Course Code and Title: BACR2 Basic Microeconomics

Lesson Number: 9

Topic: Costs of Production

Before we eat our meal, someone has to produce rice. Similarly, our economy’s ability to
produce electronics products, design computer games, and deliver a multitude of goods and
services that are part of our gross domestic product depends upon our economy’s
productive capacity.

In microeconomics, it is to study production and its costs. Basic questions that need to be
answered when we talk about the theory of the firm include how firms decide what to
produce and how much to produce, what constitutes a firm’s cost, and how do firms
determine what price to charge to determine profit.

Our goal is to understand how market forces determine the supply of goods and services. In
particular, we will layout the basic concepts of production, cost, and revenue and show how
they are linked with each other. We first explore the fundamentals of production theory,
showing how firms transform inputs into desirable outputs. Thereafter, we consider the cost
and revenue side.

Learning Objectives:

At the end of this lesson, the students will be able to:

1. Explain economic costs and distinguish what explicit costs from implicit costs.
2. Illustrate fixed costs from variable costs.
3. Challenge the concepts of Production Costs in the Long-Run
and Scale in Economics.
Pre-assessment:

I. Multiple Choice: Pick out the letter of the correct answer and write the letter
on the space provided before each number.

_____ 1. Additional cost associated with producing one additional unit of product.

a. Fixed costs
b. Marginal costs
c. Average costs
d. Implicit costs

_____ 2. The amount a firm receives for the sale of its output. P X Q = _____.

a. Profit
b. Marginal Revenue
c. Total Revenue
d. Average Profit

_____ 3. An increase in output which arises from one additional unit of input.

a. Marginal Cost
b. Marginal Revenue
c. Marginal Physical Product
d. Marginal Input
_____ 4. Input costs that may not have a direct outlay of money. Value of the opportunity
cost.

a. Fixed Cost
b. Implicit Cost
c. Variable Cost
d. Explicit Cost
_____ 5. Time in which all costs are variable.

a. Long Run
b. Short Run
Lesson Presentation:

Economic costs are the value

to society of all resources used
in the production of an item. The
economic cost, or opportunity
costs, are measured by the
value of the resources in their
best use, that is, the value in the
foregone opportunities. As a
firm’s production costs,
economic costs are those
payments a firm must make, or
incomes it must provide, to
resource supplies in order to
attract these resources away
from alternative lines of
production. These payments or
incomes may either be:

 Explicit costs are the value of resources purchase for production.

 Implicit costs are the value of self-owned, self-employed resources utilized in
production.
Explicit costs are recorded by accountants and appear on income statements for a firm.
Although they may not be recorded by accountants, implicit costs are also important. A
rational person is unlikely to devote personal resources to uses that provide lower returns
than the resources could earn elsewhere in the economy.
Example 1.
An entrepreneur pays P200,000 in wages/salaries, P30,000 in interest on borrowed money
capital, and P 120,000 for the yearly rental of its office. His explicit costs are P350,000. If
the entrepreneur worked for somebody else as a manager he would earn at most P180,000
per year which is his implicit cost. Thus, his total cost (explicit plus implicit) are P530,000.
Since the total revenue from selling the year’s output is P600,000, this entrepreneur earns a
(pure or economic) profit of P70,000 for the year. Economic profits are total revenue less
all (explicit plus implicit, the latter including a normal profit to the entrepreneur).
Fixed and Variable Costs

Fixed Costs

Unlike variable costs, a company's fixed costs do

not vary with the volume of production. Fixed
costs remain the same regardless of
whether goods or services are produced or
not. Thus, a company cannot avoid fixed
costs.

Using the same example above, suppose

company ABC has a fixed cost of $10,000 per
month to rent the machine it uses to produce mugs.
If the company does not produce any mugs for the
month, it would still need to pay $10,000 for the
cost of renting the machine. On the other
hand, if it produces one million mugs, its fixed
cost remains the same. The variable costs
change from zero to $2 million in this example.
The most common examples of fixed costs include lease and rent payments,
utilities, insurance, certain salaries, and interest payments.

Special Considerations

The more fixed costs a company has, the more revenue a company needs to break even, which means it
needs to work harder to produce and sell its products. That's because these costs occur regularly and rarely
change.

While variable costs tend to remain flat, the impact of fixed costs on a company's bottom line can change
based on the number of products it produces. So, when production increases, the fixed costs drop. The price
of a greater amount of goods can be spread over the same amount of a fixed cost. In this way, a company
may achieve economies of scale by increasing production and lowering costs.

For example, ABC has a lease of $10,000 a month on its production facility and it produces
1,000 mugs per month. As such, it may spread the fixed cost of the lease at $10 per mug. If
it produces 10,000 mugs a month, the fixed cost of the lease goes down, to the tune of $1
per mug.

Fixed cost = Total Cost - Variable Cost

Variable Costs

Variable costs are a company's costs that are associated with the number of goods or
services it produces. A company's
variable costs increase and decrease
with its production volume. When
production volume goes up, the variable
costs will increase. On the other hand, if
the volume goes down, so too will the
variable costs.

Variable costs are generally different between

industries. Therefore, it's not useful to compare
the variable costs of a car manufacturer and an
appliance manufacturer, for example, because
their product output isn't comparable. So it's
better to compare the variable costs between two
businesses that operate in the same industry,
such as two car manufacturers.

You may calculate variable costs by

multiplying the quantity of output by the
variable cost per unit of output. This
calculation is simple and does not take
into account any other costs such as
labor or raw materials.

Suppose company ABC produces ceramic mugs for a cost of $2 a mug. If the company
produces 500 units, its variable cost will be $1,000. However, if the company does not
produce any units, it will not have any variable costs for producing the mugs. Similarly, if the
company produces 1000 units, the cost will rise to $2,000.

Examples of variable costs may include labor, commissions, packaging, and raw materials for production.

 
Companies may have what is called semi-variable costs, which are a mixture of both
variable and fixed costs.

Total Costs

Total costs are the sum of fixed costs plus variable costs in the run. Given a short-run
production schedule and prices for inputs, it is possible to derive fixed, variable, and total
cost schedules by using the definition of each.
TC = FC + VC
FC = TC – VC
VC = TC - FC
Table 1 and Figure 1 show that: variable costs change the output; fixed costs are
independent of the level of output; and, the total cost of any output is the vertical sum of the
fixed and variable costs of that output.

Average and Marginal Costs

The different types of costs can be expressed as averages and marginal as well as totals.
Average costs are the cost per unit of output. Averages can be computed for fixed,
variable, and total costs.

Average Fixed

1. Average Fixed costs (AFC) can be derived by dividing total fixed costs (FC) by the
corresponding output (Q). That is
2. Average variable cost (AVC) is found by dividing total variable cost (VC) by the
corresponding output (Q). That is,

3. Average total cost (ATC) is calculated by dividing total cost (TC) by total output (Q)
or, adding AFC and AVC. That is

Marginal cost (MC) is the additional or extra cost incurred by producing one more unit
of output. Marginal cost is the change in total cost for a one-unit change in quantity.