Managerial Economics: WC Aranas

PRODUCTION AND COST

What is the significance of cost and production in managerial decision making? Study of costs is essential for
making a choice from among the competing production plans. Production decisions are not possible without their respective
cost considerations.

COST is the combination losses of any goods that have a value attached to them by any one individual. Economic cost is
used mainly by economists as means to compare the prudence of one course of action with that of another. The factors to be
taken into consideration are money, time, and other resources. It is the value of money that has been used up to produce
something or deliver a service, and hence is not available for use anymore.

 COST FUNCTION is used to chart how production expenses will change at different output levels. In other words, it
estimates the total cost of production given a specific quantity produced.

 The COST OF PRODUCTION changes as the firm output changes, in the short run and in long run.

 In the SHORT RUN, at least one input is fixed (e.g., plant depreciation) and all other cost may either be fixed or variable.

 In the LONG RUN, all inputs are variable. All costs are variable (e.g., additional plant can be built.) In the long run, firms can
choose their production technology, so all costs become variable costs.

 A PRODUCTION TECHNOLOGY is the specific combination of labor, physical capital, and technology that makes up a
particular method of production.

 VARIABLE COSTS are the costs paid to the variable input. Inputs include labor, capital, materials, power and land and
buildings. Variable inputs are inputs whose use vary with output. Conventionally the variable input is assumed to be labor.

 FIXED COSTS are the costs of the fixed assets those that do not vary with production. In example. Depreciation of a
building, manager’s salary, rent expense.

 TOTAL COST is the total economic cost of production and is made up of variable cost, which varies according to the
quantity of a good produced and includes inputs such as labour and raw materials, plus fixed cost, which is independent of
the quantity of a good produced and includes inputs that cannot be varied in the short term: fixed costs such as buildings and
machinery, including sunk costs if any. FIXED COST PLUS VARIABLE COST

 MARGINAL COST is the additional cost of one additional output. In example, the additional cost of producing one
additional pizza. (Change in Total Cost vs. Change in Output)

Fixed
Output Variable Cost Total Cost Marginal Cost
Cost
0 Php 0.00 Php 10.00
1 Php 10.00
2 Php 17.00
3 Php 25.00
4 Php 40.00
5 Php 50.00
6 Php 110.00

 AVERAGE VARIABLE COST (AVC) is a firm’s variable costs (labour, electricity, etc.) divided by the quantity of output
produced.

 AVERAGE FIXED COST (AFC) is the fixed costs of production (FC) divided by the quantity (Q) of output produced.
Average fixed cost is fixed cost per unit of output. As the total number of units of the good produced increases, the average
fixed cost decreases because the same amount of fixed costs is being spread over a larger number of units of output.

 AVERAGE TOTAL COST (ATC) also known as average total cost (ATC), is the average cost per unit of output. To find
it, divide the total cost (TC) by the quantity the firm is producing (Q).
 Managerial Economics: WC Aranas

Calculate:
1. ATC of 6 Units
2. AFC of 2 Units
3. AVC of 4 Units
4. ATC of 1 Unit
5. AVC of 5 Units
6. AFC of 5 Units
7. ATC of 5 Units

Costs

Php 20.00

Php 18.00

Php 16.00

Php 14.00

Php 12.00

Php 10.00

Php 8.00

Php 6.00

Php 4.00

Php 2.00

Php 0.00 Quantity

1 2 3 4 5 6
 Managerial Economics: WC Aranas

PRODUCTION is a process of combining various material inputs and immaterial inputs (plans, know-how) in order to
make something for consumption (output). It is the act of creating an output, a good or service which has value and
contributes to the utility of individuals.

 PRODUCTION FUNCTION is a mathematical function that relates the maximum amount of output that can be obtained
from a given number of inputs – generally capital and labor.

 TOTAL PRODUCT is the total quantity of the output produced in a given period.

 MARGINAL PRODUCT is the change made in total product from a change in a variable input (e.g., labor). In economics
the term “marginal’’ is often used to mean “additional”. In economics and in particular neoclassical economics, the marginal
product or marginal physical productivity of an input (factor of production) is the change in output resulting from employing
one more unit of a particular input (for instance, the change in output when a firm's labor is increased from five to six units),
assuming that the quantities of other inputs are kept constant.

 AVERAGE PRODUCT is the total product per unit of output (e.g., labor). It is total product divided by the quantity of
labor employed. Another term for average product is PRODUCTIVITY. In example, 10 units produced by 2 personnel.

 INCREASING MARGINAL RETURNS occur when the marginal product of an additional worker exceeds the marginal
product of the previous worker. In most productions, increasing marginal returns occur initially but DECREASING
MARGINAL will occur eventually.

SHORT-RUN PRODUCTION COSTS

COST FORMULA LEGEND
1 TC FC + VC = ATC x Q TC = TOTAL COST ATC = AVERAGE TOTAL COST
2 VC TC - FC =AVC x Q FC = FIXED COST AVC = AVERAGE VARIABLE COST
3 FC TC - VC =AFC x Q VC = VARIABLE COST AFC = AVERAGE FIXED COST
4 MC ∆TC ÷ ∆Q = ∆TVC ÷ ∆Q MC = MARGINAL COST Q = QUANTITY
5 ATC TC ÷ Q = AFC - AVC ∆TC = CHANGE IN TOTAL COST
6 AVC VC ÷ Q = ATC - AFC ∆Q = CHANGE IN QUANTITY
7 AFC FC ÷ Q = ATC - AVC ∆TVC = CHANGE IN TOTAL VARIABLE COST

 AVC is initially constant until inefficiencies of producing in a fixed-size facility cause variable costs to rise; MC initially
decreases but begins to increase due to inefficiencies.

 The cause of inefficiencies is known as the LAW OF DIMINISHING RETURNS. The law states that as we try to produce
more and more outputs with a fixed productive capacity, marginal productivity will decline.
 Managerial Economics: WC Aranas

 LONG-RUN PRODUCTION COSTS are all variable costs. As the firm expands by increasing plant size, ATC tends to fall
at first because of the economies of scale, but as this expansion continues, ATC begins to rise because of the diseconomies of
scale.

- ECONOMIES OF SCALE (a decline in ATC) arise because of labor and management specialization, efficient capital,
and factors such as spreading advertising cost over an increasing level of output. It’s the cost advantages that
enterprises obtain due to their scale of operation (typically measured by amount of output produced)
Example: If a firm increases labor hours by 10%, output increase by 50%. Hence, ATC decreases.

- DISECONOMIES OF SCALE arise primarily from the problems of inefficiency managing and coordinating the firms
operations as it becomes a large-scale producer.
Example: if a firm increases input by 50%, output increases by 3%. Hence, ATC increases.

- CONSTANT RETURNS TO SCALE is the range of output where long-run ATC does not change.
Example: a firm may double its production by doubling its production facility; the firm can build identical production
line and hire an identical number of workers. So when production increases, ATC remains constant.

ORGANIZATION OF PRODUCTION is simply the manner in which you organize the process of production of
goods or services in your business. It is through production organization that you are able to effectively coordinate the
factors of production, which include raw materials, labor and capital.

PRODUCTION FUNCTION gives the technological relation between quantities of physical inputs and quantities of
output of goods. Useful in the short-run and in the long run. OUTPUT = f (INPUT)

OTHER CONCEPTS
What are actual costs and opportunity costs? Actual costs which a firm incurs for producing or acquiring a product or a service.
As example for this is the cost on raw materials, labor, rent, interest.
What are incremental costs and sunk costs? Incremental cost is the additional cost due to change in the level of nature or business
activity. Sunk costs are the costs that are not altered by a change in quantity produced and cannot be recovered.
What are explicit costs and implicit costs? Explicit or paid out costs are those expenses which are actually paid by the firm.
Implicit costs are the theoretical costs in the sense that they go unrecognized by the accounting system.
What are past costs and future costs? Past costs are the actual costs incurred in the past are generally contained in the financial
accounts. Future costs are costs that are expected to occur in some future period or periods.
What are accounting costs and economic costs? Accounting costs are the actual outlay costs. Economic cost relate to the future.
What is direct and indirect cost? Direct costs are traceable cost or assignable cost are the ones that have direct relationship with a
unit of operation like a product, a process or a product, or a department of the firm. On the other hand, indirect costs or non-
traceable costs or common or non-assignable costs are the costs whose course cannot be easily and definitely traced to the plant.
What are private costs and social costs? Private costs are those which are actually incurred or provided for the business activity
by an individual or the business firm. Social costs on the other hand are the total costs to the society on account of production of a
good.
What are controllable and non-controllable costs? Controllable costs are those which are capable of being controlled or regulated
by the managers ant = d it can be used to assess the managerial efficiency in controlling the cost in his department. Non controllable
costs are those which cannot be subjected to administrative controls and supervision.
What are replacement costs and original costs? Original costs or the historical costs are the costs paid for assets such as land,
building, cost of plant, equipment and materials. Replacement costs are the costs that the firm incurs if it wants to replace or acquire
the same assets now.
What is shut down cost and abandonment cost? Shutdown costs are costs in which the firm incurs if it temporarily stop its
operation. Abandonment costs are the costs of retiring altogether a fixed asset from use.
What are incremental cost and marginal cost? Incremental cost is important when dealing with decisions where discrete
alternatives are to be compared. Marginal cost deals with unity unit output.
What are the determinants of cost? (1) Level of output (2) Price of inputs (3) Size of plant (4) Output stability (5) Production lot
size (6) Level of capability utilization (7) Technology (8) Learning effect (9) breadth of product range & (10) geographical location.