COST OF PRODUCTION

The Total sum of money required for the Production of a specific quantity of output.

COST CONCEPTS

Nominal and Real Cost Explicit and Implicit Cost Opportunity Cost

THE SHORT RUN

As long as there are any fixed cost, we are in the short run The short run is the length of time where a firm can not change all its inputs as there exist a fixed input/cost. The present time is always in Short run.

SHORT RUN COST OF PRODUCTION

Total Fixed Cost (TFC)

Fixed cost stays the same no matter how much output changes Some examples of fixed cost are rent, insurance, salaries, property taxes, and interest payments etc. TFC line is horizontal line because it remains same at any output

Total Variable Cost (TVC)

Cost which changes with the level of output. They include payments for materials, fuel, power, transportation services, and most labor cost etc. TVC first increases by decreasing amount but later it increases by increasing amount because of Law of Diminishing Returns.

Total Cost (TC) =

TFC + TVC

SHORT RUN COST OF PRODUCTION

Total Product 0 1 2 3 4 5 6 7 8 9 TFC 100 100 100 100 100 100 100 100 100 100 TVC 0 90 170 240 300 370 450 540 650 780 TC 100 190 270 340 400 470 550 640 750 880

Total, Average & Fixed Cost Curves

900
800 Total Cost Total Variable Cost TFC

700
600

500

Cost

400 300 200 TVC Total Cost Total Fixed Cost 1 2 3 4 5 6 7 8 9 Units of Output

10 0 0

AVERAGE COST

Average Fixed Cost (AFC)

It declines as output increases but never touches the horizontal The process of calculating AFC is referred to as Spreading the Cost/Overhead

Average Variable Cost (AVC)

As variable resources increase output, AVC declines initially, reaches a minimum and then increases again. AVC is U-shaped because of Law Diminishing Returns

Average Total Cost

AFC + AV

ATC curve is the vertical summation of AFC and AVC curves

MARGINAL COST

Marginal Cost is the extra or additional cost of producing 1 more unit of output. MC is determined by noting the change in TC by that unit of output or by noting the change in TVC. MC curve first declines, reaches a minimum, and then start increasing. This is because of TC or TVC increase first by decreasing amounts and then by increasing amounts.

SHORT RUN COST OF PRODUCTION

Total product 0 1 TFC 100 100 TVC 0 90 TC 100 190 100 90 190 90 AFC AVC ATC MC

2
3 4 5 6 7 8 9

100
100 100 100 100 100 100 100

170
240 300 370 450 540 650 780

270
340 400 470 550 640 750 880

50
33.33 25 20 16.67 14.29 12.50 11.11

85
80 75 74 75 77.14 81.25 86.67

135
113.33 100 94 91.67 91.43 93.75 97.78

80
70 60 70 80 90 110 130

Average and Marginal Cost Curves

180
160

140
120

Marginal Cost

100

Average T. C. Average Variable Cost

Cost

80 60 40

20
0 1 2 3 4 5 6 7

Average Fixed Cost 8 9 Units of Output

RELATION OF MC TO AVC & ATC

MC curve cuts AVC curve and ATV curve at their minimum points. It is because of the fact that when MC is below ATC, ATC falls, when MC is above ATC, ATC rises. Similarly, when MC is below AVC, AVC falls, and when MC is above AVC, AVC rises.

RELATION OF MC TO MARGINAL PRODUCT

MC and AVC curve is the opposite of MP and AP curve.

It is because of the fact that as long as MP is rising, MC will fall. When MP is at its maximum point, MC will be at minimum point. When MP is falling, MC will be rising.

RELATION OF MC TO MARGINAL PRODUCT

Average product and marginal product

AP MP
Quantity of labor

Costs (dollars)

MC AVC

Quantity of output

DECISION IN SHORT RUN

A firm has two basic options in the short run. The firm can Operate

If it operates, it will produce the output that will yield the highest possible profits If it is losing money, it will operate at that output at which losses are minimized

The firm can Shut Down

If the firm shuts down, the output is zero The firm must still meet its fixed costs The firm can not go-out-of-business until all fixed cost obligations are eliminated

Case 1
Fixed costs Variable costs Prospective Sales Decision $5 6 7 Operate

Case 2
$10 9 8

Case 3
$ 8 12 10

(All dollar figures in millions)

Case # 1 Decision - Operate or shut Down?

Operate
TC = FC + VC ($5 + $6) = $11 Sales = . . . . . . . . . . . . . . . . 7

Shut Down
TC = (FC) = $5 Sales = . . . . . . 0

Loss = . . . . . . . . . . . . . . . . $ 4

Loss = . . . . . . $5

Case 1
Fixed costs Variable costs Prospective Sales Decision $5 6 7 Operate

Case 2
$10 9 8 Shut down

Case 3
$ 8 12 10

(All dollar figures in millions)

Case # 2 Decision - Operate or shut Down?

Operate
TC = FC + VC ($10 + $9) = $19 Sales = . . . . . . . . . . . . . . . . . . 8

Shut Down
TC = (FC) = Sales = . . . . . . $10 0

Loss = . . . . . . . . . . . . . . . . . . $11

Loss = . . . . . . $10

Case 1
Fixed costs Variable costs Prospective Sales Decision $5 6 7 Operate

Case 2
$10 9 8 Shut down

Case 3
$ 8 12 10 Shut down

(All dollar figures in millions)

Case # 3 Decision - Operate or shut Down?

Operate
TC = FC + VC ($8 + $12) = $20 Sales = . . . . . . . . . . . . . . . . . . 10

Shut Down
TC = (FC) = Sales = . . . . . . $8 0

Loss = . . . . . . . . . . . . . . . . . . $10

Loss = . . . . . . $8

Case 1
Fixed costs Variable costs Prospective Sales Decision $5 6 7 Operate

Case 2
$10 9 8 Shut down

Case 3
$ 8 12 10 Shut down

(All dollar figures in millions)

In the short run . . . A firm has two options

The firm operates when sales exceed variable cost
The firm shuts down when variable cost are greater than sales

THE LONG-RUN

The long run is the time at which all cost become variable cost. In long run a firm can change all its inputs.

Firms can alter its plant capacity, can build new plant.
Long run allows sufficient time for new firms to enter or for existing firms to leave an industry.

THE LONG-RUN COST CURVE

In the long run all cost become variable so therefore, there is no concept of fixed cost. Therefore, we take Total Cost and Average Total Cost only in cost analysis. LAC is first downward sloping because of economies of large scale production and later on it starts moving upward because of diseconomies of scale.

THE LONG-RUN COST CURVE

The Long-run ATC just envelopes all of the short-run ATC curves Unit Costs
SAC-1 SAC-2 SAC-3 SAC-4 SAC-5

LAC

Output

DECISION IN LONG-RUN

In the long run firms must decide to stay in business or go out of business. The firm will stay in business if prospective sales are greater than its total cost. The firm will go out of business if the total cost exceed prospective sales.