Costs of

Production
 The Meaning of Costs

• Opportunity costs
– meaning of opportunity cost
– examples
• Measuring a firm’s opportunity costs
– factors not owned by the firm: explicit costs
– factors already owned by the firm: implicit
costs
– irrelevance of:
• historic costs
• replacement costs
 Production in the Short run

• Production functions
– factors of production
• labour
• land and raw materials
• capital
• entrepreneurship

– the relationship between inputs and output

• TPP = ƒ(F1, F2, F3, … Fn)
 Production in the Short run

• Long-run and short-run production

– fixed and variable factors
– distinction between short run and long run
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP,
APP and MPP
 Wheat production per year from a particular farm
Number of
40 workers TPP
0 0
Tonnes of wheat produced per year

1 3
2 10
30 3 24
4 36
5 40
6 42
7 42
20 8 40

10

0
0 1 2 3 4 5 6 7 8
Number of farm workers
 Wheat production per year from a particular farm
Number of
40 workers TPP
0 0
Tonnes of wheat produced per year

1 3
2 10
30 3 24
4 36
5 40
6 42
7 42
20 8 40

10

0
0 1 2 3 4 5 6 7 8
Number of farm workers
 Wheat production per year from a particular farm
d
40
TPP
Tonnes of wheat produced per year

30 Maximum output

Diminishing returns
set in here
20
b

10

0
0 1 2 3 4 5 6 7 8
Number of farm workers
Wheat production per year from a particular farm
40

Tonnes of wheat per year

TPP
30

20

10
∆TPP = 7
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14 ∆L = 1
Tonnes of wheat per year

12

10

8
MPP = ∆TPP / ∆L = 7
6

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
Wheat production per year from a particular farm
40

Tonnes of wheat per year

TPP
30

20

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
Tonnes of wheat per year

12

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Wheat production per year from a particular farm
40

Tonnes of wheat per year

TPP
30

20

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
Tonnes of wheat per year

12 APP = TPP / L
10

4 APP
2

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Wheat production per year from a particular farm
40

Tonnes of wheat per year

TPP
30

20 b
Diminishing returns
10 set in here

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year

12

10

4 APP
2

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Wheat production per year from a particular farm
d
40

Tonnes of wheat per year

TPP
30

20 Maximum
b
output
10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year

12

10

4 APP
2

0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Wheat production per year from a particular farm
d
40
Slope = TPP / L c

Tonnes of wheat per year

= APP TPP
30

20
b

10

0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
Tonnes of wheat per year

12

10
c
8

4 APP
2

0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
 Costs in the Short run

• Costs and inputs

– costs and the productivity of factors
– costs and the price of factors
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
• TVC and the law of diminishing returns
– total cost (TC = TFC + TVC)
 Total costs for firm X
Output TFC
100 (Q) (£)

0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20

0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
Output TFC
100 (Q) (£)

0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
Output TFC TVC
100 (Q) (£) (£)

0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
Output TFC TVC
100 (Q) (£) (£)

0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
Output TFC TVC TC
100 (Q) (£) (£) (£)

0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
Output TFC TVC TC
100 (Q) (£) (£) (£) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Total costs for firm X
100 TC
TVC
80

Diminishing marginal
60
returns set in here

40

20
TFC
0
0 1 2 3 4 5 6 7 8
 Costs in the Short run

• Marginal cost

– marginal cost (MC) and the law of

diminishing returns
 Average and marginal costs
MC

Diminishing marginal
returns set in here
Costs (£)

Output (Q)
 Costs in the Short run

• Marginal cost

– marginal cost (MC) and the law of

diminishing returns

– the relationship between MC and TC curves

 Average and marginal costs
MC
Costs (£)

Output (Q)
 Costs in the Short run

• Average cost

– average fixed cost (AFC)

– average variable cost (AVC)

– average (total) cost (AC)

• Relationship between average and

marginal cost
 Average and marginal costs
MC
AC

AVC
Costs (£)

x
AFC

Output (Q)
 Production in the Long run

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

Short-run and long-run increases in output
Short-run and long-run increases in output
Short-run and long-run increases in output
Short-run and long-run increases in output
 Production in the Long run

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

– decreasing returns to scale

 Production in the Long run

• All factors variable in long run

• The scale of production:

– constant returns to scale

– increasing returns to scale

– decreasing returns to scale

• Returns to scale and economies and

diseconomies of scale
 Production in the Long run

• Economies of scale
– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
• Economies of scope
 Production in the Long run

• Diseconomies of scale
– managerial diseconomies
– effects of workers and industrial relations
– risks of interdependencies
• External economies of scale
• External diseconomies of scale
• Location
– balancing the distance from suppliers and
consumers
– importance of transport costs
 Production in the Long run

• Optimum combination of factors

– MPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Decision making in different time
periods
– very short run
– short run
– long run
– very long run
– decisions can be made for all time periods
at the same time
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
 Alternative long-run average cost curves

Economies of Scale
Costs

LRAC

O Output
 Alternative long-run average cost curves

LRAC
Diseconomies of Scale
Costs

O Output
 Alternative long-run average cost curves

Constant costs
Costs

LRAC

O Output
 A typical long-run average cost curve

LRAC
Costs

O Output
 A typical long-run average cost curve

Economies Constant Diseconomies LRAC

of scale costs of scale
Costs

O Output
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve

• Long-run marginal costs

 Long-run average and marginal costs

Economies of Scale
Costs

LRAC
LRMC

O Output
 Long-run average and marginal costs

LRMC

LRAC
Diseconomies of Scale
Costs

O Output
 Long-run average and marginal costs

Constant costs
Costs

LRAC = LRMC

O Output
 Long-run average and marginal costs

LRMC
Initial economies of scale,
then diseconomies of scale
LRAC
Costs

O Output
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and
short-run average costs
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and
short-run average costs
– the envelope curve
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3

5 factories
Costs

1 factory
2 factories
3 factories4 factories

O
Output
Deriving long-run average cost curves: factories of fixed size

SRAC1 SRAC SRAC5

2
SRAC4
SRAC3

LRAC
Costs

O
Output
Deriving a long-run average cost curve: choice of factory size
Costs

Examples of short-run
average cost curves

O
Output
Deriving a long-run average cost curve: choice of factory size

LRAC
Costs

O
Output
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and
short-run average costs
– the envelope curve
• Long-run cost curves in practice
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and
short-run average costs
– the envelope curve
• Long-run cost curves in practice
– the evidence
 Costs in the Long run

• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and
short-run average costs
– the envelope curve
• Long-run cost curves in practice
– the evidence
– minimum efficient plant size