Lecture 3(i)

Cost &
Production

Reading:
Sloman and
Garratt,
chapter 5
Prepared by:
Dr. Bawani
ECN1014 Lelchumanan &
Dr. Chong Poh
INTRODUCTORY Ling (DEF, SBS)
ECONOMICS
 LEARNING
OBJECTIVES (LO)
After this lecture, you should be able to:
Describe the cost concepts
Explain short-run costs and long run costs
Explain the relationship between cost and production
Distinguish between economies of scale and diseconomies of scale
Concept of revenue
Identify how profit is determined and maximized.
Cost Concepts
Cost of production: expenses incurred by the producer in
producing a particular quantity of output.
Economists think of cost differently from financial accountants.
Accountants - retrospective view of firm’s finances and
operation.
Economists - forward-looking view; concerning with the
allocation of scarce resources (including opportunity cost)

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Cost Concepts
Example:
A firm owns its own building and pays no rent for office space.
Does this mean the cost of office space is zero?
Accountant: Yes.
Economist: No. the building could have been rented instead.
Foregone rent is the opportunity cost of using the building for
production and should be included in economic costs of doing
business.

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Implicit cost and Explicit cost
Implicit Cost: the value of input services that are used in production
which are not purchased in the market.
 Example: the opportunity cost of owner’s wife providing (labor)
service in production, self- owned factory.

Explicit cost: the value of resources purchased for production.

 Examples: wages and salaries to workers, electricity and
expenditure in machinery and equipment.

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Cost Concept
Economic Cost = Implicit cost + Explicit cost
Accounting Cost = Explicit Cost

Accounting Cost < Economic Cost

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 Cost Curves in the Short Run
Short Run: the period where at least one of the inputs must be
fixed.

1. Total Fixed Cost (TFC) - costs of input that are independent of

output; has no relationship with output.
TFC remain constant throughout the production period even
though output changes. Thus, TFC curve is horizontal.
Examples: salaries of permanent staff

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Cost Curves in the Short Run

2. Total Variable Cost (TVC) - cost of input that change with

output.
When output is zero, TVC also zero; as output increases, TVC will
also increase. TVC changes in response to changes in quantity or
output.
Examples: supplies of raw materials, cost of utilities.

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Cost Curves in the Short Run

3. Total Cost (TC) - sum of cost of all inputs, fixed and variable
inputs used to produce goods and services.

TC  TFC  TVC

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Cost Curve in the Short Run
Total cost TC
Total Variable cost
is the vertical
Cost 400 increases with
sum of FC
($ per TVC Production. The shape
and VC.
year) is due to the law of
300 diminishing returns..

200
TFC Fixed cost does not
100
vary with output
50
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output

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Cost Curve in the Short Run

4. Average Fixed Cost (AFC): the fixed cost per unit of output.
AFC is obtained by dividing the total fixed cost (TFC) by the total
output.
TFC
AFC 
Q

AFC is continuously declines as Q increases because of the

spreading of fixed costs.

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Cost Curve in the Short Run

5. Average Variable Cost (AVC): the variable cost per unit of output.
AVC is obtained when TVC is divided by total output.
TVC
AVC 
Q

AVC is U shape: decreases in the first stage, reaches a minimum and

later increases.

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Cost Curve in the Short Run

6. Average Total Cost (ATC): total cost per unit of output.

ATC is obtained by adding the average fixed cost and the average variable
cost.
TC TC TFC TVC
ATC   AFC  AVC ATC   
Q Q Q Q

ATC curve is U-shaped because it consists of AFC and AVC.

AVC u-shaped because of increasing and diminishing returns

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Cost Curve in the Short Run

7. Marginal Cost (MC) - change in the total cost that results from
producing another unit of output.

ΔVC ΔTC
MC  
ΔQ ΔQ

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Cost Curve in the Short Run

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 50
100 50 50 50 100
128 28 25 39 64
148 20 16.7 32.7 49.3
162 14 12.5 28 40.5
180 18 10 26 36
200 20 8.3 25 33.3
225 25 7.1 25 32.1
254 29 6.3 25.5 31.8
292 38 5.6 26.9 32.4
350 58 5 30 35
435 85 4.5 35 39.5

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Cost Curve In The Long Run
In the long run, all inputs are variable inputs, there is no fixed
cost.
Long Run total cost (LRTC) - cost of producing goods and services
in the long run.
Long-run average cost curve (LRAC) - shows the minimum cost
of producing any given output when all the inputs are variable.
The LRAC curve is derived by a series of short- run average cost
curve (SAC). Tangent points of the SAC are joined and make up
the LRAC.

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Cost Curve In The Long Run
When a firm has a plant
relating to SAC1 , total output
is Q1
If demand increase and the
firm wants to increase its
output from Q1 to Q2, the firm
can still operate on the same
plant to produce Q2. By
expanding the output in SAC2,
Q2 can produce at a lower
average point.

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Cost Curve In The Long Run
Economies Of Scale - when inputs increase by
some percentage and output increases by a
greater percentage, causing unit costs to fall.
Constant Returns To Scale - when inputs
increased by some percentage and output
increases by an equal percentage, causing unit
costs to remain constant.
Diseconomies Of Scale - when inputs increase
by some percentage and output increases by a
smaller percentage, causing unit costs to rise.

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Cost Curve In The Long Run

Why Economies Of Scale?

Growing firms can take advantage of highly efficient mass
production techniques and equipment, and are economical only if
they can be spread over a large number of units. e.g. assembly line
techniques.

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Cost Curve In The Long Run

Why Diseconomies Of Scale?

Because a firm’s size causes coordination, communication, and
monitoring problems.
Firms will reorganize, divide operations, hire new managers, and
take other measures to reverse the diseconomies of scale.

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 Concept Of Revenue
1. Total Revenue (TR): the value of a firm’s sales. Ttotal amount
of money that a firm can obtain from the sales of its product.
TR=P x Q

2. Average Revenue(AR): the total revenue per unit output sold.

AR = TR/Q
3. Marginal Revenue (MR): change in total revenue resulting
from a one unit increase in quantity sold.
MR= ∆ TR/ ∆Q

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PROFIT
MAXIMISATIO
N
Finding the profit-maximising output
 profit maximised where MR = MC
FINDING THE PROFIT-MAXIMISING
OUTPUT USING MARGINAL CURVES
16

12
Costs and revenue (£)

0
1 2 3 4 5 6 7
Quantity
-4
MR
FINDING THE PROFIT-MAXIMISING
OUTPUT USING MARGINAL CURVES
MC
16

12
Costs and revenue (£)

4 e Profit-maximising
output

0
1 2 3 4 5 6 7
Quantity
-4
MR
PROFIT
MAXIMISATION

Finding the profit-maximising output

 profit maximised where MR = MC

Measuring maximum profit

 using AR and AC curves to measure profit per unit

 multiplying this by output

 MEASURING THE MAXIMUM
PROFIT USING AVERAGE CURVES
MC
16 Maximum total profit shown
by shaded area

12 AC
Costs and revenue (£)

8
AR = 6
AC = 42/3 TOTAL PROFIT
4
AR
0
1 2 3 4 5 6 7
Quantity
-4 MR