BM1704

PRODUCTION AND PRODUCTION COSTS

Concepts in Production

Classifications of Cost
• Variable inputs or costs are inputs whose quantities can be readily changed in response to
changes in market conditions. Labor is typically a variable input. If you have a large increase in the
demand for a product, working longer or hiring another worker is relatively easy to do.
• Fixed inputs or costs are inputs whose quantities can’t be readily changed in response to market
conditions. A factory, for example, would take a long time to build.

Technical and economic efficiency

• Technical efficiency happens when a firm produces the maximum output possible for a given
combination of inputs and existing technology. When a firm is being technically efficient, every
input is being utilized to the fullest extent possible, and there is no other way to get more output
without using more of at least one input.
• Economic efficiency is achieved when the firm produces its chosen level of output at the lowest
possible total cost. Managers focus on economic efficiency because profit cannot be maximized
unless the firm’s output is produced at the lowest possible cost.

Isoquants
• Isoquants refer to the different input combinations used to efficiently produce a specified output.
For isoquants, this refers to technical efficiency, or the least-cost production of a target level of
output.
• Most firms use multiple variables of production, so firms can also utilize various combinations of
inputs to produce the same level of output. (This is similar to an indifference curve, since the
points that lie on the same isoquant are inputs that, when combined, produce the same level of
output.)
• A higher isoquant is associated with higher levels of output.
• In some production systems, input substitution is easily accomplished. This means that production
can substitute an input for one product to another product.
• The Marginal Rate of Technical Substitution (MRTS) is the rate at which a producer can substitute
between two (2) inputs and maintain the same level of inputs. It is the absolute value of the slope
of the isoquant and is the ratio of the marginal products:
𝑀𝑀𝑀𝑀𝑋𝑋
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 =
𝑀𝑀𝑀𝑀𝑌𝑌
• The 𝑀𝑀𝑀𝑀𝑋𝑋 refers to the input on the x (horizontal) axis, while 𝑀𝑀𝑀𝑀𝑌𝑌 refers to the input in the Y
(vertical) axis.
• The Law of Diminishing Marginal Substitution states that as less of one (1) input is used,
increasing amounts of another input must be employed to produce the same level of output.

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Isocosts
• Isocosts, meanwhile, shows all the different costs that can arise from the different levels of inputs.
It is the producer’s budget line.
• If there is a change in the input costs, the slope of isocost line will change. If the price of one (1)
input falls, the firm could buy more of that input, and the line will shift away from the origin.
• The slope depends on the prices of inputs and the amount of money which the firm spends. When
the amount of money spent by the firm changes, the isocost line may shift but its slope remains
the same.
Cost minimization
• The firm can maximize its profits either by maximizing the level of output for a given cost or by
minimizing the cost of producing a given output. In both cases the factors will have to be
employed in optimal combination at which the cost of production will be minimum.
• Cost is minimal when the slope of the isoquant (MRTS) is equal to the slope of the isocost line
(cost of production).
• If the firms produce lower than the cost-minimizing input mix, they could produce more with the
same amount of inputs. If the firms produce more than the cost-minimizing input mix, the cost of
production is too high.

Short Run Production Costs

Costs and costs curves

• Total costs – This is the sum of variable and fixed costs. The total cost curve slope upward, because
increasing output increases total costs. Variable cost curves are similar to total cost curves, but
fixed cost curves are depicted as a horizontal line. This is because fixed costs do not change no
matter how many units are produced.
• Average costs – These are the costs per unit of output. They indicate how efficiently scarce
resources are being used (lower ATC means less costs per good). It can be computed by adding
the average variable costs and the average fixed costs.
o Average fixed costs (AFC) is obtained using the equation, 𝑇𝑇𝑇𝑇𝑇𝑇/𝑄𝑄. Thus, AFC is high when
there are relatively low levels of output; because the denominator increases as output
increases. If output continues to increase, AFC would approach zero (0).
o Average variable cost (AVC) is the total variable cost divided by output, 𝑇𝑇𝑇𝑇𝑇𝑇/𝑄𝑄. In a graph,
if first declines, then rises.
o Average total costs (ATC) is the short-run total cost divided by output, 𝑇𝑇𝑇𝑇/𝑄𝑄. It has the same
general structure as the AVC, in that it first declines, then increases. However, the minimum
ATC is attained at a larger quantity than at which the AVC attains it minimum.
• Marginal cost – This is the change in total cost when production increases by one (1) unit. It is
important to note that marginal cost is derived solely from variable costs, and not fixed costs.
Therefore, in the short run, the marginal cost (SMC) can be expressed using the equation:

∆𝑇𝑇𝑇𝑇𝑇𝑇 ∆ 𝑇𝑇𝑇𝑇
𝑆𝑆𝑆𝑆𝑆𝑆 = =
∆𝑄𝑄 ∆𝑄𝑄

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The marginal cost curve falls, then rises because of the following reasons:
o In the beginning, marginal costs are falling. The firm incurs costs when making goods and
services, but since these can be covered by the additional products sold, marginal cost is
decreasing.
o After a certain point, marginal costs will neither decrease nor increase. This point signifies the
highest quantity that a firm can produce while keeping costs at a minimum.
o Beyond this point, the firm’s marginal costs will just increase when they produce an additional
unit. In short, the firm may sell something, but the cost of producing it is greater. It will not
be profitable to keep producing at this level.
• The lowest price that a firm is prepared to supply is the price that just covers marginal cost.

Relationships between the curves

• AVC and ATC have the same behavior. They first decline, reach a minimum, then rise. When AVC
is at the minimum, short-run MC equals AVC. When ATC is at minimum, short-run MC equals ATC.
• Short-run MC first declines, reaches a minimum, and rises thereafter. When MC is below the ATC
and AVC curves, average cost is declining, and when MC is above the ATC and AVC curves, average
cost is rising.
• There is a simple explanation for this relationship among the various cost curves. Again, consider
your grade in this course. If your grade on an exam is below your average grade, the new grade
lowers your average grade. If the grade you score on an exam is above your average grade, the
new grade increases your average. In essence, the new grade is the marginal contribution to your
total grade. When the marginal is above the average, the average increases; when the marginal
is below the average, the average decreases. The same principle applies to marginal and average
costs.

Long Run Production Costs

Long run average cost curves

• The long run average cost curve (LRAC) is known as the envelope curve and is drawn on the
assumption that there is an infinite number of production plants. It defines the minimum average
cost of producing alternative levels of output, allowing for optimal selection of both fixed and
variable factors of production.
• It is known as the envelope curve because it is the lower portion of all short-run average cost
curves. This means that the long-run average cost curve lies below every point on the short-run
average cost curves, except that it equals every short-run average cost curve at the points where
the firm uses fixed inputs optimally.
• If the LRAC is falling when output is increasing, then the firm is experiencing economies of scale.
When there are economies of scale, increasing the size of production decreases the minimum
average cost. Economies of scale are the cost advantages from expanding the scale of production
in the long run. This will reduce average costs over a range of outputs.
• These lower costs are caused by an improvement in productive efficiency and can give a business
a competitive advantage in a market. Lower costs also lead to lower prices and higher profits.
• As long as the long run average total cost curve is declining, economies of scale are being
exploited.

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• After a point, further increases in production will lead to an increase in the average costs. This is
known as diseconomies of scale. In the graph, diseconomies of scale are seen when LRAC is rising.
• Sometimes the technology in an industry allows a firm to produce different levels of output at the
same minimum average cost. This condition is called constant returns to scale.

Comparing the short run and the long run

• Short run
o This is the period of time when the capital assets are fixed and the only available business
decision is the amount of inputs to be used.
o In the short run, fixed costs are already paid and are unrecoverable.
o Also, the number of firms in the markets are already fixed. Firms have already chosen
what industry they will enter and the scale of the technology of production.
o In the short run, firms will produce if the market price at least covers variable costs, since
fixed costs have already been paid and, as such, do not enter the decision-making process.
Firm’s profits can be positive, negative, or zero.

• Long run
o The long run is not defined as a specific period of time. It is the time horizon needed for
a producer to have flexibility over all relevant production decisions, such as the number
of workers or production processes.
o In the long run, fixed costs are not yet decided and paid, and thus are not truly “fixed”.
o Firms in the long run have the flexibility to fully enter or exit an industry, since they can
choose whether or not to incur the fixed costs of getting into or staying in an industry.
o Firms will enter a market if the market price is high enough to result in positive economic
profit, and will exit if the market price is low enough to result in negative economic profit.
o If firms have the same costs, firm profits will be zero (0) in the long run in a competitive
market. These firms have lower costs and can maintain positive economic profit, even in
the long run.

References
Baye, M., & Prince, J. (2013). Managerial economics and strategy, 8e. New York: McGraw HIll.

Bentzen, E., & Hirschey, M. (2016). Managerial economics. Hampshire: Cengage Learning.

Graham, R. (2013). Managerial economics for dummies . New Jersey: John Wiley & Sons.

Thomas, C., & Maurice, S. (2015). Managerial economics: Foundations of business analysis and strategy.
New York: McGraw Hill Education.

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