Cost of production

The Cost of Production

Sunk Costs: Expenditure that has been made and cannot be recovered.
It should not influence the firms decision.

What is the opportunity cost for the goods with sunk cost?

Prospective sunk cost: It is an investment decision.

It is an economic cost.
The Cost of Production
Fixed Costs: Cost that does not vary with the level of output.
This cost can be eliminated by going out of business.

Variable Costs: Cost that varies as output varies.

Fixed cost and variable cost are differentiated based on time period.
Over a short time period capital cost is fixed.
Over a long time period, most of the costs are variable.
The Cost of Production
Marginal Costs: Incremental cost- It is the increase in cost that result from
producing one extra unit of output.
Which cost changes over time?

MC = VC/ q MC = TC/ q

Average total Costs: It is the firms total cost divided by its level of output.
ATC = TC/ q
Average fixed costs: Fixed cost divided by the level of output.
AFC = FC/ q
Average variable costs: Variable cost divided by the level of output.
AVC = VC/ q
Firms cost- short run
Output Fixed cost Variable Total Cost MC (Rs. AFC (Rs. AVC (Rs. ATC (Rs.
(Units per (Rs. per Cost (Rs. (Rs. per Per unit) Per unit) Per unit) Per unit)
year) year) per year) year)
0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
 Cost (rupees
per year)
TC
400
VC
Cost curves
300

Fixed Cost curve: Fixed cost does not vary with

output. 175
A
Variable Cost curve: It increases with increase in
output. 100
FC

0
Total Cost curve: Vertical addition of FC and VC. 2 4 6 8 10 12
Output (units per year)
100 Cost (rupees
per unit) MC
Average Fixed Cost curve: Average fixed cost
declines as the rate of output increases. 75
ATC

Average Variable Cost curve: Average variable 50

cost decreases and then increases. AVC

25

AFC
0
2 4 6 8 10 12
Output (units per year)
Marginal and average cost curve
Marginal cost curve: Marginal cost curve
decreases with increase in output.
It is the slope of VC. 100 Cost (rupees
per unit) MC
Average cost curve:
75
AVC decreases till, MC < AVC. ATC

AVC start increasing after MC > AVC. 50

AVC
A

25
Average variable cost curve is minimum
when MC = AVC AFC
0
2 4 6 8 10 12
Output (units per year)
Cost in the short run
Marginal cost :
Change in Variable cost = wage per unit of labour X change in labour to produce extra
output.
MC = VC/ q = w L/ q
MC = w/ MPL
If marginal product of labour is low, then marginal cost would be
higher.
Diminishing Marginal returns and costs: When diminishing marginal
productivity of labour sets in then the marginal cost would increase
with increase in output.
Isocost
All possible combinations of labour and capital that can be purchased for a given
total cost.
C = wL + rK Capital per year

K2 B

Slope of isocost line = -(w/r) = -K/ L

A
K1
The point of tangency of a isocost line with
the isoquant line shows the minimum cost Q1
combination. C0 C1 C2
0
L1 L2
Labor per year
Choosing inputs
What happens when there is a change in expenditure of all inputs?
The slope of isocost does not change (change is proportionate)
There is change in intercept
Capital per
year

What happens when there is a change in

cost of an input? Slope - K/L= -w/r
= - MPL/ MPK= MRTS
K2 B
The slope of isocost line changes
A
There is change in w/r K1
q1
With increase in wage of labour, lesser C1
C2
labour is used and more capital is used. 0
L1 L2
Labour per year
Expansion path and long run costs

Capital per
Expansion path shows the lowest cost 150 hour
combination of labour and capital to Expansion Long-run Total
path cost
produce output in the long run.
100
By varying both inputs to production.
50
C 300 unit
B
The output cost combination of the A
200 unit
100 unit
expansion path gives the long-run total cost 0
curve. 100 200 300
Labour per
hour
Long-run versus Short-run cost curves
Inflexibility of short-run production: In short run,
factors of production are not flexible.
Capital per
hour
Long-run
Expansion
Q1 is produced by using L1 units of labour and path
K1 units of capital.

C Short-run
Q2 would be produced by using fixed capital K2 Expansion path
K1 and L3 units of labour. B D q2
K1
This is at a higher Isocost curve IC3. A IC2 IC3 q1
IC1
0
L1 L2 L3
Labour per
With higher capital K2, Q2 can be produced at a hour
lower Isocost curve IC2.
Long-run average cost

In the long-run, the ability of a firm to change the inputs allows

the firm to reduce costs.
Depends on returns to scale
Constant returns to scale:
the long run average cost is constant at all level of outputs.
Decreasing returns to scale:
the long run average cost increases with increase in output.
Increasing returns to scale:
the long run average cost decreases with increase in output.
Long-run Average and Marginal cost
Cost (rupees
per unit of
output)

Long-run curves are determined by LMC

scale of production whereas short run is LAC

determined by marginal productivity.

A

Output
Economies and diseconomies of scale
Economies of scale: Average cost goes down when output increases.
Increasing returns in inputs

Diseconomies of scale: Average cost goes up when output increases.

Decreasing returns in inputs.

U-shaped long run average cost curve characterize

economies of scale for relatively low output levels and
diseconomies of scale at higher level.
Economies of scale

Economies of scale: It is measured in terms of a cost-output

elasticity.
Ec = (C/C)/(q/q)
Ec = (C/q)/(C/q) = MC/AC
 Relationship between short-run and long-
run cost
LAC is the envelope of the short-run average cost curves.
For producing q0 quantity, a firm should have the smallest plant.
For producing q2, the middle size plant is suitable. And for q3, the largest plant
must be chosen.
SAC1
SAC3
Cost (rupees SAC2
per unit of
output) SMC1 SMC3 LAC
SMC2

LMC A

q0 q1 q2 q3 Output
Relationship between short-run and long-run
cost
Points of minimum average cost of the smallest and largest
plants do not lie on the long run average cost.

Economies of scale.

A small plant operating at minimum average cost is not efficient

because a larger plant can take advantage of increasing returns to scale.

A large plant is inefficient due to setting in of diseconomies of scale.

Economies of scope
Firms produce more than one output.
Products may be related or unrelated.

Product transformation curve Number of

Variety is more important than specialization. tractors

Negative slope represents that the firm must give

up one output to have more of the other output.
O2
O1
Straight line represent that there is no difference if a
single firm produce the products or two firms.
Number of
cars
Economies and diseconomies of scope
Economies of scope: Situation in which joint output of a single firm is greater
than output that could be achieved by two different firms.

Diseconomies of scope: Situation in which joint output of a single firm is less

than could be achieved by separate firms when each produces a single
product.

Degree of economies of scope: Percentage of cost savings resulting when two

or more products are produced jointly rather than individually.
SC = (C (q1)+C(q2)-C(q1,q2))/C(q1, q2)