Production Choices &

Cost
SUPPLY DECISIONS
COSTS
FIRM THEORY

Dr. Mudenda
Don’t panic
 Many concepts used when studying the firm have a clear
counterpart in the consumer theory: Examples

Utility function Production function

Goods Inputs
Budget Line Isocost
Indifference curve Isoquant
Marginal rate of Marginal rate of
substitution technical substitution
Max utility Max profits
Min expenditure Minimize costs
 COST FUNCTIONS

 Recall:
 Measuring Costs
 Accountants and economists don’t agree on
costs
 the accountant’s view of cost stresses out-of-pocket
expenses, historical costs, depreciation, and other
bookkeeping entries
 economists focus more on opportunity cost

 Opportunity costs are what could be obtained by using

the input in its best alternative use

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 COST FUNCTIONS
 Capital Costs (accountants and economists differ…)
 accountants use the historical price of the capital and apply
some depreciation rule to determine current costs
 the cost of the capital is what someone else would be willing to
pay for its use (and this is what the firm is forgoing by using
the durable goods e.g., machine)
wewill use r to denote the rental rate for capital
 Costs of Entrepreneurial Services
 accountants believe that the owner of a firm is entitled to all
profits
 revenues or losses left over after paying all input costs

 We consider the opportunity costs of time and funds that

owners devote to the operation of their firms
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 COST FUNCTIONS

 Labour Costs
 To both economist and accountants, labour costs are very
much the same thing: labour costs of production (hourly wage)
 The economic cost of any input is the payment
required to keep that input in its present employment
 the remuneration the input would receive in its best
alternative employment
 Sunk cost—a past expenditure that cannot be recovered—
though easily observed, is not relevant to a manager when
deciding how much to produce now

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 COST FUNCTIONS
 In discussing we refer to the market value of the inputs a
firm uses in production.
 The cost of production will depend on two elements:
 First, it depends on the price of inputs. A firm must pay:
 a wage to the workers it employs and it must pay the price of
machinery that it wants to buy
 The higher the prices of inputs, the higher will be the cost of
production.
 Second, the cost of production will depend on the
productivity of the inputs
 The higher is the productivity of inputs and the lower is the
amount of inputs needed to produce a given level of output,
the lower is thus the cost of producing that output.
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 COST FUNCTIONS
 We analyse these costs based on the short-run and Long-run
periods as we did under production
 Recall: The short-run production function of a firm tells us the
relationship between variable factor and fixed inputs and
output produced
 Similarly total costs of production can be broken down into
fixed costs and variable costs
 Total costs are defined as the sum of the total fixed costs
(TFC) and total variable costs (total variable Costs)
 TFC = TVC + TFC

 Fixed costs are costs that do not vary with the level of
production. The producer has to meet these costs whether he
produces or not. These costs are called fixed costs and remain
constant regardless of the level of output
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 COST FUNCTIONS

 for examples of fixed costs - rent on buildings (example,

whether a shop is closed during Covid or not, rent has to be
paid to the owners of the building
 Variable costs are the costs of hiring variable inputs, in
our case labour. These are costs that change as the firm
alters the quantity of output produced
 The total variable costs (TVC) increase as the total variable
factor inputs are increases to increase the level of output.
 For example, while the cost of rent may remain the same, the
producers may employ more labour and pay more in wages.
 In summary: TC = TFC +TVC

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EXAMPLE 2: Costs ( K)

Q FC VC TC
 When discussing the cost and
0 100 K0 K100 production structures of a firm, we
wish to observe and understand what
1 100 70 170
happens to production as well as
2 100 120 220 costs as the firm uses more and more
resources or factors of production to
3 100 160 260 increase output
4 100 210 310  The hypothetical example is
presented in the Table:
5 100 280 380
 The firm incurs additional costs of
6 100 380 480 production when it decides to
increase product its output of Q.
7 100 520 620

COSTS 9
EXAMPLE 2: Costs ( K)

Q FC VC TC
 The costs arise because the resources
0 100 K0 K100 used in the production of the good
are not free, they have to be paid for
1 100 70 170
by the firm
2 100 120 220  Therefore as the firm increases its
variable factor in the short-run, so
3 100 160 260
will output and also will total costs
4 100 210 310 variable costs increase.
5 100 280 380  The fixed costs will remain constant
in the SR –at 100 in this example,
6 100 380 480 regardless of the level of production
 This means that the cost of using the
7 100 520 620
fixed factors remain constant.

COSTS 10
Graphical Presentation
k800 FC
Q FC VC TC K700 VC
TC
0 100 K0 K100 K600
1 100 70 170 K500

Costs
2 100 120 220
K400
3 100 160 260
K300
4 100 210 310
K200
5 100 280 380
K100
6 100 380 480
K0
7 100 520 620 0 1 2 3 4 5 6 7
Output
COSTS 11
 COST FUNCTIONS

 Note:
 We assume that the increases in output in table above arise
from increases in the variable factor of production
 The variable factor itself, which is labour here is not shown
because we are discussion the cost of production.
 We simply assume that there is an underlying production
process taking place
 Labour is assumed to be the only variable factor while
capital is fixed.
 As labour increases, the firm will encounter diminishing
returns to scale and the average productivity of labour will
fall. We assume we are in a competitive market.
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 Example 2: COST FUNCTIONS
 The next question is, how Q (x) SFC SVC STC SAFC SATC

much does it cost to make the 0 30 0 30  

typical unit of good x in terms 1 30 22 52 30 52
of fixed costs, VC and TC?
2 30 38 68 15 34
 The last 2 columns show the
3 30 48 78 10 26
SR average fixed costs and the
SR average variable cost of 4 30 61 91 7.5 22.75
each unit of output produced. 5 30 79 109 6 21.8
1. Short-run average fixed cost 6 30 102 132 5 22
(SAFC) equals short-run fixed
7 30 131 161 4.29 23
cost (SFC) divided by output:
 AFC = SFC/Q (output) 8 30 166 196 3.75 24.5
9 30 207 237 3.33 26.33
 AFC is defined as the fixed cost
per unit of output 10 30 255 285 3.0 28.5

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 Example 2: COST FUNCTIONS
Q (x) SFC SVC STC SAFC SAVC
 The average fixed cost
falls steadily because total 0 30 0 30 
fixed cost (‘overheads’) is 1 30 22 52 30 22
spread over ever-larger 2 30 38 68 15 19
output levels, thus reducing 3 30 48 78 10 16
average fixed cost. 4 30 61 91 7.5 15.25
 In this example, the AFC
5 30 79 109 6 15.8
decline from K30 t0 K 3
6 30 102 132 5 17
2. Average variable costs
7 30 131 161 4.29 18.71
(SAVC) this refer to
variable costs divided by the 8 30 166 196 3.75 20.75
quantity of output: 9 30 207 237 3.33 23
 AFC = SAVC/Q 10 30 255 285 3.0 25.5

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 Example 2: COST FUNCTIONS
Q (x) SFC SVC STC SAFC SAVC
2. Average variable costs
(SAVC) this refer to 0 30 0 30 
variable costs divided by the 1 30 22 52 30 22
quantity of output: 2 30 38 68 15 19
 AFC = SAVC/Q 3 30 48 78 10 16
 Thus SAVC is defined as the 4 30 61 91 7.5 15.25
variable cost per unit of 5 30 79 109 6 15.8
output.
6 30 102 132 5 17
 The SAVC are falling up to
7 30 131 161 4.29 18.71
output 5 and then begin to
rise. 8 30 166 196 3.75 20.75
9 30 207 237 3.33 23
10 30 255 285 3.0 25.5

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 Example 2: COST FUNCTIONS
Q (x) SFC SVC STC SAFC SATC
3. The average total cost
(SATC) defined as the 0 30 0 30  
total cost per unit of output. 1 30 22 52 30 52
It is computed as total cost 2 30 38 68 15 34
divided by the quantity of 3 30 48 78 10 26
output
4 30 61 91 7.5 22.75
 It is obtained by summing
5 30 79 109 6 21.8
AFC and AVC
6 30 102 132 5 22
 ATC = AFC +AVC
7 30 131 161 4.29 23
C VC + FC VC FC
AC = = = + = AVC + AFC 8 30 166 196 3.75 24.5
Q Q Q Q
9 30 207 237 3.33 26.33
10 30 255 285 3.0 28.5

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 Example 2: COST FUNCTIONS
Q (x) SFC SVC STC SAFC SATC
 The ATC declines and
0 30 0 30  
reaches a minimum at output
5 as the fixed costs are spread 1 30 22 52 30 52
over larger output and 2 30 38 68 15 34
initially the firm benefits 3 30 48 78 10 26
from increasing returns to 4 30 61 91 7.5 22.75
the variable factor
5 30 79 109 6 21.8
 After output 5, ATC increases
as the influence of 6 30 102 132 5 22
diminishing returns, which is 7 30 131 161 4.29 23
pushing the AVC outweighs 8 30 166 196 3.75 24.5
the declining AFC. 9 30 207 237 3.33 26.33
10 30 255 285 3.0 28.5

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 Example 2: COST FUNCTIONS
Q SVC STC SAFC SATC SMC
 Although ATC tells us the cost (x)
of the typical unit, it does not 0 0 30   -
tell us how much TC will 1 22 52 30 52 22
change as the firm alters its
2 38 68 15 34 16
level of production.
3 48 78 10 26 10
 The last column in the Table
shows the amount that total 4 61 91 7.5 22.8 13
cost rises when the firm 5 79 109 6 21.8 18
increases production by 1 unit 6 102 132 5 22 23
of output. This number is 7 131 161 4.29 23 29
called marginal cost (MC)
8 166 196 3.75 24.5 35
4. SMC – is the increase in
9 207 237 3.33 26.3 41
total cost that arises from an
extra unit of production 10 255 285 3.0 28.5 48

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 Example 2: COST FUNCTIONS
Q SVC STC SAFC SATC SMC
4. SMC – is the increase in (x)
total cost that arises from an 0 0 30   -
extra unit of production 1 22 52 30 52 22
 SMC is the extra cost of
2 38 68 15 34 16
making an extra unit of
3 48 78 10 26 10
output in the short run
while some inputs remain 4 61 91 7.5 22.8 13
fixed 5 79 109 6 21.8 18
 MC = TC/Q 6 102 132 5 22 23
 For example when q 7 131 161 4.29 23 29

changes from 3 to 4: 8 166 196 3.75 24.5 35

 MC = (91-78)/(3-1) = 13 9 207 237 3.33 26.3 41
10 255 285 3.0 28.5 48

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 SHAPES OF COST FUNCTIONS

 Key features of the cost

curves when graphed:
1. SAVC is falling up to output
4, because at low levels of
output, L has enough capital
to work with.
 Above output 4, L has less
and less K to wok with Taken
together, the two effects give a AFC
U –shaped AVC
 We say that the diminishing
average returns in the variable
factor L set in at the minimum
point of AVC curve
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 SHAPES OF COST FUNCTIONS

2. AFC will decline

continuously as output
increases because the
constant TFC is being
divided by bigger and
bigger levels of output
3. ATC declines until output
reached 5 units. This initial
decline is because: AFC

a. The TFC is divided by larger

and larger outputs
returns to L. Above 7 units of
b. At the same time, the firm is
output ATC increases because now
benefiting from increasing
the effect of diminishing returns
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 SHAPES OF COST FUNCTIONS

• Above 7 units of output ATC

increases because now the
effect of diminishing returns
outweigh the decline in AFC
• recall ATC = AFC +AVC,
therefore if AVC is increasing
while AFC is falling, ATC will
increase because AVC
dominates ATC
AFC
• Again the ATC curve is U –
shaped curve
• The diminishing returns with
respect to the ATC set in at 5 is the lowest point of the ATC curve.
units of outputs because this
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 SHAPES OF COST FUNCTIONS

4) SATC is falling when SMC is

less than SATC, while it is
rising when SMC is greater
than SATC. The same applies
for the relationship between
SMC and SAVC.
5) SATC is at a minimum at the
output at which the SMC
curve and the SATC curve AFC
cross. The SAVC is at its
minimum at the output at
which the SMC curve and the
SAVC curve cross

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 SHAPES OF COST FUNCTIONS
 Overall, the shape of the MC
curve is related to the
behaviour of the marginal
product (MP) curve which we
already encountered under
production
 At low output levels, when a
firm is benefiting from
increasing marginal returns to
labour. MP is increasing which AFC

means the MC will be

declining. MC reaches a
minimum at the same level of
output where MP reaches
maximum
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 SHAPES OF COST FUNCTIONS
 When the firm reaches
diminishing marginal returns,
so that MP is falling, MC Q
begins to rise 5
 The MC is also U shaped. It
cuts the AVC and ATC curves at MPL
their minimum points. L
 Thus, if firm is maximising Cost
profits, it must produce output
where the MC = MR. This rule
applied for all types of markets.
5
Output

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 Overall

 The marginal-cost curve crosses the average-total-

 cost curve at the efficient scale.
 Why? At low levels of output, marginal cost is below
average total cost, so average total cost is falling.
 But after the two curves cross, marginal cost rises above
average total cost
 Production in the long-run
 In the long run all factors of production are all variable, i.e., the
inputs of all factors of production can be varied.
 In the long run, the problem facing the firm is choosing the right
mix of inputs to produce the quantity that maximizes the firm’s
profit
 Because many decisions are fixed in the short run but variable in
the long run, a firm’s long-run cost curves differ from its short-run
cost curves
 In all the decisions , the firm will wish to minimize the costs of
production.
 When deriving the LR average cost (LRAC) , we assume that a firm
can build an infinite number of plants of different capacities.

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 Production in the long-run
SRAC1 LAC
 As the firm moves along the SRAC4
long-run curve, it is adjusting Cost

the size of the factory to the SRAC2

quantity of production SRAC3

 The cost minimising firm will

produce along the LRAC
which is the expansion path 0 q1 q3
Output
 The expansion path shows
the minimum possible of production for each level of
average cost of producing an output, given that the plant of
level of output with all factors appropriate capacity has been
of production being variable constructed.
 The LR curve above indicates
the minimum average cost
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 Overall concepts
 In general the LATC curve is a much flatter U-shape than the
short-run average-total cost curve.
 In addition, all the short-run curves lie on or above the LR curve.
 These properties arise because of the greater flexibility firms
have in the long run
 In essence, in the long run, the firm gets to choose which
short-run curve it wants to use. But in the short run, it has to
use whatever short-run curve it chose in the past.
 Long-run total cost (LTC) is the minimum cost of producing each output
level when the firm can adjust all inputs.
 Long-run marginal cost (LMC) is the rise in long-run total cost if output rises
permanently by one unit.
 Long-run average cost (LAC) is the total cost LTC divided by the level of
output Q.

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 Example of LATC

 The relationship between

LMC and LAC is exactly the
same as the one discussed
for the short-run case.
 When LMC is below LAC,
LAC decreases. When LMC
is above LAC, LAC increases
 Furthermore, LMC and LAC
cross at the point where LAC
reaches a minimum.

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 ECONOMIES AND DISECONOMIES OF SCALE

 Scale refers to the output of the firm when all inputs can be
varied. Therefore it is a long-run concept.
 It refers to the relationship between the long-run average
cost and output produced by a firm when all inputs of
production are variable.
 When long-run average cost decreases as output increases,
the firm faces increasing returns to scale (or economies
of scale).
 When the long-run average cost remains constant as output
increases, the firm faces constant returns to scale.
 If the long-average cost increases with output, then we have
decreasing returns to scale (or diseconomies of
scale).
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 ECONOMIES OF SCALE

 Economies of scale (or increasing returns to scale)

mean long-run average cost falls as output rises
 There are several sources, which can be internal or external
A. Internal economies of scale: - these refer to factors which bring
about a reduction in the AC as the scale of production of the
individual firm rises. Examples of internal economies of scale
are:
1. Technical economies of scale . These include:
a) Increased specialisation . Specialisation is a situation where factors
of production are employed in the provision of a single good or
service on a continuous basis. Often the larger is the scale of
production, the greater is the scope for specialisation of both
machinery and labour.

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 ECONOMIES OF SCALE

1. Technical economies of scale . These include:

a) Increased specialisation . The production process is broken down
into tasks, with each worker performing a single task. This is referred
to as division of labour
 By performing the same tasks repeatedly , labour can
become very skilled and perform with speed and dexterity
 Similarly, if machines are adapted to specialise in different
stages which quicken the production process
b. Research and Development – large firms can invest in research
and development which may result in cost reducing
innovations.
c. Principle of Multiples –if the production process involves the use of
different types of machinery, a large firm can arrange to have more
of machines with a small output and fewer of the machines with high
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 ECONOMIES OF SCALE

 High output , thereby achieving high utilisation rate.

 A small firm with a single machine may find the high-capacity
machines standing idle for much of the time.
 Large scale is often needed to take advantage of better machinery
d) Factor indivisibility in the production process; that is, a
minimum quantity of inputs required by the firm to be in
business at all whether or not output is produced.
 These are sometimes called fixed costs, because they do not vary with
the output level. There are economies of scale because these fixed
costs can be spread over more units of output as output is increased,
reducing average cost per unit of output.
 By using indivisible factors of production, firms can lower their
average costs than smaller costs
e) Economies of increased dimensions+
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 ECONOMIES OF SCALE
 Economies of increases dimensions - suggest that increasing the
dimensions of any structure will lead to a proportionately larger
increase in capacity. The resulting increased capacity from
increased dimensions imply that the unit storage or transport
costs of liquids or gases or containerised products falls as larger
containers are used .
2. Financial Economies – these happen because large firms are
able to get loans at lower interest rate than smaller firms. Also,
large firms can provide more security to obtain bigger loans.
Finally, investors will be willing to invest money in large and
stable firms
3. Marketing economies -large firms can buy inputs at large
scale and negotiate large cost-saving discounts, i.e., quantity
discounts (a reduction in unit price when purchasing a large
quantity of a product
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 ECONOMIES OF SCALE
4) Risk Bearing Economies – large firms are better able to
diversity into many products and markets making them able to
easily withstand adverse trading conditions in one particular
market/product. The firms spreads out its risks
B. DISECONOMIES OF SCALE
 Diseconomies of scale (or decreasing returns to scale) mean
long-run average cost rises as output rises.
 Beyond some output, the U-shaped average cost curve turns up
again as diseconomies of scale begin.
 Management is harder as the firm gets larger: there are
managerial diseconomies of scale. Management becomes a
problem to perform effectively . Large firms often have several
departments which take time to coordinate at times delaying
decision making. Workers in larger firms are likely to feel more
uncommitted resulting in poor performance.
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 Profit maximisation
 Total costs refer to the market value of the inputs a firm uses
in production. We assume we have only labour and capital as
inputs. Total costs for the firm are given by
total costs = C = wl + rk
 Total revenue for the firm is given by
total revenue = pq = pf(k,l)
 Economic profits () are equal to
 = total revenue - total cost
 = pq – (wl + rk)
 = pf(k,l) - wl – rk
 This suggest that economic profits depend on the amount of K
and L employed

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 Profit maximisation

 Profit is defined as the

difference between total
revenue (firms’ sales) and
total economic costs of
production
 Recall accountants focus
we get one definition of profit
 Accounting profit = Total
revenue – Accounting costs
 Economists have a broader
conception of costs
(opportunity costs)
 Economic profit = Total Total revenue minus All costs of
revenue minus al costs production Or Total revenue –
(Explicit costs + Implicit costs.
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 Profit maximisation

 In this case the economic

profits () are the difference
between total revenue and
total costs
 Profit maximizing firms
choose to produce and sell
where the gap between
revenue and costs is highest
as illustrated in the figure
 In the diagram, the firm
chooses out q*= 284 is where
the difference between
revenue and cost is
maximized and the firm will
produce and sale these units
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 Profit maximisation

 Profits in symbols:
  = TR – TC
 where  is profits, TR is
total revenue and TC is
total costs
 Total revenue –is income
from the sales of the firm’s
output and is obtained by
multiplying the price by
number of units/quantity
sold:
 TR = p x q
Total revenue minus All costs of
 Where p is price and q is
production Or Total revenue –
quantity (Explicit costs + Implicit costs.
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 Profit maximisation

 The question is what happens to

MC
profits as quantity increases?
 We answer this question, we use
the concepts of marginal cost
and marginal revenue MR
 Marginal revenue (MR)– is the
change in TR from the sale of q1
each additional unit of output  By producing an additional unit
 The MR curve is derived from of output, the firm will add
the average revenue/demand more revenue than costs
curve. This means that it is  Hence profits increase
downwards sloping.
 If MR > MC , firm must increase
 The firm maximizing profits will output
not produce at q1 because MR >
 If MR < MC -firm must reduce q
MC
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 Profit maximisation

 In order to maximise profits a

firm must produce that MC
quantity at which MR and MC A B
MR
are equal.
 However, in instances where
the MC cuts the MR curve twice
q1 q3 q2
as in graph , what happens?
 In the graph, if the firm finds
itself at q1 it can still increase its
revenue by producing at q3, as
MR > MC. Thus, q1 is not
profit maximizing
 If the firm produced at an level

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 Profit maximisation

 If the firm produced at an level

less than q2, the MR remains MC
greater than MC, implying that A B
MR
it can still make profits
 Any point beyond q2 implies
costs that are greater than
q1 q3 q2
revenue.
 Thus, a profit maximizing firm
will produce where:

 Provided the MC curve is rising

so that it cuts the MR curve
from the below at this point.

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 Profit maximisation

 The question is what happens to  This condition says that

profits as quantity increases?
 We answer this question, we use
the concepts of marginal cost
and marginal revenue
 Marginal revenue (MR)– is the
change in TR from the sale of
each additional unit of output
 The MR curve is derived from the
average revenue/demand curve
marginal revenue should
equal marginal cost
 The necessary condition
for choosing the level of q
that maximizes profits can
be found by setting the
derivative of the 
function with respect to q
equal to zero

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