Session 5

Costs of Production
Economic versus Accounting costs
Defnition of explicit costs: input costs that require an outlay of money by the
frm.
Defnition of implicit costs: input costs that do not require an outlay of money by
the frm.
Accountants focus on only explicit costs, while economists examine both explicit
and implicit costs.
Opportunity cost: The cost of something is what you give up to get it. Or is the
cost of the foregone best alternative use of a resource
Sunk cost: expenditure that has been made and cannot be recovered.
That resource that cannot be used and has no alternative use, whose opportunity
cost is zero.
Fixed costs versus sunk costs: Fixed costs are costs paid by the frm as long it is in
operation, irrespective of the level of production. They can be discontinued by
the frm shutting down operation however sunk costs cannot be recovered even
though the frm goes out of operation.
Computer companies such as Zenith, HP, IBM have higher variable costs, so they
will look to reduce their costs by either getting better costs of components or
reducing labor requirements.
Microsoft on the other hand has most of its costs as Sunk, e.g. to develop
software hence entering such kind of business involves considerable risk.
A restaurant has more of fxed costs, which can be sold when the restaurant
closes down and the variable component is very small. As the fxed costs are
high, restaurants do not make a very high proft.
Fixed and Variable Costs
Defnition of fxed costs: costs that do not vary with the quantity of output
produced.
Defnition of variable costs: costs that do vary with the quantity of output
produced.
Total cost is equal to fxed cost plus variable cost.
T C = F C + V C
Average and Marginal Cost
Defnition of average total cost: total cost divided by the quantity of output.
Defnition of average fxed cost: fxed costs divided by the quantity of output.
Defnition of average variable cost: variable costs divided by the quantity of
output.
Defnition of marginal cost: the increase in total cost that arises from an extra unit
of production.
Average total cost tells us the cost of a typical unit of output and marginal cost
tells us the cost of an additional unit of output.
Marginal and Variable cost:
Marginal cost is the increase in cost by producing one extra unit of output.
As fxed costs do not change with the level of production, marginal cost is equal
to increase in variable cost or increase in total cost.
MC = VC / q = TC / q
Average Total Cost (ATC): A frms total cost divided by the level of output.
ATC = AFC + AVC
Because fxed cost is fxed, AFC declines as level of quantity increases and AVC is
Variable cost divided by level of production.
The total cost curve gets steeper and steeper as output rises.
A T C =
T C
Q
; A V C =
V C
Q
; A F C =
F C
Q
M C =
c h a n g e i n t o t a l c o s t
c h a n g e i n o u t p u t
Cost Curves and Their Shapes
1. Rising Marginal Cost
This occurs because of diminishing marginal product.
At a low level of output, there are few workers and a lot of idle equipment. But
as output increases, the factory gets crowded and the cost of producing another
unit of output becomes high.
2. U-Shaped Average Total Cost
Average total cost is the sum of average fxed cost and average variable cost.
AFC declines as output expands and AVC typically increases as output expands.
AFC is high when output levels are low. As output expands, AFC declines
pulling ATC down. As fxed costs get spread over a large number of units, the
efect of AFC on ATC falls and ATC begins to rise because of diminishing
marginal product.
Defnition of efcient scale: the quantity of output that minimizes average total
cost.
3. The Relationship between Marginal Cost and Average Total Cost
Whenever marginal cost is less than average total cost, average total cost is falling.
Whenever marginal cost is greater than average total cost, average total cost is
rising.
The marginal cost curve crosses the average total cost curve at minimum average
total cost (the efcient scale).
4. Typical Cost Curves
Marginal cost eventually rises with output.
The average-total-cost curve is U-shaped.
A T C = A F C + A V C
Marginal cost crosses average total cost at the minimum of average total cost.
Costs in the Short Run.
Determinants of Short-run cost
From the table we can see that variable costs and total costs increase with level of
output.
The rate at which these costs depend on the rate of diminishing returns.
Assuming that labor is the only variable input, let us see what happens when the
level of output is increased.
If the marginal product of labor decreases then more expenditure has to be made
to get the output at a higher rate.
As a result variable cost increases with level of output, on the other hand if the
marginal product falls only slightly then costs will not rise so quickly when the
rate of output is increased.
If W is the rate at which labour is employed and MC is change in variable cost
which is W X No of labour needed to produce 1 more unit of output so
MC = VC / q = W X L / q
MPL is change in output resulting from one unit change in labour or q/ L.
Therefore the extra labour needed to produce the extra unit of output is
L / q = 1 / MPL and hence MC = W/ MPL
So we can say that when there is only one variable input, marginal cost is equal to
the price of the input divided by the marginal product.
Diminishing marginal returns and Marginal cost:
Diminishing marginal returns means that marginal product declines as the
quantity labor employed increases, so as output increases marginal costs will
rise.
Shapes of cost curves:
Firstly let us look at the total cost curves. The total cost is the vertical sum of the
fxed and variable cost.
ATC is the sum of AFC and AVC. Marginal cost crosses AVC and ATC at their
minimum points. But the lowest point of the ATC will be at a higher output.
Average and Marginal relation
Even in costs average and marginal share the same relation, the marginal
determines the average.
The ATC curve is the average total cost of production which is the sum of the
average fxed and average variable cost, AFC declines, the distance between the
ATC and AVC curves decrease as output increases.
Marginal and Average cost are very important concepts, they help managers to
determine the level of output.
If the frm is operating at a level where marginal costs are rising then if the
manager sees increasing demand in the future, management might want to
increase capacity to avoid higher costs.
Costs in the Short Run and in the Long Run
The division of total costs into fxed and variable costs will vary from frm to
frm.
Some costs are fxed in the short run, but all are variable in the long run.
1. For example, in the long run a frm could choose the size of its factory.
2. Once a factory is chosen, the frm must deal with the short-run costs
associated with that plant size.
3. The long-run average-total-cost curve lies along the lowest points of the
short-run average-total-cost curves because the frm has more fexibility in
the long run to deal with changes in production.
4. The long-run average total cost curve is typically U-shaped, but is much
fatter than a typical short-run average-total-cost curve.
5. The length of time for a frm to get to the long run will depend on the frm
involved.
Economies and Diseconomies of Scale
Defnition of economies of scale: the property whereby long-run average total
cost falls as the quantity of output increases.
Defnition of diseconomies of scale: the property whereby long-run average total
cost rises as the quantity of output increases.
Defnition of constant returns to scale: the property whereby long-run average
total cost stays the same as the quantity of output changes.
OUTPUT
Number of
cars
FIXED
COSTS
VARIABLE
COSTS
(Rs.250 per
car)
TOTAL
COSTS
AVERAGE
COSTS
(total
costs /
output)
1 2500 250 2750 2750
5 2500 1250 3750 750
10 2500 2500 5000 500
20 2500 5000 7500 375
50 2500 12500 15000 300
100 2500 25000 27500 275
1000 2500 250000 252500 252
Observations
- Fixed costs remain the same however many are produced
- Variable costs increase with output
- Total costs are FC + VC
- Average costs are found by dividing TC by output
- Average costs fall as output increases
- This is because fxed costs are spread out over more units of output
- This is an example of economies of scale