The Theory of the Firm

The Costs of Production

 Outline
• What are costs?
• Link between firm’s production process and its
total cost
• Measures of Cost
• Costs in the short-run and costs in the long-run
 Basic Concepts

• Total Revenue- Amount a firm receives for

the sale of its output
• Total Cost- Market value of the inputs a firm
uses in production
• Profit = Total Revenue – Total Cost
 Actual Cost & Opportunity Cost

• Explicit/Actual Costs
-Actual expenditure incurred for producing goods/services
-Costs that are generally recorded in the books of account,
eg. Salaries paid, cost of materials/inputs purchased
- Input costs that require an outlay of money by the firm. Eg.
X starts a business, pays Rs 100000 as salaries, Rs 100000
is the actual cost
 Actual Cost & Opportunity Cost
• Implicit/Opportunity Costs
-OC of a good/service is measured in terms of revenue which
could have been earned by employing that good/service in
another alternative use
-Eg. X could earn Rs 50000 a month as a software
professional, this foregone income is an opportunity cost
• An accountant would consider only explicit costs as visible
money flows are observed in business
• An economist would also consider implicit costs like
foregone income
 Cost of Capital as an Opportunity Cost
• Opportunity Cost of the financial capital
invested in business
• Eg. X has invested 1000000 to start a business.
Opportunity cost is the income X forgoes had
he kept this amount in a bank (at the rate of 5-
7%). This is the implicit opportunity cost of the
business
 Economic Cost
 In economics, the notion of a firm’s costs
is based on the notion of economic cost.
• The key principle underlying the
computation of economic cost is
opportunity cost.
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what you
sacrifice to get it.
 Accounting versus Economic
Cost
Accounting versus Economic Cost
Accounting Economic
Approach Approach
Explicit Cost (purchased inputs) $60,000 $60,000
Implicit: opportunity cost of entrepreneur’s time 30,000
Implicit: opportunity cost of funds 10,000
______ ______
Total Cost $60,000 $100,000
 Economic Profit Vs Accounting Profit
• Economic Profit = Total Revenue minus
Total Cost, including both explicit and
implicit costs
• Accounting Profit = Total Revenue minus
Total explicit costs
• Economic Value-Added = NOPAT – Cost of
Capital (Cost of Debt + Cost of Equity)
 Fixed Costs & Variable Costs
• In buying factor inputs, the firm will incur costs
• Costs are Classified as:
– Fixed costs – costs that are not related directly to
production – rent, insurance costs, admin costs. They
can change but not in relation to output/production.
– Fixed Costs are incurred even when output is nil
– Variable Costs – costs directly related to variations in
output. Raw materials, labour, primarily.
– Increase in volume means a proportionate increase in
total variable cost and vice versa
 Variable Cost

Total
Fixed Total
Fixed Cost
Cost Variable
Cost

Output Output
 Short-run & Long-run Costs
• Time Horizon key factor in dividing costs into short-run and
long-run costs
• Short run – In the short-run increase in production results from
adding successive quantities of variable factors to a fixed factor
- Short-run costs are costs that vary with output when fixed plant
and capital equipment remain the same
- Relevant when a firm decides whether or not to produce more in
the immediate future
• Long run – Increases in capacity results in increasing production.
All costs become variable in the long-run
- Long-run costs are those which vary with output when all input
factors including plant and equipment vary
- Relevant when a firm decides whether to set up a new plant.
Analysis of Production Function:
Short Run
In times of rising
sales (demand)
firms can increase
labour and capital
but only up to a
certain level –
they will be limited
by the amount of
space. In this
example, land is
the fixed factor
which cannot be
altered in the
short run.
Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example it reduces
its labour and
capital but again,
land is the factor
which stays fixed.
Analysis of Production Function:
Short Run
If demand slows
down, the firm can
reduce its variable
factors – in this
example, it
reduces its labour
and capital but
again, land is the
factor which stays
fixed.
 Analysing the Production Function:
Long Run
• The long run is defined as the period of time taken to vary
all factors of production.
– By doing this, the firm is able to increase its total
capacity – not just short term capacity
– Associated with a change in the scale of production
– The period of time varies according to the firm and the
industry.
– In electricity supply, the time taken to build new
capacity could be many years; for a market stall holder,
the ‘long run’ could be as little as a few weeks or
months!
 Analysis of Production Function:
Long Run

In the long run, the firm can change all its factors of production thus
increasing its total capacity. In this example it has doubled its capacity.
 Past Costs & Future Costs
• Past costs are actual costs incurred in the past and generally
contained in the financial accounts
-Record keeping activity however passive function for management
-These costs can be observed and evaluated in retrospect
• Future costs are expected to be incurred in some future period
-Their incurrence is a forecast and they are subject to management
control, hence matter to managerial decisions
-Managerial uses of future costs are cost control, projection of future
profit and loss statements, expansion programmes and pricing,
introduction of new products
 Incremental/Differential Costs & Sunk Costs
• Incremental cost is the additional cost due to a change
in the level or nature of business activity
-Change may take several forms: addition of a new
product-line, changing channel of distribution, adding
of new machines, expansion into additional markets
• Sunk Costs is one which is not affected/altered by a
change in the level or nature of business activity
-Remains the same whatever the level of activity
Eg operating costs and space and occupancy costs
remain the same whether equipment is purchased or
hired
 Other Cost Categories

• Out-of-pocket and Book Costs

-Out-of-pocket costs involve current cash payments to
outsiders
-Book costs do not require current cash payments, eg
depreciation
• Direct and Indirect Costs
-Direct/traceable costs can be identified very easily
with a unit of operation eg salary of a divisional
manager
-Indirect costs are those that are not easily traceable to
a unit of operation eg salary of a general manager
 …Other Cost Categories

• Replacement and historical costs

-Historical cost is the original price paid for
equipment, replacement cost means price
that would have to be paid currently for
acquiring the same equipment
• Controllable and Uncontrollable costs
Production & Costs
Production Function
 Production Function
• States the relationship between inputs and outputs.
• Inputs – the factors of production classified as:
– Land – all natural resources of the earth – not just ‘terra firma’!
• Price paid to acquire land = Rent
– Labour – all physical and mental human effort involved in
production.
• Price paid to labour = Wages
– Capital – buildings, machinery and equipment not used for its
own sake but for the contribution it makes to production.
• Price paid for capital = Interest
 Production Function

Inputs Process Output

Land
Product or
Labour service
generated
– value added
Capital
 … Production Function
• Marginal Product: Increase in output that arises
from an additional unit of input
• Diminishing Marginal Product: Marginal Product
of an input declines as the quantity of the input
increases (Why?)
-Initially increasing returns due to efficient
utilisation of fixed factor as more units of variable
factor are applied to it (MP increasing)
-Subsequently diminishing returns as the fixed factor
becomes more and more scarce in relation to the
variable factor (MP diminishing)
 Analysis of Production Function:
Short Run
• In the short run at least one factor fixed in supply but all other
factors capable of being changed.
• Reflects ways in which firms respond to changes in output
(demand).
• Can increase or decrease output using more or less of some
factors but some likely to be easier to change than others.
• Increase in total capacity only possible in the long run
 Production Function
• Mathematical representation of the
relationship:
• Q = f (K, L, La)
• Output (Q) is dependent upon the amount
of capital (K), Land (L) and Labour (La)
used.
 Diminishing Returns and
Marginal Cost
• The key principle behind the firm’s short-
run cost curves is the principle of
diminishing returns.
PRINCIPLE of Diminishing Returns
Suppose that output is produced with two or more
inputs and we increase one input while holding the
other inputs fixed. Beyond some point—called the
point of diminishing returns—output will increase at a
decreasing rate.
Labor Input and Output
 The shape of the
production function is
explained by diminishing
returns.
 Beyond 15 workers the
marginal product of labor
decreases and the
production function
becomes flatter.
 Costs
• Total Cost - the sum of all costs incurred in
production
• TC = FC + VC
• Average Cost – the cost per unit of output
• AC = TC/Output
• Marginal Cost – the increase in total cost that
arises from producing an additional unit of output
• MC = TCn – TCn-1 units
Labor Input and Output
 The shape of the
production function is
explained by diminishing
returns.
 Beyond 15 workers the
marginal product of labor
decreases and the
production function
becomes flatter.
 Short-run Average and Marginal
Costs: An Example
Per-unit costs
Output: Short-run Average Short-run Short-run
Rakes per Marginal Fixed Average Average 40
Minute Cost Cost Variable Cost Total Cost 35

Q SMC AFC SAVC SATC 30

Cost in $
0 - - - - 25
1 8 36.00 8.00 44.00
20
2 4 18.00 6.00 24.00
15
3 3 12.00 5.00 17.00
4 5 9.00 5.00 14.00 10
5 7 7.20 5.40 12.60 5
6 9 6.00 6.00 12.00 0
7 12 5.14 6.86 12.00 0 1 2 3 4 5 6 7 8 9 10 11
8 17 4.50 8.13 12.63 Output: Rakes per minute
9 25 4.00 10.00 14.00
10 40 3.60 13.00 16.60 MC ATC AFC AVC
Short-run Average Total Cost
(SATC)
• The SATC curve is U-
shaped because of the
behavior of its two
components as output
produced increases.
– AFC decreases as
output increases.
– SAVC increases as
output increases.
 Diminishing Returns and
Increasing Marginal Cost
Diminishing Returns and Increasing Marginal Cost
Additional Additional Additional Marginal
Quantity of Chips
Labor Hours Labor Cost Material Cost Cost
Small: 100 2 $16 $10 $26
Medium: 300 6 48 10 58
Large: 400 10 80 10 90
Initially, it takes 4 additional labor hours to increase the quantity of chips by
200, from 100 to 300. Then, it takes another 4 hours of labor to increase
output by only 100 more chips, from 300 to 400. Marginal cost increases
because output increases at a decreasing rate with additional labor hours.
 Relationship between Short-run
Marginal and Average Cost Curves
• As long as SATC is
declining, marginal cost
lies below it.
 When SATC rises,
SMC is greater than
SATC.
 At point m,
SATC=SMC.
 Relationship between Short-run
Marginal and Average Cost Curves
Marginal Average
Quantity
Cost Total Cost
Produced
($) ($)
100 26 90
300 58 58
400 90 68
 The marginal cost curve
(SMC) intersects the
average cost curve
(SATC) when average
cost is minimum.
 Production and Cost in the Long
Run
• The key difference between the short run and the
long run is that there are no diminishing returns in
the long run.
 Diminishing returns occur because workers
share a fixed facility. In the long run the firm
can expand its production facility as its
workforce grows.
 Long-run Average Cost
• Long-run average cost (LAC) is total cost
divided by the quantity of output when the firm
can choose a production facility of any size.
• The LAC curve describes the behavior of average
cost as the plant size expands. Initially, the curve
is negatively sloped, then beyond some point, it
becomes horizontal.
 Long-run Average Cost
• When long-run total cost is proportionate to the quantity
produced, long-run average cost does not change as
output increases.
Average cost: $ per rake

Long-run Average Cost Curve

Output: Long-run
Rakes per Long-run Average
Minute Total Cost Cost

12 LAC
3.5 $70 $20.00
7 $84 $12.00
14 $168 $12.00
0
0 7 14 21 28
28 $336 $12.00
Output: Rakes per minute
 The long-run average cost
curve is horizontal for 7 or
more rakes per hour.
 Labor Specialization
• In a large operation, each worker specializes in
fewer tasks thus is more productive than his or
her counterpart in a small operation.
• Higher productivity (more output per worker)
means lower labor costs per unit of output, thus
lower production costs (ever-decreasing average
cost).
 Economies of Scale
• Economies of scale: a situation in which an increase in
the quantity produced decreases the long-run average
cost of production.
• Economies of scale refer to cost savings associated with
spreading the cost of indivisible inputs and input
specialization.
• When economies of scale are present, the LAC curve will
be negatively sloped.
 Minimum Efficient Scale
• The minimum efficient scale describes the
output at which economies of scale are exhausted
and the long-run average cost curve becomes
horizontal.
• Once the minimum efficient scale has been
reached, an increase in output no longer decreases
the long-run average cost.
 Diseconomies of Scale
• A firm experiences diseconomies of scale when
an increase in output leads to an increase in long-
run average cost—the LAC curve becomes
positively sloped.
• Diseconomies of scale may arise for two reasons:
– Coordination problems
– Increasing input costs