Cost of Production

Production Cost
are those which must be received by resource owners in order to
assume that they will continue to supply them in a particular time of
production.
Cost of Production
is meant the total sum of money required for the production of a
specific quantity of output.
Types/Classifications of Cost of Production:
According to Prof, Mead in his book, "Economic Analysis and Policy" has
classified these costs into three main sections:
(1) Production Costs:
It includes material costs, rent cost, wage cost, interest cost and normal
profit of the entrepreneur.
(2) Selling Costs:
It includes transportation, marketing and selling costs.
(3) Sundry Costs:
It includes other costs such as insurance charges, payment of taxes and rate,
etc.
Measuring Cost: Which Costs Matter?
1. For a firm to minimize costs, we must clarify what is meant by costs and how
to measure them
1.1. It is clear that if a firm has to rent equipment or buildings, the rent they
pay is a cost
1.2. What if a firm owns its own equipment or building?
1.1.1. How are costs calculated here?
2. Accountants tend to take a retrospective view of firms’ costs, whereas
economists tend to take a forward-looking view
3. Accounting Cost
Actual expenses plus depreciation charges for capital equipment
Measuring Cost: Which Costs Matter?
4. Economic Cost
Cost to a firm of utilizing economic resources in production, including
opportunity cost
5 . Economic costs distinguish between costs the firm can control and
those it cannot
Concept of opportunity cost plays an important role
6. Opportunity cost
Cost associated with opportunities that are foregone when a firm’s
resources are not put to their highest-value
Total cost can be divided into:
1. Fixed Cost (FC)
Does not vary with the level of output
2. Variable Cost (VC)
Cost that varies as output varies
TC-FC+VC
Which costs are variable and which are fixed depends on the time
horizon?
• Short time horizon – most costs are fixed
• Long time horizon – many costs become variable
• In determining how changes in production will affect costs, must consider if
fixed or variable costs are affected.
Marginal and Average Cost

1. In completing a discussion of costs, must also distinguish between

1.1. Average Cost
1.2. Marginal Cost
2. After definition of costs is complete, one can consider the analysis between short run
and long-run costs

Measuring Costs

1. Marginal Cost (MC):

The cost of expanding output by one unit
2. Fixed costs have no impact on marginal cost, so it can be written as:
MC=ΔTC/ΔQ
Average Costs

Average variable Cost (AVC)

𝑇𝑉𝐶
𝐴𝑉𝐶 =
𝑄

Average Fixed Cost (AFC)

𝑇𝐹𝐶
𝐴𝐹𝐶 =
𝑄

Average Total Cost (ATC)

𝐴𝑇𝐶 = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
Total and Average Cost
Output Total Total Total Average Average Average Short run
(Q) Fixed Variable Cost Fixed Cost Variable Total Cost Marginal
Cost Cost (TVC) (TC) Cost cost
(TFC)
0 6,000 0 6,000 - - - -

100 6,000 4,000 10,000 60 40 100 40

200 6,000 6,000 12,000 30 30 60 20
300 6,000 9,000 15,000 20 30 50 30
400 6,000 14,000 20,000 15 35 50 50
500 6,000 22,000 28,000 12 44 56 80
600 6,000 34,000 40,000 10 56.7 66.7 120
 Least Combination of Total Costs

Output LAC LMC

Labor (units) Capital (Units) W=5, r=10

100 10 7 120 1.20 1.20

200 12 8 140 0.70 0.20
300 20 10 200 0.67 0.60
400 30 15 300 0.75 1.00
500 40 22 420 0.84 1.20
600 52 30 560 0.93 1.40
700 60 42 720 1.03 1.60
Marginal Revenue – A linear demand curve is elastic at high prices and inelastic at
low prices. If the monopolist produces zero units of output, its revenues are zero. As
output is increased by zero, demand is elastic and the increase in output.

The marginal revenue is the change in total revenue attributable to the last unit of
output; geometrically, it is the slope of the total revenue curve.

Figure (a) (graph above) – shows the marginal revenue schedule for a monopolist
lies below the demand curve; in fact, for a linear demand curve, the marginal revenue
schedule lies exactly halfway between the demand curve and the vertical axis.
 A monopolist, marginal revenue is less than the price charged for good. There are two
ways to understand why the marginal revenue schedule lies below the monopolist’s demand
curve. Consider first a geometric explanation marginal revenue is the slope of the total revenue
curve [R(Q)] figure (b). Over this range marginal revenue decreases until it reaches zero when
output is Q0. As output expands beyond Q0, the slope of the total revenue curve becomes
negative and gets increasingly negative as output continues to expand.
Monopolistic Competition – is a market structure that lies between the
extremes of monopoly and perfect competition. This market structure
exhibits some characteristics present in both perfect competition and
monopoly.

Conditions for monopolistic competition

An industry is monopolistically competitive if:
1. There are many buyers and sellers.
2. Each firm in the industry produces a differentiated product.
3. There is free entry into and exit from the industry.
❑There are numerous industries in which firms produce products that are close substitutes.
And the market for hamburgers is a prime example. Many fast-food restaurants produce
hamburgers, but the hamburgers produced by one firm differ from those produced by other
firms. Moreover, it is relatively easy for new firms to enter the market for hamburgers.
❑The key difference between the models of monopolistic competition and perfect
competition is that in a market with monopolistic competition, each firm produces a
product that differs slightly from other firm products. The product are close but not perfect
substitutes.
❑The fact that the products are not perfect substitutes in a monopolistically competitive
industry thus implies that each firm faces a downward-sloping demand curve for its
product. To sell more of its product, the firm must lower the price.
❑There are two important differences between a monopolistically competitive
market and a market serviced by a monopolist. First, a monopolistically
competitive firm faces a downward-sloping demand for its product, there are
other firms in the industry that sell similar products. Second, in a
monopolistically competitive industry, there are no barriers to entry. This
implies that firms will enter the market if existing firms earn positive economic
profits.
Profit maximization
❑The determination of profit-maximizing price and output under monopolistic
competition is precisely the same as for a firm operating under monopoly. Consider the
demand curve for the monopolistically competitive firm presented in this presentation.
❑The demand and marginal revenue curves used to determine the monopolistically
competitive firm’s profit-maximizing output and price are based not on the market
demand for the product but on the demand for an individual firm’s product. The demand
curve facing a monopolist, in contrast, is the market demand curve.
❑Firms in monopolistically competitive industry produced differentiated products, the
notion of an industry or market demand curve is not well-defined. In monopolistically
competitive markets, each firm produces a product that differs from other firms’
products.
ECONOMICS PRODUCTIVITY

Productivity, in economics, the ratio of what is produced to what is required to

produce it. Usually this ratio is in the form of an average, expressing the total output of
some category of goods divided by the total input of, say, labour or raw materials.
Labour is by far the most common of the factors used in measuring productivity.
The productivity of land, though it receives considerably less attention than the
productivity of labour, has been of historical interest.
The productivity of capital—plant, equipment, tools, and other physical aids—is
a subject of long-standing
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❑Productivity measurement
A nation or an industry advances by using less to make more. Labour productivity is
an especially sensitive indicator of this economizing process and is one of the major
measures used to chart a nation’s or an industry’s economic advance.
Productivity is valuable also as an indicator of comparative rates of change among
industries and products. Growth in general can be better understood if the relative
contributions of individual industries and the circumstances underlying productivity changes
in each of these industries are understood.
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❑Measure of efficiency
Productivity is also used to measure efficiency, as an aid in economic planning
and forecasting, and as a means of assessing the uses to which resources are being put.
As to the first of these, the efficiency of industrial operations, for instance, may be
evaluated by the yardstick of output per worker or machine, and such a yardstick may
also provide the basis for supplemental or premium payments for workers.
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❑Wage and price analysis

Real average labour compensation has increased over the long run at about the
same pace as labour productivity. The association of these two variables must be close so
long as the labour share of total cost does not change much. If nominal average earnings
were to increase more than labour productivity, labour cost per unit of output would rise
and so would prices unless profit margins were reduced to compensate.
There is a significant negative correlation between relative industry changes in
productivity and in prices—when productivity rises, price tends to fall. In the industrial
sector of an economy in which there is a significant price elasticity of demand (i.E.,
Where price is relatively responsive to changes in demand), there is also a significant
positive correlation between relative industry changes in productivity and in output—
when productivity rises, output tends to rise as well.
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❑Factors that determine productivity levels
The level of productivity in a country, industry, or enterprise is determined by a number
of factors. These include the available supplies of labour, land, raw materials, capital facilities,
and mechanical aids of various kinds. Included also are the education and skills of the labour
force; the level of technology; methods of organizing production; the energy and enterprise of
managers and workers; and a range of social, psychological, and cultural factors that underlie
and condition economic attitudes and behaviour.
These variables interact and mutually condition one another in determining productivity
levels and their changes. Thus, in any country one expects the level of technology, the skills of
the work force, the quantity of capital, and the capacity for rational economic organization to be
positively correlated.
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❑Measurement of productivity
As a prelude to an examination of productivity trends over time,
this section considers various methods of measuring the output and input
components of productivity ratios and some of the difficulties and
limitations of the resulting estimates.
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❑Output
With respect to output, ideally the numbers of units of each category of tangible commodity or
service should be counted in successive time periods and aggregated for the firm, industry, or total
economy in terms of some indicator of relative importance, usually price or cost per unit as of a
particular period.
The unit value “weights”—price, cost, or other—must be held constant for two or more periods
being compared so that changes in aggregate output reflect changes in physical volumes rather than in
prices. An alternative procedure that produces the same results with ideal data is to “deflate” current
values of the various items produced by index numbers that reflect relative price changes in order to
eliminate the effects of price changes.
Price deflation is usually employed to obtain estimates of real gross product by sector and
industry to be used as numerators of productivity ratios. For tangible industrial production measures,
quantities of the various commodities are generally weighted together by constant unit values.
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❑Inputs
Labour input is relatively easy to measure if one is content to count heads of persons
engaged in production or, preferably, hours worked.
Capital input is usually assumed to change in the same direction as and proportionally
to changes in the real stocks of structures, equipment, inventories, and natural resources. The
rates of return on those capital goods in some base period are taken to be indicative of their
productivity for the purpose of weighting them together with other factor inputs. Some analysts
adjust the capital estimates to take into account changing rates of utilization of capacity;
otherwise, changes in utilization rates are reflected in the productivity estimates.
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❑Inputs
Interindustry purchases and sales of intermediate products—those materials, energy,
and other services that are consumed in the production process—are accounted for on a value-
added basis and cancel out in the national income and product estimates by industry (one
industry’s output being the next one’s input).