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Mic 7
- 1. Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
MICROECONOMICS 17– 1
- 2. CHAPTER
7 Cost of Production
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 2
- 3. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 3
- 4. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 4
- 5. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 5
- 6. SHORT-RUN PRODUCTION COST
(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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 6
- 7. SHORT-RUN PRODUCTION COST
(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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 7
- 8. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 8
- 9. THE RELATIONSHIP
BETWEEN COST CONCEPTS
Cost
MC
ATC
AVC
AFC
Quantity
The marginal cost cuts through the
minimum point of ATC and AVC
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 9
- 10. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 10
- 11. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 11
- 12. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 12
- 13. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 13
- 14. ISOCOST LINE
Isocost Line
6
5
4
Capital
3
Isocost
2
1
0
0 1 2 3 4 5
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 14
- 15. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 15
- 16. COST MINIMIZING TECHNIQUES
Cost minimizing techniques is
selecting a combination of inputs that
minimize the total cost at a given level
of output.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 16
- 17. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 17
- 18. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 18
- 19. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 19
- 20. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 20
- 21. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 21
- 22. 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.
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 22
- 23. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 23
- 24. 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
Microeconomics All Rights Reserved
© Oxford University Press Malaysia, 2008
7– 24