Costs of Production

Explicit cost refers to the making of actual

payments in the process of production.
Eg. wages, transportation costs, costs of raw
materials.
Implicit cost imputed costs(not incurred directly)
of the firm for the use of factors of production.
Eg. ones own labor

 Sunk Cost
A sunk cost is an expenditure that has been made and
cannot be recovered Irrecoverable cost involved in
production.
Eg: a firm buys a highly specialized machine for a
plant. It can be used only what it was designed for.
That is, it cannot be put in alternative uses. Its
opportunity cost is zero.

- role of sunk cost in decision making.Is it largely

ignored?

 The opportunity cost of anything produced can thus

be defined as the next best alternative that can be
produced instead by the same factors or by an
equivalent group of factors costing the same amount
of money.
Resources are limited and therefore they cannot be
used for more than one purpose at the same time. E.g.
If land is used for building a house, the same land
cannot be used for agricultural purpose. In general
terms, if a resource can produce either A or B, then
the opportunity cost of producing A is the loss of
B.

Costs in the Short run

Total cost-the market value of all resources used to
produce a good or service.
Total cost = fixed cost + variable cost
TC=FC+VC

Fixed cost(FC or TFC)- costs of production that

does not change when the rate of output is altered.
Variable cost(VC or TVC)- costs of production that
change when the rate of output is altered.

OUTPUT

Total Cost

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14

2
3
3.8
4.4
4.8
5.2
5.8
6.6
7.6
8.8
10.2
11.8
13.6
15.6
17.8

Fixed
Cost
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2

Variable
Cost
0
1
1.8
2.4
2.8
3.2
3.8
4.6
5.6
6.8
8.2
9.8
11.6
13.6
15.8

TC increases initially at a diminishing rate and then increases

at an increasing rate.

Average total cost = Average fixed cost + Average variable

cost
ATC(AC)=AFC+AVC
Average total cost- Total cost divided by the quantity of output.
ATC = Total cost/Output
AC= TC/Q
Average fixed cost- Fixed costs divided by the quantity of
output.
AFC=FC/Q
Average variable cost- Variable costs divided by the quantity
of output.
AVC=VC/Q

 Marginal Cost
- Change in total cost associated with an
additional unit of output.
- MC increases whenever marginal physical
product diminishes.
MC = Change in total cost
Change in output
MC = TC/Q

OUTPUT

Total Cost

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14

2
3
3.8
4.4
4.8
5.2
5.8
6.6
7.6
8.8
10.2
11.8
13.6
15.6
17.8

Fixed
Cost
2
2
2
2
2
2
2
2
2
2
2
2
2
2
2

Variable
Cost
0
1
1.8
2.4
2.8
3.2
3.8
4.6
5.6
6.8
8.2
9.8
11.6
13.6
15.8

OUTPUT

TC

FC

VC

AFC

AVC

ATC

MC

0
1
2
3
4
5
6
7
8
9
10
11
12
13
14

2
3
3.8
4.4
4.8
5.2
5.8
6.6
7.6
8.8
10.2
11.8
13.6
15.6
17.8

2
2
2
2
2
2
2
2
2
2
2
2
2
2
2

0
1
1.8
2.4
2.8
3.2
3.8
4.6
5.6
6.8
8.2
9.8
11.6
13.6
15.8

2
1
0.67
0.5
0.4
0.33
0.29
0.25
0.22
0.2
0.18
0.17
0.15
0.14

1
0.9
0.8
0.7
0.64
0.63
0.66
0.7
0.76
0.82
0.89
0.97
1.05
1.13

3
1.9
1.47
1.2
1.04
0.97
0.94
0.95
0.98
1.02
1.07
1.13
1.2
1.27

1
0.8
0.6
0.4
0.4
0.6
0.8
1
1.2
1.4
1.6
1.8
2
2.2

 The nature of AFC, AVC, ATC curves

Increase in output will lower AFC and AFC curve
constantly declines (declines always) as output rises
because the fixed cost is distributed over a large
number of units.
With both AFC and AVC falling, ATC declines.
Rising AVC, ATC curves
- AVC rises as output increases because of
diminishing returns in production.
- ATC rises because AVC rises substantially.

 U shaped ATC
- during initial stages large declines in AFC outweigh
any increase in AVC and as a result ATC tends to fall.
- after reaching a minimum point increase in AVC
becomes more than the fall in the AFC, and hence
ATC rises.
Rising Marginal Cost
- marginal cost rises with the quantity of output
produced. This reflects the property of diminishing
marginal product.
- i.e. when the quantity of output being produced is
already high, then marginal product of an extra
worker is low, and hence the marginal cost of an extra
unit of output is large.

 The marginal-cost curve intersects the averagetotal cost curve at the minimum of average total
cost. This point represents the least-cost output.
i.e. at minimum cost output, AC=MC.
At output less than minimum cost output, MC is
below AC, so AC is falling.
At output greater than minimum cost output, MC
is above AC, so AC is rising.

 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-totalcost curve at the minimum of average total cost.

LONG RUN COSTS

The long run(LR) opens up a whole new range of options
as there is no fixed cost. The LR cost possibilities are
determined by all possible short run options.
Three choices according to plant sizes: a small
factory(ATC1), a medium-sized factory(ATC2), a large
factory(ATC3).
In the LR, well chose the plant which gives the lowest
AC for any desired rate of output.
ATC1 starts to rise at relatively low levels of output.
ATC2 can produce the maximum possible output of
ATC1 at lower cost. But ATC2 also rises.
To produce large quantities, ATC3 offers the lowest
ATC.

LRAC
SRAC2

SRAC1

SRAC3

LONG RUN COSTS with unlimited options

If plants of all sizes can be built, short run
options are infinite. In this case, the long run
average cost (LRAC) curves becomes a smooth U
shaped curve.
Each point on the curve represents lowest cost
production for a plant size suitable to one rate of
output.
The LRAC curve has its own MC curve. It is not
the composite of short run MC. The LR MC
intersects LRAC at its lowest point.

 The long-run average cost curve is the envelope

of an infinite number of short-run average
total cost curves, with each short-run average
total cost curve tangent to, or just touching, the
long-run average cost curve at a single point
corresponding to a single output quantity.
When LRAC is falling, LRAC is tangential to
the falling portion of SRAC(s)
When LRAC is rising, LRAC is tangential to the
rising portion of SRAC(s)
When LRAC is minimum, it is tangential to the
lowest point of SRAC

Deriving a long-run average cost curve

Costs

LRAC

Output
fig

Minimum efficient scale (MES)

- the lowest point on the long run average cost
curve .
- range of output levels where the firm achieves
constant returns to scale and has reached the
lowest feasible cost per unit in the long run.

Economies and diseconomies of scale

Economies of scale refer to reductions in
minimum average cost attained with larger
plant size.
- the property whereby long-run average total
cost falls as the quantity of output increases
Diseconomies of scale- the property whereby
long-run average total cost rises as the
quantity of output increases.
- If ATC rises with plant size, diseconomies of
scale exist.

 constant returns to scale-the property whereby

long-run average total cost stays the same as
the quantity of output changes.
What
might
cause
economies
or
diseconomies of scale?
Economies of scale often arise because higher
production levels allow specialization among
workers, which permits each worker to
become better at his or her assigned tasks.
Diseconomies of scale can arise because of
coordination problems that are inherent in
any large organization.

why long run average total cost curves are

often U shaped?
At low levels of production, the firm benefits
from increased size because it can take
advantage of greater specialization.
At high levels of production, the benefits of
specialization have already been realized, and
coordination problems become more severe
as the firm grows larger.

Economics of Scope
Economies of Scope a production characteristic in which
the total cost of producing given quantities of two goods in
the same firm is less than the total cost of producing those
quantities in two single-product firms.
Mathematically,
TC(Q1, Q2) < TC(Q1, 0) + TC(0, Q2)
Stand-alone Costs the cost of producing a good in a
single-product firm, represented by each term in the righthand side of the above equation.

Economics of scope
Hub and spoke network and economics of
scope in airline industry.

Transportation Networks and Economics of Scope

Break Even Analysis

Break even is the point of production where a
firms total revenue is equal to the total cost of
production.
When total revenue is equal to total cost the
process is at the break-even point.
TR = TC
Margin of safety - the difference between the
firms current level of output and break even
output

Break-Even Analysis
TR (p = Rs2)

Costs/Revenue

Profit

TC
VC

Loss
FC

Q1

Output/Sales