COSTS OF

PRODUCTION
Chapters 11

Short-Run vs. Long Run

Firms typically have several types of inputs that they can

adjust to adjust production.

Long-run - When firms are able to adjust all of their inputs
including physical plant.
Short-run When firms are able to adjust only some of
their inputs (usually energy, labor, and raw material costs).

Productivity
Average Productivity of Labor is output per work.

Total Product
APL
Labor
Marginal Productivity of Labor is the extra production that

is obtained from an extra unit of labor.

TP
MPL
Labor

Short Run Production Function

Total
Product
TP
Labor
TP
Labor

TP
MPL
Labor

Production in the Short-Run

Given a set of fixed inputs (like plant and capital equipment),

a firm can vary other inputs (typically labor) and to vary

production.
Typically, as you add workers, you get more output.
Up to a point each additional worker adds synergy and

adding more workers leads to more and more extra pay-off.

But at some point, capacity constraints bind, diminishing
returns sets in, and the addition of extra workers will
generate less and less extra production.

Bakery
35
30
25
20
Loaves
15
10
5
0

Hours

Productivity
Labor productivity depends on the number of workers
First, increasing, then, decreasing
Average product of labor begins decreasing when

marginal product of labor drops below average.

Note: Marginal Product crosses through average product at

the peak of average product.
As long as the next worker adds more product than the
average worker, they will increase the average.
Once diminishing returns set in, additional workers may add
less to output than the average worker, reducing the overall
average.

MPL, APL

MPL

APL

Small Scale Schedule

Large Scale Schedule

Fixed Costs vs. Variable Costs

In short-run, we distinguish between the costs that are

adjustable as production is adjusted (variable costs) and

costs that are unchanged regardless of production (fixed
costs).
Variable costs (Wages of production workers, supply and raw

materials costs)
Fixed costs (Depreciation costs, Financial costs, wages of nonproduction workers).

Types of Costs
Total Fixed Costs Invariant to the number of goods

produced (in the short-run)

Average Fixed Costs Decreasing in the number of goods

produced.

Total Variable Costs- Increasing in the number of goods

produced.
Total Costs: Fixed Costs + Variable Costs

Bakery: Wages $10 per Worker, $5 Wheat

per Loaf

Total Variable Costs are increasing at an accelerating rate.

Reason: Diminishing returns to variable inputs.

Cost Schedule
6000
5000
4000
3000
2000
1000
0
2

10
Fixed Costs

20

30
Variable Costs

40

50
Total Costs

60

Costs: Average vs. Marginal

Total Costs are the sum of all relevant costs for a firm.
Average Costs: Costs per unit of output.
Marginal Cost: Extra Cost per Extra Unit of Output.

Cost Schedules

Average and Marginal Costs

Average Fixed Costs
decreases as production
increases
Cost Curve
140

AVC, ATC, MC all

increase as
diminishing returns
kick in

120
100
80
$
60

MC equals AVC and ATC

when each of the latter are
at their minimum level.

40
20
0
2

10

20

30

40

50

60

Long Run Costs

In the short-run, the size of a firms physical plant is a fixed

factor.
Over-time, the plant size can adjust.
In the bakery example, extra ovens can be added.

Minimizing Costs in the Long Run

Consider average total cost schedules at different

numbers of ovens.
Each oven will have a production level that generates the
minimum average total cost.
To minimize average costs in the long-run, choose the
number of ovens which will have the lowest, minimum
average total cost.

Average Total Cost Schedules at Different

Scales of Production
228
208
1 Oven

188

2 Ovens

168

3 Ovens

148

4 Ovens

128

5 Ovens
6 Ovens

108

7 Ovens

88

8 Ovens

68
48
10 20 30 40 50 60 70 80 90 100 110 120
Output

Minimum of the different cost

Schedules
228
208
1 Oven

188

2 Ovens

168

3 Ovens

148

4 Ovens

128

5 Ovens
6 Ovens

108

7 Ovens

88

8 Ovens

68
48
10

20

30

40

50

60

70

Output

80

90

100 110

120

Connect the Dots

Long Run Average Total Costs
228
208
1 Oven

188

2 Ovens

168

3 Ovens

148

4 Ovens

128

5 Ovens
6 Ovens

108

7 Ovens

88

8 Ovens

68
48
10

20

30

40

50

60

70

Output

80

90 100 110 120

If we adjust capital scale continuously, the

collection of minimum points is the Long Run
Average Total cost cuve

Short-run ATC

LR ATC

Economies of Scale
When firms are able to adjust all of their inputs, they

can choose a size that will minimize costs.

If a firm is able to achieve some economies of
scale, increasing size will reduce the average total
cost.
Sources of Economies of Scale
Production requires major expenditure on items needed to

produce even zero products

Ex. Software, pharmaceuticals

Production requires many specific steps which can be

most efficiently done through specialization

Ex. Airplanes, automobiles

Long Run ATC increasing returns to scale.

LR ATC
Costs
Economies of Scale

Output

Returns to Scale
Scale Economies is not always likely to

characterize production.
If each production unit can act autonomously with
identical costs then we may experience constant
returns to scale.
Firms at some point experience diseconomies of
scale or increasing long run average total costs.
Sources of diseconomies of scale
Limits of managerial attention.
Limits of some other fixed resource.

Long Run ATC decreasing returns to scale.

LR ATC
Costs
Constant Returns

Scale
Diseconomies

Output

Overall Cost Function

LR ATC

Minimum Efficient
Scale

MES and Market Structure

If MES is relatively large in comparison with the market

demand:
$

The market is most

efficiently served by a
single firm---natural
monopoly!

LRAC

MES and Market Structure

If MES is relatively small in comparison with market

demand:
Many small firms
in the market.

Learning Outcomes
Students should be able to
Define and calculate various types of economic
costs.
Fixed, variable, total, average, marginal.

Describe the shape of various relevant cost

curves

Average Total (in LR and SR), Average Fixed, Marginal Costs

Describe the relationship between production,

productivity (marginal and average) and the law

of diminishing returns.