Mic 7

Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
MICROECONOMICS 17– 1

CHAPTER

7 Cost of Production
7– 2

THE COST CONCEPTS
Value of input services that are used in
IMPLICIT COST
production but not purchased in a market.
COST CONCEPTS

Total cost of production of a good that
SOCIAL COST includes direct and indirect costs.

The value of a resource in its
OPPORTUNITY COST
next best use.

Value of resources purchased for
EXPLICIT COST
production.

The cost that a firm cannot recover from
SUNK COST
the expenditure it has made.

7– 3

THE COST OF PRODUCTION
SHORT RUN
A production period in which at least
one of the input is fixed*
LONG RUN

A production period in which all the
inputs are variable**
* A fixed input is an input in which the quantity does not change according to
the amount of output, e.g. machinery.
** A variable input is an input in which the quantity varies according to the
amount of output, e.g. labour.

7– 4

SHORT-RUN PRODUCTION COST
TOTAL COST (TC)
 The sum of cost of all inputs used to produce goods and
services.
 Total cost (TC ) is 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 is  The cost of inputs that changes
independent of output. with output.
 Examples, factory,  Examples, raw materials,
machinery, etc. labours, etc.

7– 5

(CON’T)
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)
AC = TC
Q
OR
TC = TFC + TVC
7– 6

(CON’T)
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
7– 7

COSTS AT VARIOUS QUANTITES
Total costs Average costs

(1) (2) (3) (4) (5) (6) (7) (8)
Quantity Total Total Total Average Average Average total Marginal
(Q) fixed variable cost fixed cost variable cost cost (MC)
cost cost (TC) (AFC) cost (AVC) (ATC)
(TFC) (TVC) TC=TF AFC = AVC = ATC = TC/Q MC =
C+TVC TFC/Q TVC/Q ∆TC/∆Q
(4) / (1) or (5)
(2) + (3) (2)/(1) (3) / (1) + (6) ∆(4) /∆(1)

20 0 20 - - - -
1

0 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

7– 8

THE RELATIONSHIP
BETWEEN COST CONCEPTS
Cost
MC
ATC

AVC

AFC
Quantity

The marginal cost cuts through the
minimum point of ATC and AVC
7– 9

THE RELATIONSHIP
BETWEEN MC AND AVC
Cost
ATC falling, MC
curve lies below MC
ATC curve. ATC is ATC
at minimum point.
ATC curve and MC
curve are equal.
ATC starts to
increase. MC
curve lies above
ATC curve.
Quantity
7– 10

THE RELATIONSHIP BETWEEN
PRODUCTIVITY AND COST
Production

AP equal to MP, AP
MP AP curve is at maximum.
AVC equal to MC , AVC
Labour curve is at minimum.
Cost
MC AVC

Quantity
7– 11

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.

7– 12

ISOCOST EQUATION
• 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

7– 13

ISOCOST LINE

Isocost Line
6

5

4
Capital

3
Isocost
2

1

0

0 1 2 3 4 5

7– 14

ISOCOST MAP
An isocost map is a number of isocost lines that
show different levels of total cost in one diagram.
7

6

5 Isocost
(RM100)
4
Capital

3 Isocost
(RM120)
2

1

0
0 1 2 3 4 5 6

7– 15

COST MINIMIZING TECHNIQUES

Cost minimizing techniques is
selecting a combination of inputs that
minimize the total cost at a given level
of output.

7– 16

COST MINIMIZING TECHNIQUES
At point y, the slope of isoquant curve is equal to that of isocost line and this is the most
efficient technique for production.

Labour
7
6
5 x
Isocost (RM100)
4
Capital

3 Isocost (RM120)
y
2 Isocost
z
1
0
0 1 2 3 4 5 6

Points x and z are not efficient because the cost of production is exceeding RM120.

7– 17

LONG-RUN PRODUCTION COST
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)

This 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.
7– 18

LONG-RUN PRODUCTION COST CURVE
LRAC curve are derived by a series of short-run
average cost curves.
AC
SRAC1

SRAC5
SRAC2 LRAC
SRAC4

SRAC3

Quantity
7– 19

LONG-RUN PRODUCTION COST CURVE
• 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 a later stage.

Cost

LRAC

Increasing Constant Decreasing
Return to Return to Return to
Scale Scale Scale
Quantity
7– 20

ECONOMIES OF SCALE

• Advantages and benefits of a firm as it
becomes larger and larger.
• Reduced long-run average cost (LRAC).
• Marketing economies, financial economies,
labour economies, technical economies and
managerial economies.

7– 21

DISECONOMIES OF SCALE

• Problems faced by a firm as it becomes
larger and larger.
• Decreased long-run average cost
(LRAC).
• Mismanagement, competition and labour
diseconomies.

7– 22

ECONOMIES OF SCALE
Economies of scale are benefits and advantages of a
firm as it expands its production.
Economies of scale reduces the average cost.
INTERNAL EXTERNAL
Internal economies happen Advantages of the industry as a
inside an organization whole

Labour Economies
Economies of Government
Managerial Economies Action

Marketing Economies
Economies of Concentration
Techical Economies
Risk Bearing Economies Economies of Information

Transport and Storage
Economies Economies of Marketing

7– 23

DISECONOMIES OF SCALE
Diseconomies of scale are problems and disadvantages faced
by a firm when it expands production. Diseconomies of scale
increases the average cost.
INTERNAL EXTERNAL
Raise the cost of production of a The disadvantages faced by the
firm as the firm expands industry as a whole

Labour Diseconomies Scarcity of Raw Material

Managerial Problem Wage Differential

Technical Difficulties Concentration Problem

7– 24

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