COST OF PRODUCTION

Chapter 4

 Producer uses different factor of production Technological advancement and price of inputs determine

the cost of production.

Decision to use more capital/labor determine the cost of

production

 Focus on

Cost of production
Analyze short run and long run Economies of scale Diseconomies of scale

Cost curve in Short Run

Short run is a period where at least one of the input must

be fixed.
Total Fixed Cost Cost of output that are independent of output. Constant throughout the production. Will be incurred though output changes Eg;

Graph

 Total variable cost

Cost of input changes with output

Cost of incurred on the purchase of variable inputs. E.g Graph Total cost Sum of all inputs to produce goods and services Aggregate expenditure Will not start from zero because TFC has been incurred Graph

 Average Fixed Cost

Fixed cost per unit of output

AFC =

TFC Total output

TFC 100
100 100 100 100

Output 1
2 3 4 5

AFC

Graph

 Average Variable Cost

Variable cost per unit of output

Is u- shaped due to Law of Diminishing Marginal Return AVC

in the first stage, reaches a min an increase in later stage. First stage increase in output reduce AVC Second stage Normal capacity is reached.
AVC =

TVC Output/Q

 Average Total Cost

Total cost per unit of output

Also referred as average cost and always higher than

average fixed cost and average variable cost. Average Total Cost = Total cost Output/Q Graph;

 Marginal Cost

Change in total cost results from producing another unit of

output. Marginal cost = Total Cost Output

Graph

Formulas
Cost Symbol Definition Formula

Total fixed cost

TFC

Cost of inputs that are independent of output

Cost of inputs that changes with output Sum of cost of all inputs Fixed cost per unit of output Variable cost per unit of output Total cost per unit of output TC = TVC + TFC AFC = TFC / Q AVC = TVC / Q ATC = TC /q = AFC + AVC

Total variable cost

TVC

Total Cost Average Fixed Cost Average Variable Cost

TC AFC AVC

Average Total cost ATC

Marginal cost

MC

Additional cost

MC =

TC /

Review (Q)
Based on the data below answer the following questions.

Output 0 1 2 3 4 5 6

Total Cost 24

Average Cost -

TVC 0

MC

AFC 24 12 8 6 4.8 4

AVC

9 8.5 8 7.5 7.4 7.5

 Complete the table above

Scale AFC, AVC and AC in one diagram. Is the firm operating in SR or LR?

MCQ (r)
1.As output inceases, AFC A.Fall B.Increase C.Remain constant D.Initially fall, and then increase

2.If a firm decide to produce no output in the short run, its cost will be A.Zero B.Its fixed cost C.Its variable cost D.Its marginal cost
3.Which of the following is not U-shaped A.AVC C.MC B.AFC D.ATC

4.Michael Industry has RM2000 of variable costs and RM500 of fixed cost when its output is 250 units. It sells each unit for RM25. Average fixed cost at this output level is A.RM 2 B.RM 20 C.RM 8 D.RM 50 5.Average Variable cost at this output level is A. RM 2 B. RM 20 C. RM 8 D. RM 10

Marginal cost and Marginal product inversely related

Marginal Product Marginal Cost

Law of DMR

MC

MP

Qtty labor per day

tonnes of grapes per day

The MC declines as MP of variable input rises Yard labour (Variable cost), wage rate constant

Questions
Table shows the production cost of electric company in Subang Jaya.

Total Product 0 1 2 3 4

Average Variable Cost

Average Cost

Total Cost 500 700

Average Fixed Cost

Marginal Cost 200 100 250 400

510

 Distinguish between fixed cost and variable costs

With the aid of a diagram, explain the short run cost

curves Explain why the short run average cost curve is Ushaped. Explain the relationship between marginal cost and average cost with a suitable diagram.

Cost Curve in Long Run

Firm can alter its scale of operation

Only variable cost and no fixed cost

LRTC is the cost incurred as a result of producing goods

and services in the long run.

Long Run Average Cost (LRAC)

Curve that shows the minimum cost of producing any

given output when all inputs are variable.

Cost

LRAC

E
A B C

Q1

Q2

Q3

Q4

Q5

Output

 LRAC is derived by a series of SRAC where

tangential points of SRAC is derived. When firm has plant relating to SRAC1, total output is Q1. As demand increases firm increases output to Q2. Firm has TWO options plant 1/plant 2 Firm can still operate on the same plant (SRAC1), but the Average Total Cost will increase from point E to A.

 By expanding the output, SRAC2 the output of

Q2 can be produced with lower AC at point C. SRAC3 and SRAC4 refers to plants of higher capacity. Long Run firm will select the plants which gives lowest average cost at given output level. LRAC is U-shaped- Law of Returns to Scale

mc

DECREASING RETURN TO SCALE

CONSTANT RETURN TO SCALE

INCREASING
RETURN TO SCALE

COST

OUTPUT

LRAC

ECONOMIES OF SCALE
Benefits and advantages of a firm as it

become larger. Indicated by downward sloping cost per unit of output. When increasing the scale f production leads to lower unit cost per unit of output. Exist in the industry where market for product is large enough- Adam Smith

Reason(s) for EOS

Labor economies

Managerial economies
Marketing economies Technical economies Financial economies Risk-bearing economies Transport and storage economies

Diseconomies of Scale
Labour diseconomies Managerial problems Technical difficulties