COSTS OF PRODUCTION

Learning Objectives
1. Distinguish between the economic short run
and the economic long run.
2. Understand the relationship between the
marginal product of labour and the average
product of labour.
3. Explain and illustrate the relationship
between marginal cost and average total
cost.
4. Graph average total cost, average variable
cost, average fixed cost, and marginal cost.
5. Understand how firms use the long-run
average cost curve to plan.

Meaning of Production
 Production is a process of
transforming (converting) inputs (raw-
materials) into outputs (finished
goods). So, production means the
creation of goods and services. It is
done to satisfy human wants. Thus,
production is a process of
transformation.

Factors of Production
 Factors of production is an economic
term that describes the inputs that are
used in the production of goods or
services in order to make an economic
profit.
 It includes : Land , Labor, Capital and
Entrepreneurship

Meaning of Cost
 In business and accounting, cost is the
monetary value that a company has spent in
order to produce something .
 An amount that has to be paid or given up in
order to get something.
 In business, cost is usually a monetary
valuation of (1) effort, (2) material, (3)
resources, (4) time and utilities consumed,
(5) risks incurred , and (6) opportunity
forgone in production and delivery of a good
or services. All expenses are costs, but not
all costs (such as those incurred in
acquisition of an income-generating asset)
are expenses.

Meaning of Economic Costs
 Economic cost is the combination of
gains and losses of any goods that
have a value attached to them by any
one individual.
 Economic cost is used mainly by
economists as means to compare the
prudence of one course of action with
that of another.
 The goods to be taken into
consideration are e.g. money, time
and resources.

Economic Costs
 Opportunity costs : the opportunity cost of a
choice is the value of the best alternative forgone
where, given limited resources.
 Explicit costs A direct payment made to others in the
course of running a business, such as wages, rent, and
materials.
 Implicit costs The opportunity cost equal to what a
firm must give up in order to use factors which it neither
purchases nor hires.
This is true whether the costs are implicit or explicit.
Both matter for firms’ decisions.

Explicit vs. Implicit Costs: An
Example
You need $100,000 to start your business.
The interest rate is 5%.
 Case 1: borrow $100,000
◦ explicit cost = $5000 interest on loan
 Case 2: use $40,000 of your savings,
borrow the other $60,000
◦ explicit cost = $3000 (5%) interest on the loan
◦ implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
◦ In both cases, total (exp + imp) costs are
$5000.

Economic Profit vs. Accounting
Profit
 Economic profit is the monetary costs and
opportunity costs a firm pays and the revenue a
firm receives.
Economic profit = total revenue - (explicit costs + implicit costs).
 Accounting profit is the monetary costs a firm pays
out and the revenue a firm receives. It is the
bookkeeping profit, and it is higher than economic
profit.
Accounting profit = total monetary revenue- total costs.

Short run and Long run
 Short run
◦ a period of time where at least one factor
is fixed, usually capital stock is fixed, and
all others are variable.
 Long run
◦ a time period where all factors of
production, even the capital stock, can be
varied

Short-Run Production Costs
 Total Product (TP)
It is defined as the total quantity of output produced by a firm
in the given inputs.
 Marginal Product (MP)
additional output resulting from the addition of an extra unit of
a resource
∆Q = change in output, ∆L = change in labor
Marginal product (MP) = Change in output / change in labor
 Average Product (AP)
Average product equals the units of output produced per unit
of a factor of production while keeping other factors of
production constant.
Average product = Total Output in Units / Units of labor

Law of diminishing returns
 Law of diminishing returns explains
that when more and more units of a
variable input are employed on a
given quantity of fixed inputs, the total
output may initially increase at
increasing rate and then at a constant
rate, but it will eventually increase at
diminishing rates.

Law of diminishing returns
 Diminishing returns occurs in the short run when one
factor is fixed (e.g. capital)
 If the variable factor of production is increased (e.g.
labour), there comes a point where it will become less
productive and therefore there will eventually be a
decreasing marginal and then average product
 This is because, if capital is fixed, extra workers will
eventually get in each other’s way as they attempt to
increase production. E.g. think about the effectiveness
of extra workers in a small café. If more workers are
employed, production could increase but more and
more slowly.
 This law only applies in the short run because in the
long run all factors are variable.

1
2
3
4
5
6
7
8
8
20
36
48
55
60
60
56
8
12
16
12
7
5
0
-4
Variable
Resource
No. of Workers
Extra or
marginal
product
Average
product
Total
product
8
10
12
12
11
10
8.6
7
Fixed
Input
Land
4
4
4
4
4
4
4
4
hec

Continue
 There are three stages :
1. Increasing returns : AP reaches its
maximum and equals the MP at 4 workers.
Point S in diagram shows the MP and AP
curves meet. TP also increases rapidly.
Here Land is too much in relation to the
employees.
2. Diminishing returns : AP is at its maximum
to the Zero point of the MP. TP is at its
highest. Workers increases from 4 to 7. Its
lies between SB and MH. This is the only
stage in which production is feasible and
profitable.

Continue
 Negative Marginal Returns :
Production can not take place in this
stage. TP starts declining and the MP
becomes negative. 8th worker causes
a decrease in TP from 60 to 56 units
and make MP minus 4. This stage
starts from MH where MP is below X
axis. Here worker are too many in
relation to the available land.
Therefore production will not take
place.

Short run Production costs
 Fixed costs
◦ do not vary with changes in output
 Variable costs
◦ vary with changes in output
 Total costs
◦ the sum of fixed and variable costs at
each level of output

Total Costs
Quantity
Costs(dollars)
TC
Total
Cost
Fixed Cost
TVC
Variable Cost
TFC

Short run Production costs
 Average fixed costs (AFC) are found by
AFC = total fixed costs / output.
As fixed cost is divided by an increasing
output, average fixed costs will continue
to fall.
 Average variable costs (AVC) are found
by :
AVC = total variable costs / output.
The average variable cost (AVC) curve will
at first slope down from left to right, then
reach a minimum point, and rise again.

Continue
 Average total cost (ATC) can be found
by adding :
average fixed costs (AFC) + average
variable costs (AVC).
OR
ATC = total costs / output
The ATC curve is also ‘U’ shaped
because it takes its shape from the
AVC curve

Marginal Costs
 Marginal Cost (MC)
◦ the extra, or additional cost of producing
one more unit of output
Marginal Cost =
Change in Total Costs
Change in Quantity

Marginal Cost Relationships
 When MC > ATC
◦ ATC increases
 When MC < AC
◦ ATC falls
 When ATC = MC
◦ ATC is at its minimum

Costs in the Short Run & Long
Run
 Short run:
Some inputs are fixed (e.g., factories,
land).
The costs of these inputs are FC.
 Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones).
 In the long run, ATC at any Q is cost per
unit using the most efficient mix of inputs
for that Q (e.g., the factory size with the
lowest ATC).

THE COSTS OF
PRODUCTION 31
EXAMPLE 3: LRATC with 3 factory
Sizes
ATCS
ATCM
ATCL
Q
Avg
Total
Cost
Firm can choose
from 3 factory
sizes: S, M, L.
Each size has its
own SRATC curve.
The firm can
change to a
different factory
size in the long
run, but not in the
short run.

THE COSTS OF
PRODUCTION 32
EXAMPLE 3: LRATC with 3 factory Sizes
ATCS
ATCM
ATCL
Q
Avg
Total
Cost
QA QB
LRATC
To produce less
than QA, firm will
choose size S
in the long run.
To produce
between QA
and QB, firm will
choose size M
in the long run.
To produce more
than QB, firm will
choose size L
in the long run.

THE COSTS OF
PRODUCTION 33
A Typical LRATC Curve
Q
ATC
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
So a typical
LRATC curve
looks like this:
LRATC

THE COSTS OF
PRODUCTION 34
How ATC Changes as the Scale of Production
Changes
Economies of
scale: ATC falls
as Q increases.
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
LRATC
Q
ATC

Diseconomies
of scale
Constant returns
to scale
Economies
of scale
Long-Run ATC Curves
UnitCosts
Output
Long-run ATC

THE COSTS OF
PRODUCTION 36
How ATC Changes as the Scale of Production
Changes
 Economies of scale occur when increasing
production allows greater specialization:
workers more efficient when focusing on a
narrow task.
◦ More common when Q is low.
 Diseconomies of scale are due to
coordination problems in large
organizations.
E.g., management becomes stretched,
can’t control costs.
◦ More common when Q is high.