Lesson 3

PRODUCTION COST ANALYSIS

Learning Outcomes

At the end of this lesson, you should be able to:

 Explain short run cost
 Explain the long run cost
 Differentiate between economies and diseconomies of scale
 Explain the concept of revenue

3.1 PRODUCTION
Definition
It is a process of transforming the inputs (factors of production) to outputs (goods and
services).
• Factors of production
i. Land: refer to all natural resources e.g.: minerals, land, forest etc.
ii. Labor: all physical and mental talent of men who are available in the production
process.
iii. Capital: investments that are used as production aids.
Eg: machinery, equipment, factory etc.
iv. Entrepreneur: The person who takes the initiative in combining the factor of
production to produce goods and services. They have to decide and take risk in their
business to make it profitable.
3.1.1 Production; Short Run(SR) and Long Run(LR)
Short Run:

A period during which at least one of a firm’s resources is fixed.

- Firm uses variable and fixed resources.
- But firm can only adjust its variable resources in order to increase the production. E.g.:
labor.
- Fixed cost is existed. E.g.: building, equipment, tools.

Long Run:

A period during which all resources under the firm’s control are variable.
- All fixed resources will be variable resources
- Firm can alter all its resources in order to increase or decrease the production.

3.2 PRODUCTION COSTS

Definition
Refers to the expenses incurred by the producer in producing a particular quantity of output.

3.2.1 Cost curves in the short run

i) Total Fixed Costs (TFC)
The cost that firm has to pay even the output is zero. The cost remains constant even output
changes. High level of fixed costs represent a high level of risk for a business because the
business must still pay these costs if sales fall. Eg: rental payment, building, insurance premium
etc
ii) Total Variable costs (TVC)
Is the cost that varies with the changes in output. When output increase, variable costs will
increase. Eg: raw materials, labors etc.

iii) Total Costs (TC)

Sum of fixed cost and variable cost at each level of output.
TC = TVC + TFC
When output equals to zero, TC = TFC because TVC = 0. For other than zero unit of outputs, TC
varies by the same amount as does variable cost. The TC curve is shown below.
iv) Average Fixed Cost (AFC)
Fixed cost per unit of output. AFC will decrease as output increase.
𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄
v) Average Variable Cost (AVC)
Variable cost per unit of output. As output increase, AVC decrease in the first stage, reach a
minimum, then increase again.
𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄

vi) Average Total Costs (ATC@AC)

Total cost per unit of output. ATC can be obtain by adding the AFC and AVC. Therefore, ATC is
higher than AFC and AVC.
𝑇𝐶
𝐴𝑇𝐶 =
𝑄
or

𝐴𝑇𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶

vii) Marginal Costs (MC)
Refer to change in total cost as an outcome of producing another unit of output. Define as the
additional cost incurred in producing an additional unit.
∆𝑇𝐶
𝑀𝐶 =
∆𝑄
or
∆𝑇𝑉𝐶
𝑀𝐶 =
∆𝑄
3.2.2 Long run average cost
Long run average cost is a period of time where all inputs are variable, therefore, all costs are
variable.

Determining the LRAC from the SRAC

cost

SRAC 1
SRAC 2
S3
S2 SRAC 3

Output
30
 Long run is a period where firms plan how to minimize average cost by looking at
their short run average cost curves (SRAC) as their scale of production or plant size

 In the long run, firm can adjust scale of production by choosing the plant size which
minimizes the cost. For example, to produce 30 units, firm must choose SRAC 2
instead of SRAC 3.

Therefore, LRAC is;

 a graph that shows the different scales on which a firm can choose to operate in the
long run
  is derived from series of short run average cost curves (SRAC) / made up of all the
points of tangency of SRAC

cost
9
LRAC
1 8
2 7
3 6
4 5

Output
Optimum output

3.2.3 THE LAW OF RETURNS TO SCALE

LRAC is ‘U’ shaped due to law of returns to scale

 As firm expands its scale of production, at first its LRAC will decrease, reach its minimum
point, and then increase

1. Economies of scale/ Increasing returns to scale

o An  in scale of operation leads to a  in average cost per unit produced.

2. Constant return to scale

o An  in scale of operation leads to no change in average cost.

3. Diseconomies of scale / Decreasing returns to scale

o An  in scale of operation leads to an  in average cost per unit produced

Cost

Economies Diseconomies
of scale Constant of scale
return to
scale LRAC

Output
3.3 CONCEPST OF REVENUE AND ECONOMIC PROFIT
3.3.1 Revenue
 An income earned by a firm which sells good and services at a given market price

Total Revenue (TR): Total income earned TR = P x Q

Average Revenue (AR): Income earned from each unit of output AR = TR / Q

Marginal Revenue (MR): Additional income from add. unit of output MR = TR / Q

i. Goods sold at the same price

Q P TR AR MR
1 10
2 10
3 10
4 10
5 10

TR increases at same rate for the additional output sold AR = MR = P

Revenue
TR

MR = AR = P = D

Q
 ii. Goods sold at different prices

Q P TR AR MR
1 18
2 16
3 14
4 12
5 10

TR increases up to maximum point, then decreases

AR = P (downward sloping)

MR is below AR

Revenue

TR

Q
MR AR = P = D

3.3.2 Types of profit:

Since the objective of the firm is to minimize costs and to maximize profits, therefore profit
calculation is

Total Profit (TR) = Total Revenue (TR) – Total Cost (TC)

• Supernormal profit: Total Revenue(TR) > Total Cost(TC)

• Normal profit: Total Revenue(TR) = Total Cost(TC)
• Subnormal profit: Total Revenue(TR) < Total Cost(TC)