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PART I

Basic Idea of cost of production

Opportunity cost

Explicit & Implicit cost

Accounting & economic profit

D/B Short & Long Run


• It refers to the transformation of inputs or resources into
outputs of goods and services.

• & Cost exist because resources are scarce, productive &


have alternative use

• COP is a cost which a firm have to bear while involved in


production process i.e. Cost of raw material, rent, wages etc
• It is observed that peoples normally forgoes all
alternative opportunities to use their resources

• Therefore for measuring cost economist always uses


the concept of

Cost measured in terms of


next best alternative
forgone
• To apply the concept of opportunity cost over a particular firm we divide
its factors in two Categories
• Economic (Opportunity) costs include explicit and implicit costs

(Factors/Resources not owned by a Firm)


Explicit Cost are the monetary payment (or expenditure) made
by a firm for the use of resources owned by others
i.e. transportation services, Labor services etc

(Factors/Resources owned by a firm)


– Opportunity cost of resource firm owns
Implicit Cost are the money payments that a self employed
resources could have earned in their best alternative use.
e.g., owner could earn $15 as teacher, implicitly foregone to run firm.
In Accounting Profits Implicit cost is not included, It can be
calculate by Subtracting explicit cost &
depreciation form revenue
Accounting Profit = Revenue - Explicit Costs

Economic profit can be calculated by subtracting


Economic (Opportunity) costs include explicit
and implicit costs from Revenue

Economic Profit = Revenue – Opportunity (Explicit + Implicit) Costs


.
Economic profit is smaller than accounting profit.
Profits to an Profits to an
Economist Accountant
T
Economic (opportunity) Costs

Economic O
T
Profit A Accounting
L Profit
Implicit costs
R
E
V
Explicit Accounting
E
costs (explicit
Costs N
U costs only)
E
•Suppose you are sales representative for a T-short
• fdf
manufacturer
•Earning 22000$ per year
•You decided to open a retail store of your own
•You invest 20000$ from savings & made a sacrifice of 1000$
interest
• this shop is renting out for 5000$
•You also hire clerk & paying 18000$ annually

•A year after you open the store, you total up your Accounts
& find the following
Total sales Revenue 120000$
Cost of T-Shirt 40000$
Clerk salary 18000$
Utilities 5000$
Total (explicit) cost (63000$)
Accounting Profit 57000$
•But this 57000 ignores your implicit cost
•22000$ salary you are getting before opening store
•1000$ interest you are getting annually
•5000$ rent you may get when you rented out your shop
annually
•And lets take your entrepreneurial talent is worth say 5000$
annually
Accounting Profit 57000
Forgone Interest 1000
Forgone rent 5000
Forgone wages 22000
Forgone 5000
entrepreneurial income
Total implicit cost (33000)
Economic Profit 24000
• Difference between short & long Run for
production point of view

•The period of time in which one (or more) of the resources employed in a
production process is fixed or incapable of being varied.

•For example, for a production plant of fixed size and capacity, the firm can
increase output only by employing more labor, such as by paying workers
overtime or by scheduling additional shifts.
Variable Plant

•The period of time in which all the resources employed in a production


process can be varied.

•For e.g: That is, they can change the amount of all inputs used. The firm can
alter its plant capacity, it can build a larger plant or revert to a smaller plant

INPUT: A resource or factor of production, such as a raw material, labor


skill, or piece of equipment, that is employed in a production process
PART II
PART II

Short Run Production Relationship

Law of diminishing Returns

Short Run Production Cost


• The period of time in which one (or more)
of the resources employed in a production
process is fixed or incapable of being
varied.
• For example, for a production plant of
fixed size and capacity, the firm can
increase output only by employing more
labor, such as by paying workers overtime
or by scheduling additional shifts.
It is the total amount of the output
produced in physical units, such as, bushels of
wheat or a number of sneakers etc.

MP of an input is the extra output


produced by 1 additional units of that input
while other inputs are held constant.
Marginal Product = Change in Total Product
Change in Labor Input
Also called labor productivity, is the
output per unit of labor input. It equals
total output divided by total units of input.

Average Product = Total Product


Unit of Labor
minishing Marginal Produ

Diminishing marginal product is the


property whereby the marginal product of
an input declines as the quantity of the
input increases.
Example:
As more and more workers are hired at a
firm, each additional worker contributes
less and less to production because the
firm has a limited amount of equipment.
Law of Diminishing Returns
(1) (2) (3) (4)
Units of the Total Marginal Average
Variable Product Product Product
Resource Change in (2) (2) / (1)
(Labor) Change in
(1)
0 0 ___
1 10 10 10.00
2 25 15 12.50
3 45 20 15.00
4 60 15 15.00
5 70 10 14.00
6 75 5 12.50
7 75 0 10.71
8 70 -5 8.75
75
Total Product,
TP
Total Product

Quantity of Labor
Average Increasing Diminishing Negative
Product, AP, Marginal Marginal Marginal
Returns Returns Returns
and
Marginal Average
Product, MP
Product

Marginal
Quantity of Labor Product
Returns to scale
In economics, returns to
scale and economies of scale are
related terms that describe what
happens as the scale of production
increases

There are 3 types of returns to scale:


constant, increasing, and
decreasing.
Example
If the quantity of all inputs used in the
production is increased by a given
proportion,

•We have Constant returns to scale if


output increases in the same
proportion;

•Increasing returns to scale if output


increases by a greater proportion; and

•Decreasing returns to scale if output


increases by a smaller proportion.
Constant Returns to Scale

6 B

200Q

3 A

100Q

3 6
Increasing returns to scale

6 C

300Q

3 A

100Q
Labor
3 6
Decreasing Returns to Scale

capital

6
D
150Q
3 A
100Q

labor
3 6
• Short Run Costs are either fixed or Variable

Cost that in total do not vary with changes.

Cost that change with the change in level of output.


TC
TVC
Fixed
Cost
Costs (dollars)

Total Variable
Cost Cost
TFC
Quantity
Average cost is the total cost divided by the total
number of units produced.
OR
Average cost is the sum of average variable costs plus
average fixed costs.

Average cost = Total cost / output


Three types of Avg. Costs:

Average Fixed Cost (AVF) = Total FC


Quantity

Average Variable Cost (AVC) = Total VC


Quantity

Average Total Cost (ATC) = Total Cost


Quantity
ATC = AFC + AVC
It is the extra or additional cost of producing one more
unit of Output

MC = Change in TC
Change in Q
HORT RUN SCHEDULE FOR VARIOUS COST

0.94
(b) Marginal- and Average-Cost Curves

Costs

$3.00

2.50
MC
2.00

1.50
ATC
AVC
1.00

0.50
AFC
0 2 4 6 8 10 12 14
Quantity of Output (bagels per hour)
Suppose a baseball pitcher has allowed his
opponents an average of 3 runs per game in the
first three games. Now, Whether his average falls or
rises as a result of pitching a 4th(marginal) game will
depend on whether the additional runs he allowed in
the extra game are fewer or more than his current (3)
run avg. If the 4th game he allows fewer than (3) run,
for e.g., 1 run, his total runs will rise from 9 to 10 and
his Avg. will fall from (3) to (2.5). Conversely, if in the
4th game he allows more than 3 runs say, (7), his total
will increase from (9) to (16) and his avg. will rise from
3 to 4 (=16/4).
Reference: Mcconell Page number 425
Cost Curves Relations
MC relationship to AVC and AC
MC below AVC and AC, AVC and AC will
falling
MC above AVC and AC, AVC and AC will
rising
MC equals AVC, AVC at minimum
MC equals AC, AC at minimum

Shapes of cost curves related to shapes of


product curves
Average product and
Costs (dollars) Quantity of labor marginal product

Quantity of output
MP

MC
AP

AVC
PART III
PART III
LONG-RUN

LONG RUN PRODUCTION COST

LONG-RUN COST CURVES

ECOMOMIES O& DISECONOMIES OF SCALE


• In long run all factor of production are
variable, an industry and the individual
firms it comprises can undertake all
desired resource adjustments. That is,
they can change the amount of all inputs
used. The firm can alter its plant capacity,
it can build a larger plant or revert to a
smaller plant.

http://www.scribd.com/doc/6607244/Cost-of-Production
ATC

ATC 4

ATC 1 ATC 2 ATC 3 ATC 5

Output
• The long run ATC curves shows the lowest
average total cost at which any out put level can
be produces after the firm has had the time to
make all appropriate adjustments in its plant
size.
Average total cost

Long run
ATC

Out put
• refer to the property
whereby long-run average total cost falls as the
quantity of output increases.
• refer to the property
whereby long-run average total cost rises as the
quantity of output increases.
• refers to the
property whereby long-run average total cost
stays the same as the quantity of output
increases
Economies Constant returnsDiseconomies
of scale to scale of scale
Average total cost

long-run ATC

Out put
Average total cost

long-run ATC

Out put
long-run ATC
Average total cost

Out put