AE 11 (MANAGERIAL ECONOMICS)

Module 4: Production Cost

Activity Description Time to Complete

1. Formative Economics costs are value to society 30 Minutes

Activity of all resources used in the production
of an item. The costs are measured by
the value of the resources in their next
best use, that is, the value of the
foregone opportunities.

Section 1. Economic Costs 240 Minutes

2. Lesson Proper a. Types of Private Costs
b. Fixed and Variable Costs

Section 2. Average and Marginal Costs

a. Geometry of Cost Curves

Section 3. Long-run Cost Curves

3. Summative Application of knowledge production

45 Minutes
Assessment costs.

4. Reinforcement Reinforcement on Students’ 45 Minutes

Discussion understanding on economic costs

Total: 360 minutes

Overview of Module 4
Demand analysis is fundamentally concerned with the revenue side of an organization’s
operation; cost analysis is also vital in managerial economics, and managers must have a good
understanding of cost relationships if they are to maximize the value of the firm. Many costs are
more controllable than are factors affecting revenue. While a firm can estimate what effect an
increase in advertising expenditure will have on sales revenue, this effect is generally more
uncertain than a decision to switch suppliers, or invest in new machinery, or close a plant. Just
as with production theory, the distinction between short run and long run is an important one. In
the short run, managers are concerned with determining the optimal level of output to produce
from a given plant size (or plant sizes, for a multi-plant firm), and then planning production
accordingly, in terms of the optimal input of the variable factor, scheduling and so on. In the long
run, all inputs are variable so the most fundamental decision the firm has to make is the scale at
which to operate. The optimal scale is the one that is the most efficient, in economic terms, for
producing a given output. Cost analysis is made complex because there are many different
definitions and concepts of cost, and it is not always straightforward to determine which costs to
use and how to measure them in a particular situation. The focus here is on the relevant costs
for decision-making.

Learning Objectives
Dear students, what will you learn from this module?
At the end of the module, learners are expected to:
 Analyze Costs.
 Determine the types of Private Costs.
 Explain what are Fixed and Variable Costs.
 Discuss the difference between Average and Marginal Costs
 Appraise the Geometry of Cost Curves.
 Analyze the Long-Run Cost Curves.
 Explain Scale Economies.

Production Costs
Economic Costs
 Economics costs are value to society of all resources used in the production of an item.
The costs are measured by the value of the resources in their next best use, that is, the
value of the foregone opportunities. Economics costs are composed of both private
and external costs:
 Private costs are the costs accruing to individuals producing or consuming the
good.
 External costs are the costs accruing to persons in society who are not directly
involved in the production or consumption of a particular good. External costs are
often referred to as third-party cost.
 Production is likely to create both private and external costs.
  Activity
 Give example of an external cost

Types of Private Costs

 Two types of private costs must be considered:
 Explicit costs are the value of resources purchased for production.
 Implicit costs are the value of self-owned, self-employed resources utilized in
production.
Explicit costs are recorded by accountants and appear on income statements of a firm. Although
they may not be recorded by accountants, implicit costs are also important. A rational person is
unlikely to devote personal resources to uses that provide lower returns than the resources
could earn elsewhere in the economy.

Exercise:
 An executive chef for a large hotel-restaurant chain resigns his P1,400,000 per-year
position. He uses his life savings of P500,000 to purchase as small restaurant. At the
end of the first year of operation, his accountant provided him the following information
on revenues and explicit costs:
Revenue P2,000,000
Expenses
Food 400,000
Labor 700,000
Utilities 200,000
Miscellaneous 150,000
Net Income 550,000
Did the entrepreneur make a profit of P550,000 for a year? Explain.

Fixed and Variable Costs

 There are fixed and variable inputs in the short run by definition. Therefore, there will be
fixed and variable costs in the short run since costs correspond to commitments for
inputs.

A. Fixed costs do not vary with output.

Fixed costs are costs that do not vary directly with the level of production in the short
run. Fixed cost represents commitments to fixed resources such as plant and equipment, that
must be paid regardless of the level of production. Fixed costs exist in the short run, even if
output is zero.
𝑭𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕 = (𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒇𝒊𝒙𝒆𝒅 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕) 𝒙 (𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒇𝒊𝒙𝒆𝒅 𝒊𝒏𝒑𝒖𝒕)

B. Variable Costs vary directly with output.

 Variable costs are costs that vary directly with the level of output. Variable costs
represent commitments to inputs that vary directly with the level of output, such as raw
materials and labor.
 𝑽𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕𝒔 = (𝒑𝒓𝒊𝒄𝒆 𝒐𝒇 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒊𝒏𝒑𝒖𝒕 𝒑𝒆𝒓 𝒖𝒏𝒊𝒕)𝒙 (𝒂𝒎𝒐𝒖𝒏𝒕 𝒐𝒇 𝒗𝒂𝒓𝒊𝒃𝒂𝒍𝒆 𝒊𝒏𝒑𝒖𝒕)
C. Total Costs equal fixed cost plus variable costs.
 Total costs are the sum of fixed costs plus variable costs in the short run. (There are no
fixed inputs in the long run, by definition, so there will be no fixed costs.)
 Given a short-run production schedule and prices of inputs, it is possible to derive fixed,
variable, and total cost schedules by using the definition of each cost.

Exercise: Assume that capital constitutes a fixed input. The price of capital W K is P5.00 per
unit; the price of labor WL is P10 per unit. Multiplying, W K and W L by the amount of labor and
capital, respectively, given the production schedules. Adding the fixed and variable costs of
each output gives the total cost schedule.

Production Schedule Cost Schedules

Fixed Variable

Capital Labor Output (capital) (labor) Total

10 0 0 50 0 50

10 1 5 50 10 60

10 2 12 50 20 70

10 3 18 50 30 80

10 4 23 50 40 90

10 5 27 50 50 100

10 6 30 50 60 110

10 7 32 50 70 120

10 8 33 50 80 130

QUESTIONS:
1. What is the value of total fixed cost in all levels of output?
Answer: 50
2. What is the value of average total cost at output 30 units?
Average Total Cost = Total cost / Output
Answer: 110 / 30 = 3.67

3. When the price of labor is wl10 and the quantity of labor is 8 man hours, how much is the
value of total variable cost?
Total variable cost = Price of labor x Quantity of output
 Answer: 10 x 8 = 80
4. When total cost is ₱110.00, how much is the value of total variable cost?
Total variable cost = Total cost – Total fixed cost
Answer: 110 – 50 = 60
5. At output 18 units, how much is the marginal cost?
MC = ΔC / ΔQ = C2 – C1
Q2 – Q1
MC = 80 – 70
18 – 12
MC = 10
6
MC = 1.67

Average and Marginal Costs

 The various types of costs can be expressed as average and marginal costs as totals.

A. Average cost is cost per unit.

Average cost (AC) is the cost per unit of output. Average cost can be computed for fixed,
variable, and total costs:
𝑡𝑜𝑡𝑎𝑙 𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 = 𝑜𝑢𝑡𝑝𝑢𝑡
𝑡𝑜𝑡𝑎𝑙 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 = 𝑜𝑢𝑡𝑝𝑢𝑡
𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡
𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 =
𝑜𝑢𝑡𝑝𝑢𝑡

B. Marginal cost is the change in total cost.

 Marginal cost is the change in total cost for a one-unit change in quantity. The MC can
be calculated by several formulas:
∆𝑪 𝑪𝟐 −𝑪𝟏
𝑴𝑪 = = 𝑸𝟐 −𝑸𝟏
∆𝑸
𝒐𝒓
𝒅𝑪
𝑴𝑪=𝒅𝑸
Activity: Complete the table below.

Output Total Cost Average Cost Marginal Cost

(Q) (TC) (AC) (MC)

0 50
5 60
12 70
18 80
23 90
27 100
30 110
32 120
33 130

Geometry of Cost Curves

 Average and marginal cost curves can be constructed from total cost curves. The
process similar to the construction of average and marginal product curves.

A. Average costs are shown by the slope of a ray.

Average cost curves are given by the slope of a ray from the origin to a point on a cost
curve. The slope of the ray will be total cost C (vertical distance to the total cost curve) divided
by quantity of output Q (horizontal distance to the point).

Example: Average fixed cost will decline as output increases.

Example:
Average variable cost will be U-shaped for the total variable cost (TVC) curve. Average variable
costs will reach a minimum, since it is tangent to the total variable cost curve has minimum
slope at that point.

Example: Short-run total cost curve

The short-run total cost (TC) curve is formed by fixed and variable costs. The minimum point of
the average cost is where the ray is tangent to the total cost curve.
A. Marginal costs are shown by the slope.
 The marginal cost curve maybe constructed from the total cost curve by finding the slope
∆𝐶
of the total cost curve, 𝑀𝐶 = (∆𝑄) , which is the formula for the slope of a segment of the
total cost curve. Marginal cost can also be defined as the slope of a tangent to a point on
a total cost curve and will equal dC/dQ.
 By the law of diminishing returns, the marginal cost curve will have positive slope
beyond some point. This law implies that it will take increasingly larger incremental
increments of variable inputs to obtain an additional output. Therefore, the total variable
cost curve will increase at an increasing rate.

B. Marginal cost will be positive and increasing beyond some

point as the slope of the total variable cost curve increases.

C. The marginal cost rises to intersect average cost at

minimum.
 The marginal cost curve intersects the average cost variable cost curves at their
minimum points. The relationship will always hold. The ray of the total cost curve will be
the minimum slope of the ray equals the slope of the total cost curve. The slope of the
total cost curve is marginal cost, so MC = AC. The same argument holds for the
average variable cost curve.
Marginal cost (MC) rises to intersect the average cost (AC) at
its minimum point.

D. The average fixed cost equals the average cost minus

average variable cost.

 The variable distance between the average cost curve and the average variable cost
curve is the average fixed cost (AFC). Since average fixed costs decline as output
increases, the distance between average cost and average variable cost curves will also
decline.

Assignment: Click the links

 https://courses.lumenlearning.com/wm-microeconomics/chapter/average-costs-and-
curves/
 https://www.youtube.com/watch?v=qYKJdooEnwU
 https://www.youtube.com/watch?v=TZ0wxNYrStI
 https://www.toppr.com/guides/economics/production-and-costs/short-run-production-
costs/

Long-Run Cost Curves

 The long-run average cost (LRAC) curve will be an envelop of a series of short-run
average cost (SRAC) curves. Points on the LRAC curve corresponds to costs from
plants of different sized.
A. The LRAC is a planning curve.
 A LRAC curve is often referred to as a “planning” curve. The curve can be used to
determine optimal output and plant size in the long-run. However, once a particular plant
is built, the short-run cost curves for that particular plant become the relevant cost curve
for the producer. A particular plant may share only one or a few points with the LRAC
curve. No one plant is likely to yield all of the cost-quantity combinations shown by the
LRC curve.

B. SRAC will exceed LRAC

 The short-run average costs for a plant will exceed the long-run average costs at most
output levels. These results are as expected because the short-run and long-run
expansion paths cross at only one point. The cost levels associated with all other points
on the short-run expansion path are higher than those on the long-run expansion path.

Scale Economies
 Scale economies are a property of a long-run average costs indicating the change in
the cost per unit as output and plant size change.
 A LRAC curve with a negative slope exhibits economies of scale.
 A LRAC curve with a zero (horizontal) slope exhibits constant economies of scale.
 A LRAC curve with a positive slope exhibits diseconomies of scale.

Example: The three types of scale economies are shown below. It illustrates a LRAC that
exhibit all three types of economies over various segments.
A. Scale economies are related to returns to scale.
 Scale economies are directly related to returns to scale when input prices are constant.
However, if input prices change as the scale of plant changes, direct relationship may be
lost.

Returns to scale Scale economies Slope of LRAC curve

increasing economies negative

constant constant zero

decreasing diseconomies positive

Scale economies may influence market structure

 The scale economies for production may influence the number of products in the
industry. If there are significant economies of scale, there may be very limited number
of producers. If the economies of scale continue beyond (to the right of) the market
demand, the industry may be considered a “natural monopoly.” The costs of production
will be minimized by having only one producer. If there are significant diseconomies of
scale, then, there may be a very large number of small producers. The market structure
is likely to be “atomistic.” The constant-economies case provides no insight into market
structure. One, several, or many producers are all plausible constant economies.

References

Hirschey, M., Managerial Economics 12th ed. Pasig City: Cengage Learning Asia Pte Ltd. 2012.

Samuelson, W., Marks, S. Managerial Economics. John Wiley and Sons Inc. 2016

Thomas, C, Maurice, C., Manager Economics, Foundations of Business Analysis and Strategy 12th ed
International Edition. Mc Graw Hill 2016

Wikenson, N. Managerial Economics: A Problem Solving Approach. Harvard, Cambridge University

Press 2015