Cost of Production

Chapter outlines

Robert S. Pindyck 1. Measuring Cost: Which Costs Matter?

and Daniel L. 2. Cost in the Short Run
Rubinfeld(2013). .
Microeconomics 3. Cost in the Long Run
Eighth Edition,
Page 229-271 4. Long-Run Versus Short-Run Cost Curves

5. Production with Two Outputs: Economies of Scope

6. Dynamic Changes in Costs: The Learning Curve

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 Introduction
• Production technology
– measures the relationship between input and output
– together with prices of factor inputs, determine the firm’s
cost of production
• Given the production technology, we must choose how
to produce
• A firm’s costs depend on the rate of output and we will
show how these costs are likely to change over time
• The characteristics of the firm’s production technology
can affect costs in the long run and short run
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Measuring Cost: Which Costs Matter?
• For a firm to minimize costs, it must clarify what is
meant by costs and how to measure them.
– Accountants tend to take a retrospective view of firms’
costs, whereas economists tend to take a forward-looking
view
• Accounting Cost:
– Actual expenses plus depreciation charges for capital
equipment
• Economic Cost:
– Cost to a firm of utilizing economic resources in production,
including opportunity cost
• Opportunity cost
– Cost associated with opportunities that are foregone when a
firm’s resources are not put to their highest-value use.
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Measuring Cost: Which Costs Matter?
• An Example: Opportunity cost
– A firm owns its own building and pays no rent for office
space. The building could have been rented instead
– A person starting their own business must take into account
the opportunity cost of their time
• Could have worked elsewhere making a competitive salary
• Sunk Cost
– Expenditure that has been made and cannot be recovered
– Should not influence a firm’s future economic decisions.
Decision makers should ignore sunk costs to maximize profit
or minimize losses.
– Firm buys a piece of equipment that cannot be converted to
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 The Various Measures of Cost
• In the short run, Costs of production may be divided
into fixed costs and variable costs.
• Fixed costs are those costs that do not vary with the
quantity of output produced.
• Variable costs are those costs that do vary with the
quantity of output produced.
• Total Costs; TC = TFC + TVC
1. Total Fixed Costs (TFC)
2. Total Variable Costs (TVC)
3. Total Costs (TC)
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 Fixed, Variable and Total Costs
• TC=f(Q): Minimum total $C
cost of producing TC(Q) = TVC + TFC
alternative levels of output:
TVC(Q)

TC=f(Q) = TVC(Q) + TFC

• TVC(Q): Costs that vary

with output. TFC

• TFC: Costs that do not vary

with output. 0 Q

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 The Short Run Average Cost Function
• Average Costs: Average costs can be determined by dividing
the firm’s costs by the quantity of output it produces. It is the
cost of each typical unit of product.
1. Average total cost (ATC)
– is the average per-unit cost of using all of the firm’s inputs (TC/Q)
– ATC = AFC + AVC
2. Average variable cost (AVC)
– is the average per-unit cost of using the firm’s variable inputs
(TVC/Q)
3. Average fixed cost (AFC)
– is the average per-unit cost of using the firm’s fixed inputs (TFC/Q)
4. Marginal Cost
– Marginal cost (MC) measures the increase in total cost that arises
from an extra unit of production.
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 The short run Average Costs Curves
When MC is below AVC, AVC is falling
Average Total Cost
ATC = AVC + AFC
ATC = C(Q)/Q $(C)
MC ATC
AVC
Average Variable Cost
AVC = VC(Q)/Q

Average Fixed Cost MR

AFC = FC/Q

Marginal Cost
∆𝑉𝐶 AFC
MC = DC/DQ=
∆𝑄

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 Example : Short run Costs
Fill in the blank spaces of this table.
Q TVC TC AFC AVC ATC MC
0 $50 ---- ---- ----
1 10 $10 $60.00 $10
2 30 80
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30 60
6 210 260 8.33 35 43.33
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 Determinants of Short Run Costs
• The rate at which these costs increase depends on the nature
of the production process
– The extent to which production involves diminishing returns to
variable factors
• Diminishing returns to labor
– When marginal product of labor is decreasing
• If marginal product of labor decreases significantly as more
labor is hired
– Costs of production increase rapidly
– Greater and greater expenditures must be made to produce more
output
• If marginal product of labor decreases only slightly as
increase labor
– Costs will not rise very fast when output is increased
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 Determinants of Short Run Costs
• Assume the wage rate (w) is fixed relative to the number of
workers hired
• Variable costs is the per unit cost of extra labor times the
amount of extra labor: TVC= wL

DVC wDL w Because

MC    DQ
Dq Dq MPL DMPL 
DL
By rearranging DL 1
DL for a 1 unit DQ  
DQ DMPL
 a low marginal product (MPL) leads to a high marginal cost
(MC) and vice versa Econ2021, Theory of Cost, FIKADU A 11
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 COST IN THE LONG RUN
• In the long runs all factors are variable, and thus there are no fixed
costs.
• User cost of capital(K) or price of capital(K)
– Annual cost of owning and using a capital asset, equal to economic
depreciation plus forgone interest.
– User cost of K=depreciation(𝛿) +interest rate(i)*value of K
– We can also express the user cost of capital as a rate per dollar of capital:
r= 𝛿+ I
• The Rental Rate of Capital
– Cost per year of renting one unit of capital.
• isocost line
– Graph showing all possible combinations of labor and capital that can be
purchased for a given total cost.

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 Long Run Cost
• In the long run, all fixed costs become variable
costs.
• For the analysis of the long-run cost of production,
three curves matter in firm decision making;
– Long- Run Total Cost Curve (LTC),
– Long-Run Average Cost Curve (LAC), and
– Long- Run Marginal Cost Curve (LMC).

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 Long-Run Average & Marginal Cost Curves
• Here also, LAC and
LMC curves are U-
shaped, but they
are flatter than the
short-run cost
curves.

• The U-shape of the

LAC curve is
because of returns
to scale.

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 Optimal production: Cost Minimization
• Firms purchase INPUTS to produce OUTPUT. This output depends
upon the firm’s FUNDS and the PRICE of the inputs
• One of the goals of a firm is to produce output at a minimum
cost.
• Suppose that a firm’s owners wish to minimize costs. Let the
desired output be Q0 and Technology: Q = f(L,K)
• Cost Minimization problem: 𝑴𝒊𝒏𝑪𝑲,𝑳 =rK + wL,
Subject to :Q0 = f(L,K)
• Same solution as max Q, s.t. TC
– (∆Q/∆L)/(∆Q/∆K) = MPL/MPK = w/r
– Ratio of marginal products equals price ratio
– Cost line is tangent to an isoquant
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Optimal production: Cost Minimization(cont’ d..)
• How does the isocost line relate to the firm’s
production process?

MRTS  - DK
MPL

DL MPK

Slope of isocost line  DK  w

DL r

Equilibrium or MPL
w when firmminimizes cost
optimal point MPK r
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 Optimal production: Cost Minimization(cont’ d..)
K
Figure : Cost Minimization
C2/r

• Cost inefficient point for Q0

C1/r
Cost minimization point for Q0
C0/r
• Isoquant Q = Q0

C0/w C1/w C2/w L

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 Optimal production: Cost Minimization
(cont’ d..)
• Method to Solve Optimization Problems
• There are two methods:
a. Substitution method and
b. the langrangian method
• Steps involved in substitution methods
1. Tangency Condition; MPL/MPK = w/r
-gives relationship between L and K
2. Substitute into Production Function=f(K,L)
solves for L and K
3. Calculate Total Cost: TC=wL+rK
4. Conclude.
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 Optimal production: Cost Minimization
(cont’ d..)
• Langragian method
1. Set the langragian function(L)
– L=objective function+𝜆(Constraint function)
2. Derivate the function L with respect to K, L and 𝜆
and equate to zero
3. Solve 𝜆, K and L simultaneously

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 Finding Costs from Production Functions
• Suppose Q = 10L0.2K0.8, w=$10, r=$20. What is the cost of
producing 100 units?
• Solution:
– Use MPL/MPK = w/r
– MPL/MPK = [(0.2)/(0.8)](K/L) = ¼ (K/L)
– w/r = $10/$20 = ½
– ¼ (K/L) = ½ or K = 2L
• Substitute into Production Function
– 100 = 10(L0.2)(2L)0.8 = 10L(2)0.8 = 10L(1.74)
– L = 100/17.4 = 5.75, K = 2L = 11.5
• Cost = wL + rK = $10(5.75) + $20(11.5) = $287.40
• Conclusion: the optimal combination or cost minimizing level of K
and L are 11.5 and 5.75 respectively.
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 Numerical Example
Find the cost minimizing level of K and L if;
Q = 50L1/2K1/2 w = $5 r = $20
MPL = 25K1/2/L1/2 Q0 = 1000
MPK = 25L1/2/K1/2
• Find the cost producing 1000 output.

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 How LRAC Changes as the Scale of Production
Changes: Economies of Scale
• As businesses grow – costs of production may
decrease.
• Bigger businesses gain some advantages over
smaller businesses through Economies of Scale
• Economies of scale
– refer to the property whereby long-run average total
cost falls as the quantity of output increases.
– The advantages of large scale production that result in
lower unit (average) costs (cost per unit): AC = TC / Q
– spreads total costs over a greater range of output
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 Economies of Scale: 2 types
1. Internal Economies:
External Economies:
• Benefits the whole industry and
• Those Specifically related to not specific firms
the business itself eg:- – Skilled labour in the area,
Better road and rail networks,
– Production, Purchasing., Improves the reputation of the
Marketing, Financial and area and Attracts other
Managerial businesses.
• the advantages firms can gain as a
• Advantages that arise as a result of the growth of the
result of the growth of the firm industry; associated with a
– Technical particular area
– Supply of skilled labour
– Commercial
– Reputation
– Financial – Local knowledge and skills
– Managerial – Infrastructure
– Risk Bearing – Training facilities
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 Diseconomies of Scale;
• There are limits to the amount a business can grow.
• If businesses grow to large they start to suffer from
Diseconomies of Scale at some point in time.
– It refer to the property whereby long-run average total cost rises
as the quantity of output increases.
• The disadvantages of large scale production that can lead to
increasing average costs
• These diseconomies happen because the larger the business
the more difficult it becomes to manage;
– Decision making
– Managerial problems
– Communication problems
– Co-ordination/control problems
– Staffing problems
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 Figure 6 Average Total Cost in the Short and Long Run
Average
Total ATC in short ATC in short ATC in short
Cost run with run with run with
small factory medium factory large factory ATC in long run

$12,000

10,000

Economies Constant
of returns to
scale scale Diseconomies
of
scale

0 1,000 1,200 Quantity of

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 Economies of Scope
• If a single firm can jointly produce goods X and Y more
cheaply that any combination of firms could produce
them separately, then the production of X and Y is
characterized by economies of scope
• This is an extension of the concept of economies of
scale to the multi product case
• Economies of scope arise from “complementarities” in
the production or distribution of distinct goods or
services.
– Exist when a firm expands the variety or scope of its
activities, e.g.,
• a finance company uses their financial data to produce marketing
reports
• a group of small firms shares a secretarial pool
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 Economies of Scope(cont’d..)
• The relative costs of producing a variety of goods
and/or services in conjunction with each other is
lower than the costs of producing the same set of
goods and/or services in isolation of one another
• Mathematically;

TC(Qx , Qy )  TC(Qx ,0)  TC(0, Qy )

• This implies :
– “producing these products together is cheaper than
producing them separately”
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Dynamic Changes in Costs: The Learning Curve
• Firms may lower their costs not only due to economies of
scope, but also due to managers and workers becoming
more experienced at their jobs
• As management and labor gain experience with production,
the firm’s marginal and average costs may fall.
• Reasons
1. Speed of work increases with experience
2. Managers learn to schedule production processes more
efficiently
3. More flexibility is allowed with experience; may include more
specialized tools and plant organization
4. Suppliers become more efficient, passing savings to company
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 The Learning Curve
• The learning curve measures the impact of
workers’ experience on the costs of
Hours of labor
per machine lot production
10 • It describes the relationship between a
firm’s cumulative output and the amount of
8 inputs needed to produce a unit of output
The horizontal axis measures the cumulative
6 number of hours of machine tools the firm has
produced

4 The vertical axis measures the number of hours of

labor needed to produce each lot
2
Cumulative number of
machine lots produced
0 10 20 30 40 50
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 Dynamic Changes in Costs – The Learning Curve
• The learning curve in the figure is based on the following
relationship:
N  cumulative units of output produced

L  A  BN L  labor input per unit of output
A, B and  are constants
A & B are positive and  is between 0 and 1
If N = 1
L equals A + B and this measures labor input to produce the first unit of
output
If  = 0
Labor input per unit of output remains constant as the cumulative level
of output increases, so there is no learning
If  > 0 and N increases,
L approaches A, and A represents minimum labor input/unit of output after all learning has
taken place
The larger ,
The more important the learning effect
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