Chapter 6 - Cost of Production

Principles of Economics second edition
Oxford Fajar Sdn. Bhd. (008974-T) 2010
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Ch. 6: 1
CHAPTER
COST OF PRODUCTION

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Ch. 6: 2
COST CONCEPTS
IMPLICIT COST
Value of input services that are used in
production but not purchased in a market.
EXPLICIT COST
Value of resources purchased for production.
COST
CONCEPTS
OPPORTUNITY COST
The value of a resource in its next best use.
SOCIAL COST
Total cost of production of a good that
includes direct and indirect costs.
SUNK COST
The cost that a firm cannot recover from
the expenditure it has made.
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Ch. 6: 3
COST OF PRODUCTION
SHORT RUN
A production period in which at least on

of the input is fixed*.
LONG RUN
A production period in which all the

inputs are variable**.
* A fixed input is an input which the quantity does not change
according to the amount of output. E.g. machinery
** A variable input is an input which the quantity varies according to
the amount of output. E.g. labour
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Ch. 6: 4
SHORT-RUN PRODUCTION COST

TOTAL COST (TC)
The sum of cost of all inputs used to produce goods and services.
Total cost (TC ) also defined as total fixed cost (TFC) plus
total variable cost (TVC).
TC = TFC + TVC
TOTAL FIXED COST (TFC)
The cost of inputs that are
independent of output.
Examples: Factory, machinery and
etc.

TOTAL VARIABLE COST (TVC)

The cost of inputs that changes
with output.
Example: Raw materials, labours,

etc.
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Ch. 6: 5

(cont.)
AVERAGE TOTAL COST (ATC)

The total cost per unit of output.
The formula for average total cost (ATC) is the total
cost (TC) divided by the output (Q).
ATC =
TC
Q
TC = TVC + TFC
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Ch. 6: 6

(cont.)
AVERAGE FIXED COST (AFC)
Total fixed cost (TFC) divided by total output:
AFC = TFC
Q
AVERAGE VARIABLE COST (AVC)
Total variable cost (TVC) divided by total output:
AVC = TVC
Q
MARGINAL COST (MC)
The change in total cost that results from a change in output;
the extra cost incurred to produce another unit of output:
MC = TC
Q
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Ch. 6: 7
SHORT-RUN COST CURVES

COST
TC
TVC
TOTAL COST (TC)

The sum of cost of all inputs used to produce goods
and services.
Also defined as TFC plus TVC
TC = TVC + TFC
TOTAL VARIABLE COST (TVC)
The cost of inputs that changes with output.
TFC
TOTAL FIXED COST (TFC)
The cost of inputs that is independent of output.
QUANTITY

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Ch. 6: 8
SHORT-RUN COST CURVES (cont.)

MARGINAL COST (MC)
Change in total cost that results from a change in output
MC = TC
Q
COST
MC
ATC
AVERAGE TOTAL COST (ATC)

Total cost per output
ATC = TC
Q
ATC = AFC + AVC
AVC
AVERAGE VARIABLE COST (AVC)
Total variable cost (TVC) divided by total output
AVC = TVC
Q
AVERAGE FIXED COST (AFC)

Total fixed cost (TFC) divided by total output
AFC = TFC
Q
AFC
QUANTITY
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Ch. 6: 9
Total costs
(1)
Quantity
(Q)
(2)
Total
fixed
cost
(TFC)
(3)
Total
variable
cost
(TVC)
Average costs
(4)
Total
cost
(TC)
TC=TFC
+TVC
(5)
Average
fixed cost
(AFC)
AFC =
TFC/Q
(6)
Average
variable
cost (AVC)
AVC =
TVC/Q
(7)
Average
total cost
(ATC)
ATC =
TC/Q
(8)
Marginal
cost (MC)
(2)+(3)
(2)/(1)
(3)/ (1)
(4)/(1) or
(5)+(6)
(4) /(1)
MC =
TC/Q
20
20
20
15
35
20
15
35
15
20
25
45
10
12.50
22.50
10
20
30
50
6.67
10
16.67
20
35
55
8.75
13.75
20
45
65
13
10

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Ch. 6: 10
SHORT-RUN COST CURVES

COST
STAGE I
STAGE II
STAGE III
STAGE I
SATC
AFC begins to fall with an increase in output and AVC decreases.

As long as the falling effect of AFC is higher than the rising
effect of AVC, the ATC tends to decrease.
SAVC
STAGE II
AFC continuous to decline and SATC will become minimum.
ATC remains constant at this stage since the falling effect of
AFC and rising effect of AVC is balanced.
.
STAGE III
The falling effect of AFC is lower than rising effect of AVC,
therefore ATC begins to increase.
SAFC
QUANITTY
ATC curve is U-Shaped because of the combined influences of AFC and AVC
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Ch. 6: 11
RELATIONSHIP BETWEEN MC AND

ATC
Cost
MC
ATC
Quantity
ATC falling, MC curve lies below ATC curve.
ATC is at minimum point, ATC curve and MC curve are equal.
ATC starts to increase, MC curve lies above ATC curve.

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Ch. 6: 12
RELATIONSHIP BETWEEN
PRODUCTIVITY AND COST
Production
MP
AP
Labour
Cost
MC
When its AP is equal to MP,

AP curve is at maximum.
When its AVC is equal to MC ,
AVC curve is at minimum.
AVC
Quantity
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Ch. 6: 13
ISOCOST
An isocost line shows various combinations of two inputs,
capital and labour, which can be purchased with a given

amount of money for a given total cost.
An isocost equation shows the relationship between the
inputs (capital and labour) used in the production and the
given total cost by a firm.
The isocost equation can be written as:
TC = wL + rk
Where:
TC = Total Cost
L = Labour
K = Capital (fixed)
w = Price of labour
r = Price of capital

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Ch. 6: 14
ISOCOST (cont.)
Isocost Line
6
Capital
5
4
3
Isocost
2
1
0
1
Labour
Isocost line shows the various combinations of labour and capital with
given total cost for a firm in the production of shoes.

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Ch. 6: 15
ISOCOST MAP
An isocost map is a number of isocost lines that
show different levels of total cost in one diagram.
Isocost Map
7
6
Capital
4
Isocost (RM100)
3
Isocost (RM120)
2
1
0
1

7 Labour
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Ch. 6: 16
COST MINIMIZING TECHNIQUES

The cost minimizing technique is selecting combinations of inputs
that minimize the total cost at the given level of output.
Capital
At point y, the slope of isoquant curve is equal to that of isocost line

and this is the most efficient technique for production.
7
6
5
4
3
2
1
0
Isocost (RM100)
Isocost (RM120)
Isoquant
y
z
Labour
Points x and z are not efficient because the cost of production is exceeding RM120.

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Ch. 6: 17
COST CURVES IN THE LONG RUN

Long run is a period where there are only variable factors
and no fixed cost involved.

Long run total cost (LRTC) starts from origin because of
the absence of total fixed cost.

LONG RUN AVERAGE COST CURVE (LRAC)
Shows the minimum cost of producing any given output
when all of the inputs are variable.

Long run is a period where firms plan how to minimize
average cost.

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Ch. 6: 18
LONG RUN PRODUCTION COST

LRAC curve are derived by a series of short run average cost curves
COST
SRAC1
SRAC5
SRAC2
SRAC4
LRAC
SRAC3
Tangential point of the SAC are joined

And made up the LRAC.
QUANTITY

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Ch. 6: 19

(cont.)
Long run average cost curve (LRAC) is UShaped
due to the Law of Returns to Scale.

Law of Returns to Scale states that as the firm
expand its size or scale of production, its long run
average cost (LRAC) will decrease and increase at
later stage.
Cost
LRAC
Increasing
Return to
Scale
Constant
Return to
Scale
Decreasing
Return to
Scale
Quantity
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Ch. 6: 20

(cont.)
ECONOMIES OF SCALE
Advantages and benefits of a firm as it becomes larger and
larger.
Reduce long run average cost (LRAC).
Marketing economies, financial economies, labour
economies, technical economies, managerial economics.
DISECONOMIES OF SCALE
Problems faced by a firm as it becomes larger and larger.
Decrease long run average cost (LRAC).
Mismanagement, competition, labour diseconomies.
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Ch. 6: 21
ECONOMIES OF SCALE
Economies of scale are benefits and advantages of a firm
as it expands its production.
Reduce the average cost.
INTERNAL
Internal economies happen inside an
organization
EXTERNAL
Advantages of the industry as a whole
Labour Economies
Managerial Economies
Economies of Government Action
Marketing Economies
Economies of Concentration
Technical Economies
Financial Economies
Economies of Information
Risk Bearing Economies

Transport and Storage
Economies
Economies of Marketing
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Ch. 6: 22
ECONOMIES OF SCALE (cont.)
Diseconomies of scale are problems and disadvantages

faced by a firm when it expands production.
Increase the average cost.
INTERNAL
EXTERNAL
Raise the cost of production of a firm as

the firm expands
The disadvantages faced by the industry

as a whole
Labour Diseconomies
Management Problem
Technical Difficulties

Scarcity of Raw Material

Wage Differential
Concentration Problem
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23
Ch. 6: 23
ECONOMIES AND DISECONOMIES

OF SCOPE
Economies of scope appear when an individual firms
output for two different products is higher than the output

reached by two different firms each produce a single
product.
The diseconomies of scope appear in the productions of an
individual firms because the production of one product

might inconsistent with the production of another product.

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Ch. 6: 24
CONCEPT OF REVENUE
TOTAL REVENUE (TR)
The total amount received from the sale of a firms goods and services
Total Revenue (TR) = Price (P) x Quantity (Q)
AVERAGE REVENUE (AR)

Average revenue is the total revenue per unit output sold.
Average revenue (AR) is also equal to the price (P) of the good.
Average Revenue (AR) = Total Revenue (TR)

Quantity (Q)
AR =
PxQ
= PRICE

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Ch. 6: 25
CONCEPT OF REVENUE (cont.)

MARGINAL REVENUE (MR)
The change in total revenue resulting from one unit increase in quantity sold
Marginal Revenue (MR)
Change in Total Revenue

Change in Quantity
MR = TR/ Q
(1)
Quantity
(2)
Price
(3)
Total Revenue
(1) x (2)
(4)
Average
Revenue
(5)
Marginal Revenue
(3) / (1)
(3) / (1)
10
20
30
40
50
60
70
50
45
40
35
30
25
20
500
900
1200
1400
1500
1500
1400
50
45
40
35
30
25
20
50
40
30
20
10
0
-10
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Ch. 6: 26

Case I: Under Perfect Market
Quantity
Price
Total
Revenue
(TR)
Average
Revenue
(AR)
Marginal Revenue
(MR)
10
10
10
10
10
20
10
10
10
30
10
10
10
40
10
10
10
50
10
10
Quantity
Price
AP, MP
AR, MR and price are same when

the price is constant. The graph
Shows the horizontal line at price
of RM10 which indicates that
MR = AR = Price.
15
10
5
0
AR=MR=DD
10

20
30
40
50
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Ch. 6: 27

Case II: Under Imperfect Market
Quantity
Price
Total
Revenue (TR)
Average
Revenue
(AR)
Marginal Revenue
(MR)
10
10
10
10
18
24
28
30
AR equal to but MR is less than

price when price changes.
The graph shows the AR and MR
downward sloping and MR curve
lies below AR curve.
AP, MP
Price
15
10
5
0
AR=DD
MR Quantity
10

20
30
40
50
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Ch. 6: 28

Concept of Revenue by Equation
Given demand curve as:
P
= a bQ (b is the slope)
TR = P x Q
= (a bQ) x Q
= aQ bQ2
Derivation of MR from demand curve
MR = dTR/dQ
MR = a 2bQ
(MR is of the slope of DD)
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Ch. 6: 29

Chapter 6 - Cost of Production

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Chapter 6 - Cost of Production

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Principles of Economics second edition

Oxford Fajar Sdn. Bhd. (008974-T) 2010

All Rights Reserved

Principles of Economics second edition

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A production period in which at least on

A production period in which all the

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SHORT-RUN PRODUCTION COST

Principles of Economics second edition

TOTAL VARIABLE COST (TVC)

Example: Raw materials, labours,

SHORT-RUN PRODUCTION COST

AVERAGE TOTAL COST (ATC)

cost (TC) divided by the output (Q).

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SHORT-RUN PRODUCTION COST

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SHORT-RUN COST CURVES

TOTAL COST (TC)

Principles of Economics second edition

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SHORT-RUN COST CURVES (cont.)

AVERAGE TOTAL COST (ATC)

ATC = AFC + AVC

AVERAGE FIXED COST (AFC)

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Principles of Economics second edition

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SHORT-RUN COST CURVES

AFC begins to fall with an increase in output and AVC decreases.

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RELATIONSHIP BETWEEN MC AND

Principles of Economics second edition

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When its AP is equal to MP,

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capital and labour, which can be purchased with a given

Principles of Economics second edition

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Principles of Economics second edition

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Principles of Economics second edition

COST MINIMIZING TECHNIQUES

At point y, the slope of isoquant curve is equal to that of isocost line

Principles of Economics second edition

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COST CURVES IN THE LONG RUN

and no fixed cost involved.

the absence of total fixed cost.

when all of the inputs are variable.

Principles of Economics second edition

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LONG RUN PRODUCTION COST

Tangential point of the SAC are joined

Principles of Economics second edition

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LONG RUN PRODUCTION COST

due to the Law of Returns to Scale.

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LONG RUN PRODUCTION COST

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Economies of Government Action