TUNKU ABDUL RAHMAN UNIVERSITY COLLEGE

Centre for Pre-University Studies

Course : Foundation in Business

Unit : FPEC1054 Microeconomics
Topic : 4 – COST OF PRODUCTION (KOS PENGELUARAN)

LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE TO

- Differentiate between short run and long run period in the production process
- Identify types of costs

Input/Factors of production Process outputGoods and survives

1. Definition of Production
Production is the process of using factors of production to produce goods and services. In the
production process, inputs like land, labour, capital and entrepreneur are transformed into
outputs like goods and services.

not important
2. Production Function
arral to
entreprene ur
Production function shows the relationship between inputs and outputs. It can be explained by
survices
using a mathematical equation. For example Q = f ( K, L, M).

The formula above shows that the quantity of output(Q) depends on the quantity of inputs. As the
quantity of inputs increases example K(capital), L(labour) and M(raw materials), the quantity of
output will also increase. In the production function, it is assumed that the quality of inputs is
homogeneous.

INPUT (Factors of production/ Economic factors) CHANGE TO OUTPUT (Goods and

services)
# Important
3. Definition of Short Run (JANGKA MASA PENDEK) and Long Run (JANGKA MASA
PANJANG)
*
Final Short run is a time period in which at least one of the inputs (factors of production) is fixed and the
other inputs are varied. Output can only be increased by applying more variable inputs to the
existing fixed factor.

A fixed input is an input in which the quantity does not change according to the level of output
example land, machines and building. A variable input is an input in which the quantity changes
according to the output example raw materials, labour, fuel and electricity. In the short run period,
the firm faces both fixed cost and variable cost. Production may be less flexible in the short run
because period due to the existence of fixed factors.

1
 alter-contral
change
Long run is a time period in which all inputs are variable. This means that the inputs or factors of
production can be increased or decreased based on production needs. Firms can alter the inputs to
increase outputs. In the long run, firms are able to adjust all costs as they are able to make
adjustments to their production. There is no fixed cost in the long run period as there is no fixed
factor of production. Cost of production consists of variable cost.
at least
EXAMPLE fixed
~have, one input is

FIRM A – operates in the short run period

Factors of production 1 January 1 January Fixed cost

2000 2020 ~

int)
Land 1 1 Fixed factor (EXPENSES ON FIXED
does notchange e FACTOR IS CALLED FIXED COST)
Labour 10 25
Capital 5 10 Variable factors (EXPENSES ON
Raw material 20
change
30 VARIABLE FACTOR IS CALLED
VARIABLE COST)

FIRM B – operates in the long run period

Factors of production 1 January 1 June

2020 2020
Land 1 2
Labour 5 20 Variable factors
Capital 2 5 (EXPENSES ON VARIABLE FACTOR
Raw material 10 30 IS CALLED VARIABLE COST)
flaserber
everything are
can adjust
4. Types of Cost in Different Time Periods

(a). Explicit Cost (KOS NAMPAK – EXPENSES INCURRED WHEN RUNNING A

BUSINESS / BUSINESS COST/ OUT OF POCKET PAYMENT)
have
resit/black and white efident
An explicit cost is a direct payment made by the producers to others in the course of running a
business. In other words, explicit cost is money payment by the producers to the owners for the
factors of production like rent for land, wage for labour and the purchase of raw materials
(INPUTS). It is the cost incurred when producing goods and services. Accounting profit only
takes explicit costs into account.

Accounting profit = Total revenue - Explicit costs

Restaurant-twore]IPi t

money come
out
to pay wage

2
 EXAMPLE

Farmer A – grows vegetables in Cameron Highlands

Factors of production Cost (RM)

Land Rental = 1000
Labour Wage = 5000
Seeds Purchase price = 1000
Fertilizers Purchase price = 1000
Utilities (Electricity and water) Utilities = 500
Explicit cost Total = 8500

(b). Implicit Cost (KOS TAK NAMPAK)

Implicit cost can be defined as cost incurred by the producer for using factors of production that
belongs to the owner himself like his own piece of land, self-owned factory, interest saved
because the capital is one’s own and services of his family members. Such cost is usually not
paid and is difficult to estimate the value. However, opportunity cost is used to estimate the
value of implicit cost. In the case of accountants such cost is not included in their calculations
but for economists, this cost must be included.

Economic profit = Total revenue - Explicit cost - Implicit costs

Owner standing on his own piece of land – rental = RM0 (implicit cost)

3
 Family members working on a farm owned by the family – wage = RM0 (implicit cost)

Farmer B – grows vegetables in Cameron Highlands

Factors of production Cost (RM)

Land (own) Rental = 0 Implicit cost
Labour (family members) Wage = 0 3
Seeds Purchase price = 1000
Fertilizers
Utilities (Electricity and water)
Explicit cost
Purchase price = 1000
Utilities = 1000
Total = 3000
& Elicit

Factors of production Opportunity cost (RM) (the thingslost) Implicitcost

↓
Land (own) Previously rented out = RM5000
opportunity cost
Labour (family members) Employed by other firms (wage) = RM10000
(E*)S)
Implicit cost Total = RM15000

* Opportunity cost is defined as the second best alternative sacrificed when making a
choice or decision.

* Total revenue = Price of the good X Quantity of good sold

4
 Exam
* Final
(c). Total Fixed Cost (TFC) (JUMLAH KOS TETAP)
It is also known as overhead costs and is applicable only in the short run. Total fixed cost
remains constant even though output changes. This means that total fixed costs are not
influenced by the level of output. Total fixed cost will be incurred even when there is no
production or zero output. Example: rental paid for the usage of factory, land and office
building, interest paid on a bank loan, insurance premium.

Diagram
Output Total Fixed lost
cost (RM)
i
Example: rental on a
factory)
O RM10000 (constant)

Total Fixed lost Increase RM10000 (constant)

TFC
:

Co

III
Decrease 12M10000 (constant)

⑧
G,
> Output(unit)
Q2, Go,
Based on the diagram above, when output is zero, total fixed cost exist example at Co.
Total fixed cost remains constant or unchanged as output increases or output decreases.
For example, the total fixed cost remains constant at Co when output increases from Qo
Final Exam
to Q1 or decreases from Qo to Q2. The total fixed cost curve is a horizontal straight line.
change
*
~can
(d). Total Variable Cost (TVC) (JUMLAH KOS BERUBAH)
Total variable cost refers to the cost of input that change with output. Total variable cost is
incurred when variable inputs are purchased. When output is zero, total variable cost is zero
also. As output increases, total variable cost increases also. Example: cost incurred for the
purchase of raw materials, wage paid to workers, cost of transportation, cost of fuel.
<petrol

TV c 0
=

output 0
=

Output:Increase TVC:Increase

Output decrease
=
TVC decrease
=

COST OF FUEL (PETROL)

5
 TRANSPORTATION (TOLL, PETROL)

RAW MATERIALS – TIMBER (FURNITURE)

LABOUR

Diagram

cost (RM

!dean
6
 Based on the diagram, when output is zero, total variable cost is zero also. Total variable
cost increases as output increases. For example, the total variable cost increases from Co
to C1 when output increases from Qo to Q1. Total variable cost decreases as output
decreases. For example, the total variable cost decreases from Co to C2 when output
decreases from Qo to Q2. The total variable cost curve is upward sloping starting from
the origin (0). There is a positive relationship between total variable cost and output.

(e). Total Cost (TC) (JUMLAH KOS)

In the short run period, a firm’s inputs consist of fixed factors and variable factors.
Cost of a firm comprises of fixed cost and variable cost.

TC = TFC + TVC

In the long run period, all inputs are variable factors (VARIABLE COST).
All costs are variable since there is no fixed factor (NO FIXED COST).

TC = TVC

Cost (RM)

TC

TFC TVC

TFC

0 output (unit)

• Total fixed cost (TFC) is constant and is not influenced by the level of output. Total fixed cost
exists even when output is zero. Total fixed cost curve is a horizontal line.
• Total variable cost (TVC) is zero when output is zero and rises with output. Total variable cost
curve begins from the origin and slopes upwards.
• The total cost curve (TC) is obtained by aggregating the total fixed cost (TFC) and total variable
costs (TVC) curve. The total cost (TC) curve begins from the total fixed cost and slopes upwards.
• The vertical distance between TC and TVC is TFC.
7
(f). Average Fixed Cost (AFC) (KOS TETAP PURATA)
Average fixed cost is the fixed cost per unit of output. The average fixed cost is obtained when
the total fixed cost is divided by the total output. AFC declines continuously with output in short
run as fixed cost are spread over a greater and greater number of units of output. AFC curve is
downward sloping.

AFC = TFC
Q

Output (unit) Total fixed cost (RM) Average fixed cost (RM)
RENTAL
1 1000 1000/1 10000
=

2 1000
1000/2 500
=

3 1000 1000/3 333.33=

4 1000 1000/4 255 =

Diagram

cost (KM)
A

1000

500

333.33

250 ! 4
AFC

Output Curits(

8
(g). Average Variable Cost (AVC) (KOS BERUBAH PURATA)
Average variable cost is the variable cost per unit of output. The average variable cost is obtained
when the total variable cost is divided by the total output. AVC declines in the first stage, reaches
minimum and later increases continuously with output. The average variable cost curve is U- shaped.

AVC = TVC
Q

Cost (RM)

AVC

0 output (unit)

(h). Average Cost (AC) (KOS PURATA)

It is the cost per unit output. The average cost is obtained by adding the average fixed cost and
the average variable cost or when the total cost is divided by the total output. AC declines in the
first stage, reaches minimum and later increases continuously with output. The average cost
curve is U- shaped.

AC = TC
Q
or

AC = AFC + AVC

9
(i). Marginal Cost (MC) (KOS MARGINAL/ KOS SUT) Kos tambahan ~

It is the change in total cost as a result of producing another output. The marginal cost can also be
defined as the additional cost incurred in producing an additional output. MC declines in the first
stage, reaches minimum and later increases continuously with output. The marginal cost curve is
U- shaped.

MC = ΔTC
ΔQ

OUTPUT TOTAL COST (RM) MARGINAL COST (RM)

- Additional cost

0 100 -
(fixed cost – example rental)

1 150 150 – 100 = 50

2 220 220 -150 = 70

3 320 320 – 220 = 100

LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE TO

- Determine the concept of the law of diminishing marginal returns
- Determine internal economies of scale
- Identify factors that lead to internal economies of scale

declining/decrease
5. Law of Diminishing Marginal Returns
~fixed factor

Applicable in short run where there must be at least one fixed factor.

The Law of Diminishing returns states that when an increasing quantity of variable factor is
added to the fixed factor, the total output will rise at an increasing rate until a certain level of
production and then the total output will increase but at a decreasing rate. This means that the
marginal product is falling.

10
 Table
Fixed Factor Variable factor Total product Average product Marginal
(LAND) (LABOUR) (CORN) product (MP)
1 1 5 5 5
1 2 12 6 7
35/5 11.67 23
1 3 35 35-12
= =

1 4 have 53 53/4 13.25

=
53-35=18 decrease/decline
problem 65/5 13.8 65 53 12
1 5 because 65
-
=
=

1 6 marginal 72 7216:12.0 72 - 65 7 =

product 0
1 7 decline 72 (MAX) 7217 10.29
= <2 - 72 =

1 8 70 70/8 8.75
=
-
2

At the beginning, when variable factors (eg labour) is added onto the fixed factor (eg land), the
total product (TP) increase at an increasing rate. This is shown by the marginal product (MP)
curve that is sloping upwards. At this rate the marginal product (MP) is above the average product
(AP). This occurs because the fixed factor and the variable factors are used in better proportion.

As more labour is added to the fixed factor, the total product (TP) continues to rise but at a smaller
unit. The marginal product (MP) falls as each new labour employed add less and less to total
product compared to the previous labour. This happens because the fixed factor is overworked in
combination with the variable factor. The marginal product (MP) decreases because each successive
unit of variable factor has smaller and smaller quantity of fixed factor to work with. At this stage
the total product (TP) still continues to rise but at a decreasing rate. The marginal product (MP)
curve lies below the average product (AP) curve.

Eventually, a stage is reached when the total product reaches maximum, stops to increase anymore
and then declines. At this level, the marginal product (MP) is negative. This means that the labour
employed does not add to any production but instead gets in the way of other workers (over-
crowding). The producer will never operate at this stage.

Example 2 (Example of employee working in a factory)

• When one worker is employed, he has to do everything himself. There is too much fixed
factors (eg equipment) to work with. Fixed factor is under-utilised.
• When the second and third worker are employed, division of labour can be used. Each
worker can be given a specific task and this increases efficiency. There is better use of fixed
factor.
• As more and more workers are added, there are now too few fixed factors to work with.
• The workers are underutilised. There is inefficient combination of fixed factor and variable
factor.
• This leads to a low marginal product and total product is increasing at a diminishing rate.
• When marginal product is negative, it means that the variable factors are in too large
proportion compare to the limited fixed factor.
• There are now too many workers in a limited space or too little capital equipment to work
on.
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 Relationship between Total Product (TP), Average Product (AP) and Marginal Product (MP)

• TP increases at an increasing rate, after that TP increases at a decreasing rate.

TP reaches maximum then falls.
• MP increases then falls. When TP falls, MP is negative.
• When AP increases, MP > AP
• When AP maximum, MP = AP
• When AP falls, MP < AP when maximum-maginal product
Diagram will at's
TP, AP MP (Unit)
A

maximum

I
TP
Steep
low of
diminishing

Imo,
hapen

AP

of
·
Quantity
labour (unit)
6. Economies of Scale and Diseconomies of Scale
The theory of economies of scale and diseconomies of scale apply to the long run production when
all inputs are variable factors.

Economies of Scale
Economies of scale are benefits and advantages a firm enjoys as it grows larger. Economies of
scale exist when the expansion of the firm or industry allow the product to be produced at a
lower unit cost. It refers to the advantages of large scale production. Associated with economies
of scale is increasing returns and decreasing cost.

Economies of scale can be divided into 2 types:

12
 Internal inside the firm Scale
changes
large/bigin
-

-
the firm is size
advantages,
goods,
benefity
Economies
charge output
-

the firm produces

-

* operating in the long rum period

operating in
(a). Internal Economies of Scale ~big long period in
the firm
size

run
is

(DUE TO CHANGES THAT TAKES PLACE INSIDE THE FIRM) call variable factors. no fixed
Final - refers to the benefits enjoyed by the firm itself arising from the actions of the firm itself. The average factor)
cost of production is declining. It is indicated by the downward sloping of the average cost (AC) curve.

Diagram - no need draw

10St(RM)
A

LRAC
(Long Run
Average cost)
20 -- a
-------------

a
-minimum -------------

⑧ Q >Output (Rm)
Ql
*

* Internal economies of scale refers to the benefits and advantages enjoyed by the firm itself
arising from the actions inside the firm itself. The long run average cost of production is
declining as output increases. The long run average cost decreases from Co to C1 when output
increases from Qo to Q1. This is shown by the movement of point downwards along the long
run average cost curve from point a to b. It is also indicated by the downward sloping section
of the long run average cost curve.

* Types or reasons for internal economies of scale

• Marketing economies
A large firm can buy raw materials(inputs) in bulk resulting in lower prices for their factor inputs
which mean cheaper cost. At the same time, the large firm can achieve savings in unit cost from
advertising or packaging. Large firms have their own sales department or agencies to sell their
goods. The firms would sell in large amount not only to local market but also to foreign market
as well.

13
 lot
~a

Ican buy in more

[cut cost] [use own worker
OWR chaper)
• Financial economies
Large firms often find it cheaper and easier to borrow money. They are able to borrow a large
amount of money from financial institutions and the interest rate charged is usually lower
because of their sound financial standing. The financial institutions perceive risk of lending to
Bank
⑪↑

large firm operators is lower. These loans are also usually of a longer maturity period and
collateral security is usually not required. The low interest rate would mean lower cost to large
firms.

• Managerial economies
In a large firm, specialization of labour can be implemented. Workers can specialize in jobs that
they are most capable of. The productivity of workers increases tremendously leading to lower
unit cost of production. Managerial economies also refers to the employment of professionals to
manage a specific department. Large firms also attract the best management talent through
higher salary This will ensure higher productivity and lower cost of production.

14
• Technical economies
Large firms are able to purchase machines which are modern and sophisticated. This means that
there is technological improvement in production. Hence, large firms can produce at maximum
capacity by fully utilizing these machineries and reduce average cost.

LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE TO

- Learn the concept of external economies of scale
- Identify factors that lead to external economies of scale

(b). External Economies of Scale

(CHANGES THAT TAKES PLACE OUTSIDE THE FIRM – THAT BENEFITS/BRING
ADVANTAGES TO THE FIRM)
- refers to the benefits enjoyed by the entire industry as a whole and not the individual firm only.
The average cost of production is declining. It is indicated by the average cost (AC) curve that
shifts or move downwards.
External
Diagram cost (2m)
R LRAL

LRAC1
Co - - - - - - - - - - - - -
-------------

V
↓c -------------

Po
> Output(unit]

External economies of scale refers to the benefits or advantages enjoyed by the entire industry
as a whole and not the individual firm only. The long run average cost of production is
declining. It is indicated by the long run average cost (LRAC) curve that shifts or move
downwards from LRACo to LRAC1. For example at output Qo, the long run average cost falls
from Co to C1 due to changes that takes place outside the firm.

15
Types or reasons for external economies of scale

• Economies of concentration
When a number of firms in the same industry band together in an area, they can derive a great
deal of mutual advantage from one another. With concentration, there is no necessity for the
firms to advertise their location. This would save advertising cost. Such locality will also ensure
a steady flow of demand for the industry’s product and it attracts a pool of skilled workers, better
infrastructure example roads, power station, water supply, telecommunication and railway. This
would save the firm a large amount of fixed costs and production can be carried out efficiently.

BUBBLE TEA OUTLETS IN SS15

INFRASTRUCTURE

• Economies of information
Firms in the industry can cooperate with one another, for instance, setting up research facilities
and the publication of journals. Producers will then be exposed to new information that can
improve their productivity and save cost. Firms can also collectively organize conferences,
seminars and trade fairs where knowledge can be shared out among all its members.

• Economies of marketing
Firms in the industry can cooperate with one another in the purchase of raw materials in bulk. By
doing so, they can obtain the raw materials at a cheaper price thus reducing the cost of
production.

16
 LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE TO
- Learn the concept of internal diseconomies of scale
- Identify factors that lead to internal diseconomies of scale

Diseconomies of Scale
Diseconomies of scale are problems and disadvantages faced by a firm as it grows larger. It refers to
the disadvantages of large scale production. Associated with diseconomies of scale is declining
returns and increasing cost.

Diseconomies of scale can be divided into 2 types:

Final(a). Internal Diseconomies of Scale

*
(DISADVANTAGES AND PROBLEMS FACED BY THE FIRM DUE TO CHANGES
THAT TAKES PLACE INSIDE THE FIRM ITSELF)
- refers to the problems and disadvantages faced by the firm itself arising from the actions inside the
firm itself. The average cost of production is increasing. It is indicated by the upward sloping of the
average cost (AC) curve.

Diagram Cost(RM)
N

noneed LRAC
draw

a
-

I
-

b
Co ------------- ·
-------------

8
Qo
- Output(unit)
Q
* Internal diseconomies of scale refers to the problems and disadvantages faced by the firm itself
reason arising from the actions inside the firm itself. The long run average cost of production is
increasing. This is shown by the movement from point b to c. It is indicated by the upward
sloping of the long run average cost (LRAC) curve.

17
* Types or reasons for internal diseconomies of scale

• Labour diseconomies
With division of labour, the work done will become dull and monotonous. This will lead to
boredom and disinterest thus reducing productivity. There is also the feeling of the lack of identity
and the absence of pride on the goods produced as the goods were produced through different
divisions. With low productivity, eventually the cost of production per unit rises.

• Management problems
Diseconomies of scale occur due to the difficulty in managing large firms. This includes the
problem of co-ordinating large organisations, the slow and the cumbersome process of decision-
making leading to lower output and higher cost. There will also be administrative problems and
the inability to monitor effectively the performance of workers in large organisations.

QUARRELING AMONG STAFF

• Technical difficulties
The over usage of machineries to produce large scale outputs would lead to machinery
breakdown. This will cause unnecessary expenditure in terms of repairs and replacement of
machines thus increasing the firm’s per unit cost.

18
 MACHINE BREAKS DOWN

LEARNING OUTCOME – AFTER THIS LESSON STUDENTS WILL BE ABLE TO

- Learn the concept of external diseconomies of scale
- Identify factors that lead to external diseconomies of scale

(b). External Diseconomies of Scale

(DISADVANTAGES AND PROBLEMS FACED BY THE FIRM DUE TO CHANGES
THAT TAKES PLACE OUTSIDE THE FIRM)
- refers to the problems and disadvantages faced by the entire industry as a whole and not the
individual firm only. The average cost of production is increasing. It is indicated by the
average cost (AC) curve that shifts or move upwards.

(12 m)
Diagram
cost
LRAC,

C------- LRAC.

i
↑
Co -------

> Output (unit?

Do
External diseconomies of scale refers to the problems and disadvantages faced by the entire
industry as a whole and not the individual firm only. The long run average cost of production
increases. It is indicated by the long run average cost (LRAC) curve that shifts or move upwards
from LRACo to LRAC1. For example at output Qo, the long run average cost rises from Co to
C1 due to changes that takes place outside the firm.

19
Types or reasons for external diseconomies of scale

• Concentration problems
When firms are concentrated in one area, there will be problems like traffic congestion and
pollution. Traffic congestion will lead to increase in transportation cost, hence increasing the cost of
production. There will also be delays in transportation leading to lower productivity. Serious air
pollution in an area may cause the government to implement a law that requires all factories to be
equipped with air purifiers to reduce the air pollution problem in the area.

TRAFFIC JAM

• Scarcity problem
As an industry expands there will be competition amongst firms in obtaining raw materials and
land area. Land shortages will lead to rising land prices and rental thus increasing fixed cost. The
competition amongst firms in obtaining raw materials will lead to higher material prices. As a
result, the firms will face rising per unit cost of production.

RM 45,000 /month
1250 sqft
RM36.00 psf
Pavilion Shopping Mall
Jalan Bukit Bintang, Bukit Bintang, KL City, Kuala Lumpur

• Wage problem
Wage problem occurs within the industry when there is a shortage of skilled labour. Each firm
will tend to pay higher wage for labour than the other because of limited resources. This will
result in higher variable cost. Some firms may even agree to wage rate increase to attract new
workers or to prevent the existing workers from moving to another firm.

20