ATGB2343 INTRODUCTION TO ECONOMICS

TOPIC 4: COST OF PRODUCTION AND CORPORATE ORGANISATION

BEHAVIOUR
Introduction
 The basic factor underlying the ability and willingness of firms to supply a product in the market is the cost
of production.
 Other than the market price and productivity of resources, production cost is one of the factors that
determine the amount of a product a firm is willing to supply.
 When businesses produce goods and services, they require economic resources for the production. In
obtaining and using resources, monetary payment made to resource owners (explicit costs) and costs of
using resources already owns – that could have earned in their best alternative use ( implicit cost), together
make up the firm’s cost of production/ economic costs.

Economic Cost/ Opportunity Cost

 Economic cost is the cost in economic deal with forgoing the opportunity to produce alternative goods and
services.
 Resources are scarce and have alternative use. When a combination of resources is used to produce
certain good means it forgoes all alternative opportunities to use those resources for other purposes.
 From the firm’s viewpoint, economic costs are the payment a firm must make, or the incomes it must
provide, to attract the resources it needs away from alternative production opportunities.
 Those payments to resource suppliers incur explicit costs and implicit costs to the production firm, which
together make up the economic costs.

Explicit Cost and Implicit Cost

Explicit Cost
 Explicit costs are the monetary payments a firm makes to those who supply labour services, materials,
fuel, transportation services, maintenance and the like.
 Explicit costs are incurred for the use of resources owned by others.

Implicit Cost
 Implicit costs are the costs of using its self-owned, self employed resources.
 To the firm, implicit costs are the money payments that self-employed resources could have earned in
their best alternative use.
 Implicit costs include normal profit.
 Normal profit is the opportunity cost of using entrepreneurial abilities in the production of a good, or the
profit that could have been received in another business venture.
 Normal profit is required to attract and retain resources in a specific line of production.

Economic cost = explicit cost + implicit cost (including normal profit)

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Economic Profit / Pure Profit

 Accounting profit is firm’s total revenue less its accounting costs (explicit costs).
 Economic profit is firm’s total revenue less economic costs (explicit and implicit costs where implicit costs
include a normal profit to the entrepreneur).

Economic profit = Total revenue - economic cost

Economic Profit vs Accounting Profit

Economic profit
Accounting profit
Implicit costs (including
Economic (opportunity) costs

normal profit) Total Ac

revenue cou
Explicit costs Explicit costs ntin
g
cos
ts
Accounting and economic profit

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Short Run and Long Run

 When demand changes, the firm’s profitability depends on how quickly it can adjust the amounts of the
various resources it employs.
 Quantities of many resources can be adjusted easily and quickly within a short period, such as hourly
labour, raw materials, fuel, etc.
 However, some resources need a longer time for its capacity to be altered and involved complicated
and lengthy adjustment period, such as size of plant, amount of machinery and other capital resources.
 The differences in these adjustment times necessary to vary quantities of various resources in
production make it essential to distinguish between the short run (SR) and the long run (LR) as costs
differ in these two time periods.

Short Run (SR)

 The period of time is too brief for a firm to alter its plant capacity, yet long enough to permit a change in
the level at which the fixed plant is used.
 The firm’s plant capacity is fixed in the SR. However, the firm can alter its output by applying larger or
smaller amounts of labour, materials and other resources to that plant.
 Existing plant capacity can be used more or less intensively in the SR.

Long Run (LR)

 The period of time extensive enough for these firms to change the quantities of all resources employed
including plant capacity.
 From the industry’s point of view, the LR also encompasses enough time for existing firms to leave and
for new firms to be created and enter the industry.

Short-Run Production Relationship

 Prices of the required resources and quantities of resources (inputs) determine a firm’s cost of
producing a specific output.
 Prices of the required resources will be determined by the resource supply and demand; while
 Quantities of resources will depend on the technological aspects of production, specifically relationships
between inputs ad output.
 In SR, focus will be on the labour-output relationship, given a fixed plant capacity. Before examining
these relationships, three (3) terms need to be defined:
 Total product (TP) is the total quantity (output), of a particular good produced.
 Marginal product (MP) is the extra output or added product associated with adding a unit of variable
resource (in this case labour) to the production process.
change∈total product
MP=
change∈labour input

 Average product (AP) is output per unit of labour input, also called labour productivity.
total product
AP=
unit of labour

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 In the short run, a firm can for a time increase its output by adding units of labour to the fixed plant.
 The TP and MP graphs clarifies law of diminishing returns in SR production relationships between TP, MP
and AP.

Total Product

TP

TP

Q
Labour

Average Product and Marginal Product

MP & AP Increasing Diminishing Negative

marginal marginal marginal
returns returns returns

AP maximum

AP

Q
Labour

MP

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Short-Run Production Costs

Law of Diminishing Returns

 Sometimes called law of diminishing marginal product and law of variable proportions.
 This law states that as successive units of a variable resource (say labour) are added to a fixed resource,
beyond some point the extra, or marginal, product can be attributed to each additional unit of the variable
resource will decline.
 If additional workers are applied to a given amount of capital equipment, in the short run, eventually output
will rise by a smaller and smaller amounts as more workers are employed.

Fixed, Variable and Total Costs

 Fixed costs are those costs, which in total do not vary with changes in output. The cost which must be
paid even if its output is zero.
 Variable costs are those costs which change with the level of output. The increase in variable costs
associated with each one-unit increase in output are not constant, that explains the law of diminishing
marginal returns.
 Fixed cost is the sum of fixed and variable costs at each level of output.

Total Cost =¿ Costs∧Variable Costs

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Law of Diminishing Returns

MAXIMUM POINT

TP
PHASE I PHASE II PHASE III
Rise at Rise at Rise at
Increasing rate Diminishing rate Negative rate

TP

Q
Labour

PHASE I
Extra units of labour are adding larger and larger amount to total product
TP increases in increasing rate -> MP increases (+ve)

PHASE II
Each additional
TP increases in diminishing rate -> MP decreases (+ve) unit of labour adds less to total output than did the previous amount

MAXIMUM POINT
Ditto, but yield no output
TP at maximum -> MP = 0

PHASE III
TP decreases -> MP decreases (-ve) Ditto, total product fall

MP

TP MAXIMUM POINT

Q
labour
MP

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Total, Variable and Fixed Cost

Costs

1000 TC

900 VC / TVC
800

700

600
Fixed cost
500

400
Total
300 cost
Variable cost
200

100
FC / TFC
Q
1 2 3 4 5 6 7 8 9 10 Output

Total cost: Sum of fixed cost and variable cost.

Fixed cost: Independent of the level of output.

Variable cost: Varies with output

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Per Unit, or Average, Costs

 Producers are certainly interested in their total costs but they are equally concerned with average cost
because it is usable for making comparisons with product price.

Average Fixed Costs (AFC)

 AFC is found by diving total fixed cost (TFC) by the corresponding output (Q).

TFC
AFC=
Q

 AFC will decline so long as output increases because the total fixed cost is being spread over a larger
and larger output.
 This is commonly referred to as “spreading the overhead”.

Average Variable Costs (AVC)

 AVC is found by diving total variable cost (TVC) by the corresponding output (Q).

TVC
AVC=
Q

 AVC declined initially reaches a minimum and then increase again (U-shaped). As TVC reflects the
law of diminishing returns, so must AVC.

Average Total Costs (ATC)

 ATC is found by diving total cost (TC) by the corresponding output (Q) or by adding AFC and AVC at
each level of output.

TC
ATC=
Q

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Marginal Costs (MC)

 MC is very important concept. It is the extra, or additional cost of producing one more unit of output.
 MC can be determined for each additional unit of output by noting the change in total cost, which that
unit’s production entails.

change∈TC
MC=
change ∈Q

 MC is a strategic concept because MC indicates those costs incurred in producing the last unit of
output and at the same time designates the cost that can be “saved” by not producing that last unit,
which average-cost figures do not provide this information. MC is the cost the firm can control directly
and immediately in making marginal decisions.

Marginal Costs and Marginal Product (MC and MP)

 Increase in MP will generate a decline in MC, while decrease in MP will increase MC of a particular
product. Hence the MC curve is a mirror reflection of the MP curve.
 When MP is at its maximum, MC is at its minimum; when MP is falling, MC is rising

Relationship between MC and MP

AP and MP

AP
MP

Q labour
MC
Cost
AVC

Q output

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Relation of MC to AVC and ATC

 The MC curve intersects both the AVC and ATC curves at their minimum points.
 When the amount (MC) added to total cost:
i. If MC added less than the current ATC (graphically below the ATC), ATC will fall;
ii. If MC added more than the current ATC (graphically above the ATC), ATC will rise.
iii. If MC added equals to ATC, MC=ATC, ATC at that point just stop to fall but has not begun to rise.
 There is no relationship betwee MC and AFC because the two are not related. MC includes only those
costs, which change with output.

The Relationship of the MC to AVC and ATC Curves

Cost

Q output

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Long Run (LR) Production Costs

 In the long run, an industry and the individual firms can undertake all desired resources adjustments. The
firms can alter its plant capacity; it can build a larger plant or revert to a smaller plant.
 The industry can also change its plant size and the long run also allows sufficient time for new firms to
enter or existing firms to leave an industry.

The Long Run Cost Curve of A Firm

ATC

ATC-5
ATC-1

ATC-4
Long-run ATC
ATC-2

ATC-3

Q output

Firm Size and Costs

 Increase in plant size will reduce ATC of a firm at the initial point but eventually the building of a large plant
may cause ATC to rise because larger plant will mean higher minimum average total costs.
 Law of diminishing returns does not explain the downward and upward sloping of the long-run curve. This
is because diminishing returns presume one resource is fixed in supply while the long run means all
resources are variable.
 The U-shaped long run ATC curve can be explained in terms of economies and diseconomies of large-
scale production.

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Economies of Scale
 Economies of scale explain the downsloping part of the LR ATC curve. As plant size increases, a
number of factors will for a time lead to lower average costs of production due to:
i. Labours Specialisation
Plant size increases will increase specialisation in the use of labour. Hire more workers
means jobs can be divided and subdivided. Each worker may now have one task to perform
instead of more. Workers can work full time on those particular operations, leading to
reduction in production costs. Besides, workers become more proficient at the task by
concentrating on one task, leading to higher efficiency.

ii. Managerial Specialisation

Large-scale production employs better use of and greater specialisation in management. A
supervisor who can handle 20 workers is underused in a small plant that employs only 10
workers. Besides, small firms cannot use management specialists to the best advantage, as
diversification of job scope may need them to take care of other roles and functions. A larger
scale of operations means better concentration of managerial staff in management and
supervision, leading to greater efficiency and lower unit costs.

iii. Efficient Capital

Large firm is able to employ high technology plant and effectively use such plant to optimise
the production, for example the use of robotic arm. On the other hand, in a small firm, the
purchasing of more efficient equipment and underusing it at low levels of output is also
inefficient and costly.

iv. Others
Design fees, development costs, advertising costs and other “start-up” costs, which must be
incurred irrespective of projected sales. These costs decline per unit as output is increased.

Diseconomies of Scale
 Diseconomies of scale explain the upward sloping part of the LR ATC curve. The further expansion of
firm may lead to diseconomies as to higher per unit costs is charged to a product due to:
i. Managerial problem because of difficulty in efficiently controlling and coordinating a firm’s
operations as it becomes a large-scale producer.
ii. Feeling of massive production facilities workers being alienated from the employers and care
little about working efficiently.

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