Costs of Production

Costs of
Production
The Meaning of Costs
• Opportunity costs
– meaning of opportunity cost
– examples
• Measuring a firm’s opportunity costs
– factors not owned by the firm: explicit costs
– factors already owned by the firm: implicit
costs
– irrelevance of:
• historic costs
• replacement costs
Production in the Short run
• Production functions
– factors of production
• labour
• land and raw materials
• capital
• entrepreneurship
– the relationship between inputs and output

• TPP = ƒ(F1, F2, F3, … Fn)
Production in the Short run
• Long-run and short-run production

– fixed and variable factors
– distinction between short run and long run
• The law of diminishing returns
• The short-run production function:
– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP,
APP and MPP
Wheat production per year from a particular farm
Number of
40 workers TPP
0 0
Tonnes of wheat produced per year
1 3
2 10
30 3 24
4 36
5 40
6 42
7 42
20 8 40
10
0
0 1 2 3 4 5 6 7 8
Number of farm workers
Number of
40 workers TPP
0 0
1 3
2 10
30 3 24
4 36
5 40
6 42
7 42
20 8 40
10
0
0 1 2 3 4 5 6 7 8
d
40
TPP
30 Maximum output
Diminishing returns
set in here
20
b
10
0
0 1 2 3 4 5 6 7 8
40
Tonnes of wheat per year

TPP
30
20
10
∆TPP = 7
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14 ∆L = 1
12
10
8
MPP = ∆TPP / ∆L = 7
6
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
40

TPP
30
20
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
12
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
40

TPP
30
20
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
12 APP = TPP / L
10
4 APP
2
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
40

TPP
30
20 b
Diminishing returns
10 set in here
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
4 APP
2
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
d
40

TPP
30
20 Maximum
b
output
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
4 APP
2
0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
d
40
Slope = TPP / L c

= APP TPP
30
20
b
10
0 Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
14
b
12
10
c
8
4 APP
2
0 d Number of
0 1 2 3 4 5 6 7 8 farm workers (L)
-2
MPP
Costs in the Short run
• Costs and inputs

– costs and the productivity of factors
– costs and the price of factors
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
• TVC and the law of diminishing returns
– total cost (TC = TFC + TVC)
Total costs for firm X
Output TFC
100 (Q) (£)
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40
20
0
0 1 2 3 4 5 6 7 8
Output TFC
100 (Q) (£)
0 12
1 12
80 2 12
3 12
4 12
60 5 12
6 12
7 12
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC
100 (Q) (£) (£)
0 12 0
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC
100 (Q) (£) (£)
0 12 0 TVC
1 12 10
80 2 12 16
3 12 21
4 12 28
60 5 12 40
6 12 60
7 12 91
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC TC
100 (Q) (£) (£) (£)
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40
20
TFC
0
0 1 2 3 4 5 6 7 8
Output TFC TVC TC
100 (Q) (£) (£) (£) TC
0 12 0 12 TVC
1 12 10 22
80 2 12 16 28
3 12 21 33
4 12 28 40
60 5 12 40 52
6 12 60 72
7 12 91 103
40
20
TFC
0
0 1 2 3 4 5 6 7 8
100 TC
TVC
80
Diminishing marginal
60
returns set in here
40
20
TFC
0
0 1 2 3 4 5 6 7 8
• Marginal cost
– marginal cost (MC) and the law of

diminishing returns
Average and marginal costs
MC
Diminishing marginal
returns set in here
Costs (£)
Output (Q)
• Marginal cost
– marginal cost (MC) and the law of

diminishing returns
– the relationship between MC and TC curves

MC
Costs (£)
Output (Q)
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
• Relationship between average and

marginal cost
MC
AC
AVC
Costs (£)
x
AFC
Output (Q)
Production in the Long run
• All factors variable in long run
• The scale of production:

– constant returns to scale
– increasing returns to scale

Short-run and long-run increases in output

– decreasing returns to scale


– decreasing returns to scale
• Returns to scale and economies and

diseconomies of scale
• Economies of scale
– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
• Economies of scope
• Diseconomies of scale
– managerial diseconomies
– effects of workers and industrial relations
– risks of interdependencies
• External economies of scale
• External diseconomies of scale
• Location
– balancing the distance from suppliers and
consumers
– importance of transport costs
• Optimum combination of factors

– MPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Decision making in different time
periods
– very short run
– short run
– long run
– very long run
– decisions can be made for all time periods
at the same time
Costs in the Long run
• Long-run average costs

– shape of the LRAC curve
– assumptions behind the curve
Alternative long-run average cost curves
Economies of Scale
Costs
LRAC
O Output
LRAC
Diseconomies of Scale
Costs
O Output
Constant costs
Costs
LRAC
O Output
A typical long-run average cost curve
LRAC
Costs
O Output
A typical long-run average cost curve
Economies Constant Diseconomies LRAC

of scale costs of scale
Costs
O Output

• Long-run marginal costs

Long-run average and marginal costs
Economies of Scale
Costs
LRAC
LRMC
O Output
LRMC
LRAC
Diseconomies of Scale
Costs
O Output
Constant costs
Costs
LRAC = LRMC
O Output
LRMC
Initial economies of scale,
then diseconomies of scale
LRAC
Costs
O Output

• Relationship between long-run and
short-run average costs

– the envelope curve
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC SRAC5

2
SRAC4
SRAC3
5 factories
Costs
1 factory
2 factories
3 factories4 factories
O
Output
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC SRAC5

2
SRAC4
SRAC3
LRAC
Costs
O
Output
Deriving a long-run average cost curve: choice of factory size
Costs
Examples of short-run
average cost curves
O
Output
Deriving a long-run average cost curve: choice of factory size
LRAC
Costs
O
Output

• Long-run cost curves in practice

– the evidence

– the evidence
– minimum efficient plant size

Costs of Production

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Costs of Production

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Costs of

– the relationship between inputs and output

• Long-run and short-run production

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

Tonnes of wheat per year

• Costs and inputs

– marginal cost (MC) and the law of

– marginal cost (MC) and the law of

– the relationship between MC and TC curves

– average fixed cost (AFC)

– average variable cost (AVC)

– average (total) cost (AC)

• Relationship between average and

• All factors variable in long run

• The scale of production:

– increasing returns to scale

• All factors variable in long run

• The scale of production:

– increasing returns to scale

– decreasing returns to scale

• All factors variable in long run

• The scale of production:

– increasing returns to scale

– decreasing returns to scale

• Returns to scale and economies and

• Optimum combination of factors

• Long-run average costs

Economies Constant Diseconomies LRAC

• Long-run average costs

• Long-run marginal costs

• Long-run average costs

• Long-run average costs

SRAC1 SRAC SRAC5

SRAC1 SRAC SRAC5

• Long-run average costs

• Long-run average costs

• Long-run average costs

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