UNIT II (PART II)

COSTS OF PRODUCTION

1
 WHAT ARE COSTS?

• Costs of production relate to the different

expenses that a firm incur in producing a
good or service.

2
Total Revenue, Total Cost, and Profit
 Total Revenue
• The amount a firm receives for the sale of its
output.
 Total Cost
• The market value of the inputs a firm uses in
production.

3
Total Revenue, Total Cost, and Profit
 Profit is the firm’s total revenue minus its total
cost.

 Profit = Total revenue - Total cost

4
 Costs as Opportunity Costs
 A firm’s cost of production includes all the
opportunity costs of making its output of goods
and services.
 Explicit and Implicit Costs
• A firm’s cost of production include explicit costs
and implicit costs.
- Explicit costs are input costs that require a direct
outlay of money by the firm.
- Implicit costs are input costs that do not require an
outlay of money by the firm.

5
 Economic Profit versus Accounting
Profit
 Economists measure a firm’s economic profit as
total revenue minus total cost, including both
explicit and implicit costs.
 Accountants measure the accounting profit as
the firm’s total revenue minus only the firm’s
explicit costs.

6
 Economic Profit versus Accounting
Profit
 When total revenue exceeds both explicit and
implicit costs, the firm earns economic profit.
 Economic profit is smaller than accounting profit.

7
 Figure 1 Economists versus
Accountants
How an Economist How an Accountant
Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

8
THE VARIOUS MEASURES OF COST
 Costs of production may be divided into fixed
costs and variable costs.
• Fixed costs are those costs that do not vary
with the quantity of output produced.
• Variable costs are those costs that do vary
with the quantity of output produced.

9
 Internal vs External Costs

Internal costs:
 Refer to the direct monetised costs (planning,
construction, management, maintenance, disposal) for a
person or organisation undertaking an activity.
External costs (also known as externalities)
• Refer to the economic concept of uncompensated social
or environmental effects.
• For example, when people buy fuel for a car, they pay for
the production of that fuel (an internal cost), but not for the
costs of burning that fuel, such as air pollution.

10
 Private and Social Costs
Private Costs:
 Costs we have to actually pay for any activity
 Eg: owning and driving a car
 It is private cost because it is specific to an
individual.
Social Costs:
 Social costs= private cost plus externalities
(external costs)

11
2-
 Negative vs Positive Etxernality
 Negative Externality:
 Eg: Air pollution from motor vehicle

 Positive Externality:
 Education, health, labour training in firms

12
 Fixed and Variable Costs
 Total Costs
• Total Fixed Costs (TFC)
• Total Variable Costs (TVC)
• Total Costs (TC)
• TC = TFC + TVC

13
 Fixed and Variable Costs
 Average Costs
• Average costs can be determined by dividing
the firm’s costs by the quantity of output it
produces.
• The average cost is the cost of each typical unit
of product.

14
 Fixed and Variable Costs
 Average Costs
• Average Fixed Costs (AFC)
• Average Variable Costs (AVC)
• Average Total Costs (ATC)
• ATC = AFC + AVC

15
Average and Marginal Costs

Fixed cost FC
AFC  
Quantity Q

Variable cost VC
AVC  
Quantity Q

Total cost TC
ATC  
Quantity Q

16
 Average and Marginal Costs
 Marginal Cost
• Marginal cost (MC) measures the increase in
total cost that arises from an extra unit of
production.
• Marginal cost helps answer the following
question:
- How much does it cost to produce an additional
unit of output?

17
 Average and Marginal Cost

(change in total cost) TC

MC  
(change in quantity) Q

18
The various measures of cost: Conrad’s coffee shop
Quantity Averag Averag Averag Marginal
of coffee Total Fixed Variabl e e e Cost
(cups per Cost Cost e Fixed Variabl Total
hour) Cost Cost e Cost
Cost
0 $3.00 $3.00 $0.00 - - -
1 3.30 3.00 0.30 $3.00 $0.30 $3.30 $0.30
2 3.80 3.00 0.80 1.50 0.40 1.90 0.50
3 4.50 3.00 1.50 1.00 0.50 1.50 0.70
4 5.40 3.00 2.40 0.75 0.60 1.35 0.90
5 6.50 3.00 3.50 0.60 0.70 1.30 1.10
6 7.80 3.00 4.80 0.50 0.80 1.30 1.30
7 9.30 3.00 6.30 0.43 0.90 1.33 1.50
8 11.00 3.00 8.00 0.38 1.00 1.38 1.70
9 12.90 3.00 9.90 0.33 1.10 1.43 1.90
10 15.00 3.00 12.00 0.30 1.20 1.50 2.10

19
 Conrad’s total-cost curve
Total Cost

$15.00
14.00 Total-cost curve
13.00
12.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00

0 1 2 3 4 5 6 7 8 9 10 Quantity of Output
(cups of coffee per hour)

Here the quantity of output produced (on the horizontal axis) is from the first column in Table 2, and the total
cost (on the vertical axis) is from the second column. As in Figure 2, the total-cost curve gets steeper as the
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quantity of output increases because of diminishing marginal product.
 Cost Curves and Their Shapes
 Marginal cost rises with the amount of output
produced.
• This reflects the property of diminishing
marginal product.

21
 Cost Curves and Their Shapes
 The average total-cost curve is U-shaped.
 At very low levels of output average total cost is
high because fixed cost is spread over only a
few units.
 Average total cost declines as output increases.
 Average total cost starts rising because average
variable cost rises substantially.

22
 Cost Curves and Their Shapes
 The bottom of the U-shaped ATC curve occurs
at the quantity that minimizes average total cost.
This quantity is sometimes called the efficient
scale of the firm.

23
 Cost Curves and Their Shapes
 Relationship between Marginal Cost and
Average Total Cost
• Whenever marginal cost is less than average
total cost, average total cost is falling.
• Whenever marginal cost is greater than
average total cost, average total cost is rising.

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Relationship between Marginal and
Average Costs

25
 Cost Curves and Their Shapes
 Relationship between Marginal Cost and
Average Total Cost
• The marginal-cost curve crosses the average-
total-cost curve at the efficient scale.
- Efficient scale is the quantity that minimizes
average total cost.

26
 Typical Cost Curves
 It is now time to examine the relationships that
exist between the different measures of cost.

27
Cost Curves for a Typical Firm

Note how
Marginal MCdeclines
Cost hits both
atATC
first and
and AVC
thenat their
Costs minimum
increases points.
due to diminishing marginal product.

$3.00 AFC, a short-run concept, declines throughout.

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output
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 Typical Cost Curves
 Three Important Properties of Cost Curves
• Marginal cost eventually rises with the quantity
of output.
• The average-total-cost curve is U-shaped.
• The marginal-cost curve crosses the average-
total-cost curve at the minimum of average total
cost.

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COSTS IN THE SHORT RUN AND IN
THE LONG RUN

 For many firms, the division of total costs

between fixed and variable costs depends on
the time horizon being considered.
• In the short run, some costs are fixed.
• In the long run, all fixed costs become variable costs.
 Because many costs are fixed in the short run
but variable in the long run, a firm’s long-run cost
curves differ from its short-run cost curves.

30
 Long-run costs

Since all inputs are variable, all costs are variable in

the long run.
Long-run average cost (LRAC) measures the long-
run cost of producing one unit of output:

Long - Run Total Cost of Production

LRAC 
Output

31
 The Relationship between Short-Run
Average Cost and Long-Run Average
Cost
LRAC shows minimum average cost of
producing any level of output when all inputs
are variable

32
 Economies and Diseconomies of
Scale
 Economies of scale refer to the property
whereby long-run average total cost falls as the
quantity of output increases.
 Diseconomies of scale refer to the property
whereby long-run average total cost rises as the
quantity of output increases.
 Constant returns to scale refers to the property
whereby long-run average total cost stays the
same as the quantity of output increases.

33
 Average Total Cost in the Short and
Long Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

Cars per Day
34
 Return to scale
what happens to LRAC as a firm increases its plant size

35
 Summary
 The goal of firms is to maximize profit, which
equals total revenue minus total cost.
 When analyzing a firm’s behavior, it is important
to include all the opportunity costs of production.
 Some opportunity costs are explicit while other
opportunity costs are implicit.

36
 Summary
 A firm’s costs reflect its production process.
• A typical firm’s production function gets flatter
as the quantity of input increases, displaying
the property of diminishing marginal product.
• A firm’s total costs are divided between fixed
and variable costs. Fixed costs do not change
when the firm alters the quantity of output
produced; variable costs do change as the firm
alters quantity of output produced.

37
 Summary
 Average total cost is total cost divided by the
quantity of output.
 Marginal cost is the amount by which total cost
would rise if output were increased by one unit.
 The marginal cost always rises with the quantity
of output.
 Average cost first falls as output increases and
then rises.

38
 Summary
 The average-total-cost curve is U-shaped.
 The marginal-cost curve always crosses the
average-total-cost curve at the minimum of ATC.
 A firm’s costs often depend on the time horizon
being considered.
 In particular, many costs are fixed in the short
run but variable in the long run.

39
 Summary
Total fixed Costs that do not depend on the TFC
costs quantity of output produced.
These must be paid even if output
is zero.
Total variable Costs that vary with the level of TVC
costs output.
Total cost The total economic cost of all the TC = TFC + TVC
inputs used by a firm in
production.
Average fixed Fixed costs per unit of output. AFC = TFC/Q
costs
Average Variable costs per unit of output. AVC = TVC/Q
variable costs
Average total Total costs per unit of output. ATC = TC/Q
costs ATC = AFC + AVC
Marginal costs The increase in total cost that MC = DTC/DQ
results from producing one
additional unit of output. 40