BM1709

PRODUCTION AND COST

Economic Costs and Production

Explicit costs – Input costs that require an outlay of money by the firm
Implicit costs – Input costs that do not require an outlay of money by the firm

Production costs
• Fixed costs are costs that do not vary with the quantity of the output produced. They are incurred
even when the firm produces nothing at all.
• Variable costs are costs that change as the firm alters the quantity of output produced.
• Total cost is the sum of a firm’s fixed and variable costs.
• Average total cost is the total cost divided by the quantity of output. “How much does it cost to
make a typical unit of output?”
• Average fixed cost is the fixed cost divided by quantity of output.
• Average variable cost is the variable cost divided by the quantity of output.
• Marginal cost is the increase in total cost that arises from an extra unit of production (How much
does it cost to produce one more unit of the output?).

Cost curves
• Marginal cost rises as the quantity of output produced increases. The upward slope reflects the
property of diminishing marginal product. When a firm produces a small quantity of product, he
has few workers and much of his equipment are not used. The marginal product of each worker
is large because there are many equipment that can be used, and the marginal cost of an extra
unit of output is small. By contrast, if quantity increases, the entrepreneur’s labor and equipment
are fully utilized, the owner can add more variable inputs, but would stay within the same fixed
inputs. Therefore, when the quantity of output produced is already high, the marginal product of
an extra worker is low, and the marginal cost of an extra unit of output is large.
• Average total cost curve is U-shaped. Recall that average total cost is the total of average fixed
costs and average variable cost.
• Average fixed cost always declines as output rises because fixed cost will be spread over a larger
number of units.
• Average variable cost typically rises because of diminishing marginal product. The bottom of the
u-shaped occurs at the quantity that minimizes average total costs. This quantity is sometimes
called the efficient scale of the firm. At lower levels of output, average total cost is lower than
efficient scale because the fixed cost is spread over so few units. At higher levels of output,
average total cost is higher than efficient scale because the marginal product of inputs has
diminished significantly. At the efficient scale, these two (2) forces are balanced to yield the
lowest average total cost.

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Shifts in the Cost Curves

• Technology – A technological change that increases productivity shifts the total product curve
upward. It also shifts the marginal product curve and the average product curve upward. With
better technology that increases productivity, the same inputs can now produce more output, so
an advance in technology lowers the average and marginal costs and shifts the short-run cost
curves downwards.
• Prices of the factors of production – An increase in the price of production increases cost and
shifts the cost curves. But how the curves shift depends on which resource price changes. An
increase in the fixed costs shifts the fixed cost curves and total cost curves upward, but leaves the
variable cost curves intact. An increase in the variable costs increases the variable cost curves and
total cost curves but leaves the fixed cost curves intact.

Short Run and Long Run Costs

The Short Run

• The short run is the time frame in which the quantities of some resources are fixed. In the short
run, a firm can usually change the quantity of labor it uses, but not its technology and quantity of
capital.
• To increase output in the short run, a firm must increase the quantity of the variable factors it
uses. Labor is usually the variable factor of production.

The Long Run

• This is the time frame in which the quantities of all resources can be varied. To increase output in
the long run, a firm can increase the size of its plant. Long run decisions are not easily reversed.
For example, if a firm buys a new plant, its resale value is usually much less than the amount the
firm paid for it.

Phases in the Long Run

• Economies of scale – This is when long run average total costs declines as output increases.
• Constant returns to scale – This is when long-run average total cost do not vary much with level
of output. Constant returns to scale occur when a firm can replicate its existing production facility
including its management system.
• Diseconomies of scale – This is when long run average total costs rise as output increase.
Diseconomies of scale arise from the difficulty of coordinating and controlling a large enterprise.
The larger the firm, the greater is the cost of communicating both up and down the management
hierarchy and among managers. Eventually, management complexity brings rising average total
cost. Diseconomies of scale occur in all production processes but in some perhaps only at a very
large output rate.

Sources of Economies of Scale

• Specialization of labor – This permits workers to be better at a specific task. The result is that the
average product of labor increases and the average total cost of producing an additional unit of
output falls. Specialization also occurs off the production line. For example, a small firm usually
does not have a specialist sales manager, personnel manager, and production manager. One

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person covers all these activities. But when a firm is large enough, specialists perform these
activities. Average product increases, and the average total cost falls.
• Specialization of capital - At a small output rate, firms often must employ general purpose
machines and tools. The result is that the output rate is larger and the average total cost of
producing a gallon of smoothies is lower.

References
Bade, R., & Parkin, M. (2015). Foundations of microeconomics, Seventh Edition. Upper Saddle River:
Pearson Education Inc.

Case, K. E., Fair, R. C., & Oster , S. E. (2017). Principles of microeconomics, Twelfth edition. Harlow: Pearson
Education Limited.

Mankiw, N. G. (2015). Principles of microeconomics. Stamford : Cengage Learning.

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