, ATC falls
 When MC is above average total cost, ATC rises
 When MC is below average variable cost, AVC falls
 When MC is above average variable c
 Notice how the gap between the ATC and AVC curves
reduces as the output level increases
 this gap depicts the AFC
 AFC keeps declining asymptotically to the horizontal
 Short Run Cost: Marginal Costs
 Relationship among AFC, AVC, ATC AND MC
 AFC keeps declining asymptotically to the horizontal
axis
 The level of output that the firm produces when it is
operating at the minimum ATC curve is called
efficient scale
 Short Run Cost: Curve Shifts
Increase in Fixed Costs
AFC,AVC,ATC,MC

MC ATC’
ATC
AVC

AFC’
AFC
0 Total Product (Q)
 Short Run Cost: Curve Shifts
 Changes in either resource prices or technology will
cause costs to change and therefore the cost curves to
shift
Increase in Fixed Costs
 An increase in fixed costs will shift the TFC curve
upwards
 This will also increase the AFC and shift the AFC
curve up
 Increase in fixed cost increases the total cost and
consequently the ATC
 The marginal cost, variable cost, and average variable
cost will not change
 Short Run Cost
Increase in Variable costs MC’
AFC,AVC,ATC,MC

ATC’
MC AVC’
ATC
AVC

AFC
0 Total Product (Q)
 Short Run Cost: Curve Shifts
Increase in Variable Costs
 An increase in variable costs will shift the TVC curve
upwards
 This will also increase the AVC and shift the AVC
curve up
 Increase in TVC increases the total cost and
consequently the ATC
 The MC will shift up-right
 Changes in TVC will not affect the fixed costs
 Short Run Cost
Relationship Between AP, MP, AVC, and MC
A
AP and MP

Stage 1 Stage 2 Stage 3 A𝑷

O 𝑳𝟏 𝑳𝟐 𝑳𝟑B Units of Labour

M𝑷
AVC
MC
AVC and MC

E’
A’

o Total Product (Q)

 Short Run Cost
Relationship Between AP, MP, AVC, and MC
 The MC curve is the mirror image of the MP curve
 The AVC curve is the mirror image of the AP curve
 Assuming that labour is the only variable input and
that its price (the wage rate) is constant, then;
 when MP is rising, MC is falling, and when MP is
falling, MC is rising
 when AP is rising, AVC is falling, and when AP is
falling, AVC is rising
 This means that MC is the reciprocal of the MP and
AVC is the reciprocal of the AP
 Short Run Cost: Task
1. Consider the cost function below
𝐶 = 200 + 20𝑄 3
i. Find the total fixed cost.
ii. Find the total variable cost.
iii. Find the average fixed cost.
iv. Find the average variable cost.
v. Find the marginal cost.
vi. Find the level of output at which the average
variable cost curve meet the marginal cost curve.
vii. Find the short run efficient scale of the firm.
viii.Plot (i) to (vii) on one graph
 Long Run Cost
 The firm is said to be in the long run if it is able to
alter all its production resources
 The long run allows sufficient time for new firms to
enter or for existing firms to leave an industry
 In the long run, we do not have fixed costs
 Hence all costs are variable and the long run cost is a
function of the variable costs
𝐶 = 𝑓 𝑇𝑉𝐶
 Is it possible for the firm to move to a short run, after
already hitting the long run?
 Long Run Cost
 After adjusting say its plant, firms output increases
 However, as the production levels increase, over time,
the plant will eventually become small and the firm
will need to adjust the plant to further increase
production
 Consider the case of Covid-19 pandemic: the existing
plant for face masks and hand sanitizer production
eventually became small and firms adjusted their
production capacities (new plants were established)
are still adjusting their plant sizes to meet the growing
demand for face masks and hand
 Long Run Cost
 The firm then playing in the cycle of moving to and
fro between the short run and the long run
 With this, the short run average costs for the firm are
different for each plant size established
 If the firm has developed five plants in different short
runs, then the firm will have five different short run
average costs
 The envelope of all these short run average costs
gives the long run average costs (LAC)
 The shape of the LAC is similar to that of the SAC
 The LAC declines, reach a minimum and then starts
to rise
LAC Long Run Cost

LAC
𝑆𝐴𝐶1

𝑆𝐴𝐶5
𝑆𝐴𝐶2 𝑆𝐴𝐶4
𝑆𝐴𝐶3

Min - LAC

0 Q* Output
Economies and Diseconomies of Scale
 Note that if the LAC is falling or rising, the point of
tangency between the LAC and the SAC is not the
minimum of the SAC
 When LAC is falling, the SAC will be tangent to the
SAC on the falling side of the SAC
 When LAC is rising, the SAC will be tangent to the
SAC on the rising side of the SAC
 At the minimum of the LAC, the point of tangecy is
the minimum of the SAC
 Output at the minimum point of the LAC is called the
minimum efficient scale of the firm
Economies and Diseconomies of Scale
LAC

Economies of Constant Disconomies

Scale Returns of Scale
to Scale
LAC

o Output
Economies and Diseconomies of Scale
 Economies of scale are rather rapidly obtained as
plant size rises
 The firm obtain economies of scale when the LAC is
falling as the firm expands its output
 At the minimum of the LAC, the firm obtains
constant returns to scale and it is at this point were the
firm produces the minimum efficient scale
 The minimum efficient scale is the lowest level of
output at which a firm can minimize long-run average
costs
 Diseconomies of scale comes in when the firm’s LAC
increases as the firm expands its output
Economies and Diseconomies of Scale
 Economies of scale are the consequence of greater
specialization of labour and management, more
efficient capital equipment, and the spreading of start-
up costs among more units of output
 Diseconomies of scale are caused by the problems of
coordination and communication that arise in large
firms
 Most firms have U-shaped long-run average total cost
curves, reflecting economies and then diseconomies
of scale