Lahore School of Economics MBA 1 (2019)

The Costs of
Production

Dr Ayesha Afzal
Assistant Professor
Lahore School of Economics MBA 1 (2019)

Economic Costs
• Economic Cost
• Opportunity Cost
• Explicit Costs
• Implicit Costs
• Normal Profit as a Cost
• Economic or Pure Profit
Economic Total Economic
Profit = Revenue
- Cost
Lahore School of Economics MBA 1 (2019)

Economic Profit Versus Accounting Profits

Economics Accounting
Economic
Profit Accounting

Total Revenue
(Opportunity)
Economic Implicit Costs Profit
(Including a
Costs Normal Profit)

Accounting
Explicit
Costs (Explicit
Costs Costs Only)

Short Run and Long Run

•Short Run: Fixed Plant
•Long Run: Variable Plant
Lahore School of Economics MBA 1 (2019)

Short-Run Production Relationships

• Total Product (TP)
• Marginal Product (MP)
• Average Product (AP)
Change in Total Product
Marginal Product =
Change in Labor Input

Total Product
Average Product = Units of Labor
Lahore School of Economics MBA 1 (2019)

Law of Diminishing Returns

(3) (3)
(1) Marginal Product Average
Units of the (2) (MP), Product
Variable Resource Total Product Change in (2)/ (AP),
(Labor) (TP) Change in (1) (2)/(1)
0 0 -
1 10
] 10 Increasing
10.00
2 25
] 15 Marginal
Returns 12.50
3 45
] 20
15.00
4 60
] 15
Diminishing 15.00
5 70
] 10 Marginal
14.00
75
] 5 Returns
12.50
6
] 0 Negative
7 75 10.71
] -5 Marginal
Returns
8 70 8.75
Lahore School of Economics MBA 1 (2019)

Law of Diminishing Returns

• Graphical Portrayal

Total Product, TP
30
TP

20

10

0
1 2 3 4 5 6 7 8 9
Marginal Product, MP

Increasing Diminishing Negative

Marginal Marginal Marginal
20 Returns Returns Returns

10 AP

1 2 3 4 5 6 7 8 9
MP O 20.2
Lahore School of Economics MBA 1 (2019)

Short-Run Production Costs

•Fixed Costs
•Variable Costs
•Total Cost
TC = TFC + TVC
Lahore School of Economics MBA 1 (2019)

Short-Run Production Costs

• Per-Unit or Average Costs
–Average Fixed Cost (AFC)
–Average Variable Cost (AVC)
–Average Total Cost (ATC)
–Marginal Cost (MC)
TFC TVC
AFC = AVC =
Q Q
TC
ATC = = AFC + AVC
Q
Change in TC
MC =
Change in Q
Lahore School of Economics MBA 1 (2019)

Short-Run Production Costs

Total Cost, Fixed and Variable Costs
$1100
1000 TC
900
TVC
800
700
Costs

600
Fixed
500 Cost
400
300 Total Variable
Cost Cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q
Lahore School of Economics MBA 1 (2019)

Short-Run Production Costs

Average and Marginal Costs
$200

MC
150

AFC
Costs

ATC
100
AVC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q
Lahore School of Economics MBA 1 (2019)

Short-Run Production Costs

• MC and Marginal Product
• Marginal Decisions
• Relation of MC to AVC and ATC
• Relationship Between
Productivity Curves and Cost
Curves
• Shifts in Cost Curves
Graphically…
Lahore School of Economics MBA 1 (2019)

Short-Run
Production Curves
Production Costs

Average Product and

Marginal Product

AP
MP
Quantity of Labor
Cost Curves
MC
AVC
Cost (Dollars)

Quantity of Output
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

• Firm Size and Costs
• Long-Run Cost Curve
• Economies of Scale
–Labor Specialization
–Managerial Specialization
–Efficient Capital
• Diseconomies of Scale
• Constant Returns to Scale
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

Long-Run ATC Curve

Average Total Costs

ATC-1
ATC-5
ATC-2
ATC-3 ATC-4

Output

Any Number of Short-Run Optimum

Size Cost Curves Can Be Constructed
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

Long-Run ATC Curve

Average Total Costs

ATC-1
ATC-5
ATC-2
Long-Run
ATC-3 ATC-4
ATC

Output

The Long-Run ATC Curve Just

“Envelopes” the Short Run ATCs
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

Long-Run ATC Curve

Average Total Costs

ATC-1
ATC-5
ATC-2
Long-Run
ATC-3 ATC-4
ATC

Output

The Long-Run ATC Curve Just

“Envelopes” the Short Run ATCs
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

Alternative Long-Run ATC Shapes
Economies Constant Returns Diseconomies
Average Total Costs Of Scale To Scale Of Scale

Long-Run
ATC

q1 q2
Output

Long-Run ATC Curve Where Economies

Of Scale Exist
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

Alternative Long-Run ATC Shapes
Economies Diseconomies
Average Total Costs Of Scale Of Scale

Long-Run
ATC

Output
Long-Run ATC Curve Where Costs Are
Lowest Only When Large Numbers Are
Participating
Lahore School of Economics MBA 1 (2019)

Long-Run Production Costs

Alternative Long-Run ATC Shapes
Economies Diseconomies
Average Total Costs Of Scale Of Scale

Long-Run
ATC

Output
Long-Run ATC Curve Where Economies
Of Scale Exist, are Exhausted Quickly,
And Turn Back Up Substantially