Costs of Production

Concepts
Cost functions show the money cost of producing various
levels of output.
Cost Functions

Short Run Long Run

Cost Functions Cost Functions
Fixed Cost and Variable
Cost

Fixed costs; costs associated with inputs that are fixed in the short
run.
Variable costs; costs associated with inputs that can be varied in
the short run.
Concepts
Opportunity cost
Opportunity cost is the cost of a good or service as measured by the
alternative uses that are foregone by producing the good or service.
– If 15 bicycles could be produced with the materials used to produce an
automobile, the opportunity cost of the automobile is 15 bicycles.
• The price of a good or service often may reflect its opportunity cost.

Explicit and Implicit Costs

• An explicit cost is a direct payment made to others in the course of running
a business, such as wage, rent and materials.

• An implicit cost, also called an imputed cost, implied cost, or notional cost,
is the opportunity cost equal to what a firm must give up in order to use
factor of production which it already owns and thus does not pay rent for.

• Accounting Costs = Explicit Costs

• Economic Costs = Explicit + Implicit Costs
Types of Cost: A Summary

dTC d ( FC + VC ) dVC
MC = = =
dQ dQ dQ
 Table: Measuring Various Costs
1 2 3 4 5 6 7 8 9
Labour Output TC= AFC= AVC= ATC=
Input (L) (Q) FC VC FC+VC FC/Q VC/Q C/Q MC
0 0 100 0 100 - - - -
1 15 100 30 130 6.7 2.0 8.7 2.0
2 31 100 60 160 3.2 1.9 5.2 1.9
3 48 100 90 190 2.1 1.9 4.0 1.8
4 59 100 120 220 1.7 2.0 3.7 2.7
5 68 100 150 250 1.5 2.2 3.7 3.3
6 72 100 180 280 1.4 2.5 3.9 7.5
7 73 100 210 310 1.4 2.9 4.2 30.0
Note: Per unit cost of labour (w) = 30
Assuming K= 2 and Per unit of cost of capital (r) = 50
dTC d ( FC + VC ) dVC
MC = = =
dQ dQ dQ
Total Cost Curves
15

TVC
Cost

10

TFC

0 5 10 15
Output
Total Cost Curves
15
TC

TVC
Cost

10

TFC

0 5 10 15
Output
Marginal Cost and Average Costs

1.5
Cost

0.5

AFC

0 5 10 15
Output
Marginal Cost and Average Costs

1.5
Cost

1
AVC

0.5

AFC

0 5 10 15
Output
Marginal Cost and Average Costs

1.5
ATC = AFC + AVC
Cost

1 ATC
AVC

0.5

AFC

0 5 10 15
Output
Marginal Cost and Average Costs

1.5
ATC = AFC + AVC
MC
Cost

1 ATC
AVC

0.5
Minimum
points

AFC

0 5 10 15
Output
Short-Run Cost Curves
• Total fixed cost is constant.
• Total variable cost and total cost both increase with
output.
• Average fixed cost slopes downward.
• The average total cost and average variable cost
curves are U-shaped.
• The marginal cost curve is also U-shaped.
• The MC curve intersects the ATC and AVC at their
respective minimums.
Why the Average Total Cost Curve is U-Shaped

• There are two opposing forces that

guarantee the short-run average total cost
curve will be U-shaped:
– Decreasing average fixed cost
– Eventually increasing average variable cost
caused by diminishing returns
• The shape of the ATC curve combines these
two effects.
Why the Average Total Cost Curve is U-Shaped
TVC wL w w
AVC = = = =
Q Q Q L APL

APL → maximum → APL 

AVC → minimum → AVC 

TVC  ( wL) w( L) w w

MC = = = = =
Q Q Q Q L MPL

MPL → maximum → MPL 

MC → minimum → MC 
Product Curves and Cost Curves
How are the product curves related to the cost curves?

• There are two factors

that determine a
firm’s cost curves:
– Its technology
– Its product curves

• Marginal product and

marginal cost move in
opposite directions.

• Average product and

average cost move in
opposite directions,
too.
Shifts in the Cost Curves
• The position of a firm’s short-run cost curves depend on
technology and the prices it pays for inputs.
• If technology changes or if factor prices change, the firm’s costs
change and its cost curves shift.
• A technological change that increases productivity shifts the
product curves upward and shifts the cost curves downward.
• An increase in factor prices increases costs and shifts the cost
curves upward.
• Changes in fixed cost only affect the fixed and total cost curves.
• Changes in variable cost shifts the variable, total, and marginal
cost curves.
Long run Cost Curves
In the long run, a firm has many sizes to choose from.

The short run requires that scale be fixed— only one or a

few resources can be changed.

The law of diminishing marginal productivity does not hold

in the long run. All inputs are variable in the long run.

The term “plant size” to talk about having a particular

amount of fixed inputs. Choosing a different amount of
plant and equipment (plant size) amounts to choosing an
amount of fixed costs.
Fixed costs as being associated with plant and equipment.
Bigger plants have larger fixed costs.
A Typical Long-Run Average Total Cost
Total Costs Total Cost Total Costs = Average Total
Quantity of Labor of Machines TCL + TCM Costs = TC/Q

11 381 254 635 58

12 390 260 650 54
13 402 268 670 52
14 420 280 700 50
15 450 300 750 50
16 480 320 800 50
17 510 340 850 50
18 549 366 915 51
19 600 400 1,000 53
20 666 444 1,110 56
A Typical Long-Run Average Total Cost Curve
• Economies of scale: the decrease in per unit
costs as the quantity of production
increases and all resources are variable
– An indivisible setup cost is the cost of an indivisible input
for which a certain minimum amount of production must
be undertaken before the input becomes economically
feasible to use.

– Causes: Labor Specialization; Management

Specialization; Efficient Use of Capital; Efficient
Use of By-Products
– The cost of a blast furnace or an oil refinery is an
example of an indivisible setup cost.

• Diseconomies of scale: the increase in per

unit costs as the quantity of production
increases and all resources are variable
– Diseconomies of scale occur on the right side of the long-
run average cost curve where it is upward sloping,
meaning that average cost is increasing.

– Causes: Worker Alienation; Communication

Problems; Coordination and Control Problems
 A Typical Long-Run Average Total Cost Curve

The minimum efficient scale (MES) is the minimum point of the long-run average-cost
curve; the output level at which the cost per unit of output is the lowest.
The minimum efficient level of production is the amount of production that spreads
setup costs out sufficiently for firms to undertake production profitably.
The MES varies considerably across industries.
The Envelope Relationship
• Long-run costs are always less than or equal to short-run
costs because:
• In the long run, all inputs are flexible
• In the short run, some inputs are fixed

• There is an envelope relationship between long-run and

short-run average total costs. Each short-run cost curve
touches the long-run cost curve at only one point.

• In the short run all expansion must proceed by

increasing only the variable input
– This constraint increases cost
Long-Run and Short-Run Cost Curves
The Envelope of
Short-Run Average Total Cost Curves

The long-run average total cost curve (LRATC) is an envelope of the

short-run average total cost curves (SRATC1-4)
Summary: Long-Run Average Total Cost
• Long-run average total cost (LRATC): the lowest-cost
combination of resources with which each level of
output is produced when all resources are variable.

• The long-run average total cost curve gets its shape

from economies and diseconomies of scale.
– If producing each unit of output becomes less costly there
are economies of scale.
– If producing each unit of output becomes more costly
there are diseconomies of scale.
– If unit costs remain constant as output rises there are
constant returns to scale.