THE COST OF PRODUCTION

CHAPTER OUTLINE
 Measuring Cost: Which Costs Matter?
 Cost in the Short Run

 Cost in the Long Run

 Long-Run versus Short-Run Cost Curves

 Production with Two Outputs—Economies of Scope

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MEASURING COST: WHICH ONE
MATTERS
 Economic Cost versus Accounting Cost
● accounting cost: Actual expenses plus depreciation
charges for capital equipment.
● economic cost: Cost to a firm of utilizing economic
resources in production, including opportunity cost.
 Opportunity Cost

Cost associated with opportunities that are forgone when a

firm’s resources are not put to their best alternative use.
It is the next best alternative:

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MEASURING COST: WHICH ONE
MATTERS
 Sunk cost: Expenditure that has been made and cannot
be recovered. Such as R&D costs.
Because a sunk cost cannot be recovered, it should not
influence the firm’s decisions.
 fixed cost (FC): Cost that does not vary with the level
of output and that can be eliminated only by shutting
down. Such as, machinery cost, rent, fixed utility bills
etc.
 variable cost (VC): Cost that varies as output varies.
Example, labor wages, input costs
 Total cost (TC): It’s the summation of fixed and
variable cost. 4
 total cost (TC) Fixed costs plus variable costs.
 total fixed costs (TFC) The total of all costs that do not change with output,
even if output is zero.
 average fixed cost (AFC) Total fixed cost divided by the number of units of
output; a per-unit measure of fixed costs.
 total variable cost (TVC) The total of all costs that vary with output in the short
run.
 total variable cost curve A graph that shows the relationship between total
variable cost and the level of a firm’s output.
 marginal cost (MC) The increase in total cost that results from producing one
more unit of output. Marginal costs reflect changes in variable costs.
 average variable cost (AVC) Total variable cost divided by the number of units
of output.
 average total cost (ATC) Total cost divided by the number of units of output.
 total revenue (TR) The total amount that a firm takes in from the sale of its
product: the price per unit times the quantity of output the firm decides to
produce (P x q).
 marginal revenue (MR) The additional revenue that a firm takes in when it
increases output by one additional unit. In perfect competition, P = MR.
MEASURING COST: WHICH ONE
MATTERS
 marginal cost (MC): Increase in cost resulting from the
production of one extra unit of output.

 average total cost (ATC): Firm’s total cost divided by

its level of output.
 average fixed cost (AFC): Fixed cost divided by the
level of output.
 average variable cost (AVC): Variable cost divided by
the level of output.
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TYPES OF COSTS: A NUMERICAL
EXAMPLE

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PAGE 239, RELATIONSHIP BETWEEN MC AND AVC; MC AND ATC
1. WHEN AVC DECREASES, MC ALSO DECREASES [ MC IS
BELOW OF AVC]
2. WHEN AVC = MC, AVC IS LOWEST
3. WHEN AVC IS INCREASING, MC IS ALSO INCREASING
[ MC IS ABOVE OF AVC]

Managerial Economics
8
COST CURVES

9
Average and Marginal Cost Curves
SHORT-RUN SUPPLY CURVE
 The point from where MC exceeds AVC, supply starts.
 If we add horizontally the MC curves, we get Supply

Managerial Economics
curve for the market.

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MATHEMATICAL EXAMPLE
3. A firm has a fixed production cost of $5,000 and a
constant marginal cost of production of $500 per unit
produced.
 What is the firm’s total cost function? Average cost?

 EXERCISE: 2 , 3, 8, 9, 11, 12

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The short-run cost function of a company is given by the
equation TC = 200 + 55q, where TC is the total cost and q is
the total quantity of output, both measured in thousands.
 What is the company’s fixed cost?

 If the company produced 100,000 units of goods, what

would be its average variable cost?
 What would be its marginal cost of production?

 What would be its average fixed cost?

 Suppose the company borrows money and expands its

factory. Its fixed cost rises by $50,000, but its variable cost
falls to $45,000 per 1000 units. The cost of interest (i) also
enters into the equation. Each 1-point increase in the interest
rate raises costs by $3,000. Write the new cost equation.
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FINDING COST MINIMIZING BUNDLE OF INPUT

 Iso-cost line is similar to

budget line with equation
of:
C = wL + rK

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 COST IN THE LONG RUN

Choosing Inputs

Recall that in our analysis of production technology, we showed

that the marginal rate of technical substitution of labor for
capital (MRTS) is the negative of the slope of the isoquant and
is equal to the ratio of the marginal products of labor and
capital:

It follows that when a firm minimizes the cost of producing a particular

output, the following condition holds:

We can rewrite this condition slightly as follows:

 Long-Run Costs
 Long-run total cost (LTC) for a given level of
output is given by:
LTC = wL* + rK*
Where w & r are prices of labor & capital,
respectively, & (L*, K*) is the input combination on
the expansion path that minimizes the total cost of
producing that output

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 Long-Run Costs
 Long-run average cost (LAC) measures the cost per unit of output
when production can be adjusted so that the optimal amount of each
input is employed. The long-run average cost curve shows the
relationship between the lowest attainable average total cost and
output when both the plant and labor are varied.
 LAC is U-shaped
 Falling LAC indicates economies of scale
 Rising LAC indicates diseconomies of scale
 Long-run marginal cost (LMC) measures the rate of change in long-
run total cost as output changes along expansion path
 LMC is U-shaped
LTC
LAC 
Q
 Economies of Scope
 Exist for a multi-product firm when the joint
cost of producing two or more goods is less
than the sum of the separate costs of
producing the two goods
 For two goods, X & Y, economies of scope
exist when:
C(X, Y) < C(X) + C(Y)
 Diseconomies of scope exist when:
C(X, Y) > C(X) + C(Y)

Michael R. Baye, Managerial Economics and Business Strategy, 4e. ©The McGraw-Hill Companies, Inc. , 2003
 SHORT RUN VS LONG RUN COST
 In the short-run one input
or factor of production
(usually capital) is
constant. And thus in the
short run we can’t make
choice between different
combinations of labor
and capital to produce a
specific quantity. When
Labor become costly we
can chose capital and thus
move to point B. In the
long run, that’s possible. 19
 INFLEXIBILITY OF SHORT-RUN
 Output is initially at level
q1. In the short run, output
q2 can be produced only by
increasing labor from L1 to
L3 because capital is fixed
at K1.

 In the long run, the same

output can be produced
more cheaply by increasing
labor from L1 to L2 and
capital from K1 to K2.
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LONG RUN VS SHORT RUN COST
CURVES
 The long-run average cost
curve LAC is the envelope
of the short-run average

Managerial Economics
cost curves SAC1, SAC2,
and SAC3.
 With economies and
diseconomies of scale, the
minimum points of the
shortrun average cost
curves do not lie on the
long-run average cost
curve. 21
Long – Run Average Total Cost Curve
• Long Run Average Total Cost Curve shows
the lowest unit cost at which the firm can
produce any given level of output.
 How ATC Changes as
the Scale of Production Changes
Economies of scale: Situation in
which output can be doubled for
less than a doubling of cost. ATC
ATC
falls as Q increases.
Constant returns to scale: ATC
stays the same LRATC
as Q increases.
Diseconomies of scale: ATC
rises as Q increases. Situation in
which a doubling of output
requires more than a doubling of
cost.
Increasing Returns to Scale:
Output more than doubles when Q
the quantities of all inputs are
doubled.

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ECONOMIES OF SCALE
 Economies of scale Situation in which output can be
doubled for less than a doubling of cost.

Managerial Economics
 Diseconomies of scale Situation in which a doubling of
output requires more than a doubling of cost.

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 LEARNING CURVE
 learning curve Graph
relating amount of
inputs needed by a firm
to produce each unit of
output to its cumulative
output.
 Firm’s production cost
may fall over time as
managers and workers
become more experienced
and more effective at
using the available plant
25
and equipment.
 APPLICATION OF LEARNING
CURVE
 A firm’s average cost of
production can decline
over time because of
growth of sales when
increasing returns are
present (a move from A to
B on curve AC1),
 or it can decline because
there is a learning curve (a
move from A on curve
AC1 to C on curve AC2).
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FEW MATHEMATICAL WORKS
1. The total cost function of a good is given by
TC = Q2 + 3Q + 36.
Calculate the level of output that minimizes average cost.
Find AC and MC at this value of Q.
2. A firm’s short run production function is given by Q =
30L2 – 0.5 L3
Find the value of L which maximizes APL and verify that
MPL = APL at this point.

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ANSWER. 1
TC = Q2 + 3Q + 36 [ TWO STAGE; Q; Q2]
FC = 36; AFC = FC/Q = 36/Q

Managerial Economics
VC = Q2 + 3Q ; AVC = VC/Q = Q+ 3
MC = dTC/dQ = 2Q+ 3
1) MC = AC
2Q+3 = TC/Q = Q+3+36/Q
2Q+3 – Q -3 - 36/Q = 0
Q -36/Q = 0
Q2 -36 = 0
Q = +-6 ; Q = 6 AT Q = 6, AC IS LOWEST]
AT Q = 6; AC = Q+3+36/Q = TAKA 15 28
 ANSWER. 2
A firm’s short run production function is given by Q = 30L 2 – 0.5 L3
Find the value of L which maximizes APL and verify that MPL =
APL at this point.

Managerial Economics
A firm’s short run production function is given by Q = 30L 2 – 0.5 L3
APL = Q/L = 30L2 – 0.5 L3/L

= 30L – 0.5l^2
MPL = dQ/dL = 60l – 0.5*3*L^3 -1
= 60L – 1.5L^2
APL = MPL
30L – 0.5l^2 = 60L – 1.5L^2
L = 0; 30
L = 30 [[ APL = = 30L – 0.5l^2 = 450]]; MPL = = 60L – 1.5L^2 =450

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EXAMPLE. EX 11, PAGE 272, CH.7
 Suppose that a firm’s production function is q =
10L1/2K1/2. The cost of a unit of labor is $20 and the cost
of a unit of capital is $80.
a. The firm is currently producing 100 units of output and
has determined that the cost-minimizing quantities of
labor and capital are 20 and 5, respectively.
Graphically illustrate this using isoquants and isocost
lines.
b. The firm now wants to increase output to 140 units. If
capital is fixed in the short run, how much labor will
the firm require? Illustrate this point graphically and
find the firm’s new total cost.
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CONTINUES......
c. Graphically identify the cost-minimizing level of capital
and labor in the long run if the firm wants to produce
140 units.
d. If the marginal rate of technical substitution is K/L , find
the optimal level of capital and labor required to produce
the 140 units of output.

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 Suppose that a firm’s production function is Q =
10L1/2K1/2. The cost of a unit of labor is $20 and the cost
of a unit of capital is $80.
 Q = 140= 10L1/2K1/2.

MRTS = SLOPE OF ISO-QUANT = K/L

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FOR COST MINIMIZATION
MRTS = w/r
k/L = 20/80 = ¼
K/L = ¼; L = 4K
Q = 140= 10L1/2K1/2.= 10(4K)^1/2*K^1/2
K = 7 ; L = 4K = 28
C = wl+rk = $20*28 + $80*7 = 1120 ; 1120/ 20 = 56L;
1120/80 = 14 32
 Cost Minimization
 Marginal product per dollar spent should be
equal for all inputs:

MPL MPK

w r
 Expressed differently
w
MRTS KL 
r
 Cost Minimization

Point of Cost
Slope of Isocost Minimization
=
Slope of
Isoquant

L
 Example
 A micro-entrepreneur produces caps and hats for women. The output-cost
data of the business is reproduced below: [ AC =TC/Q; MC = dTC/dQ]

Output Total
Cost
50 870 a. Estimate the total cost function and then use that
100 920 equation to determine the average and marginal
150 990 cost functions. Assume a cost function.
b. Determine the output rate that will minimize
200 1240 average cost and the per-unit cost at that rate of
250 1440 output.
300 1940 c. The current market price of caps and hats per unit
350 2330 is Tk. 6.00 and is expected to remain at that level
for the foreseeable future. Should the firm continue
its production? [DECISION MAKING; P> AC;
MAKE PROFIT, P<AC, LOSS; DO NOT
CONTINUE]
 Estimate of Example
TC= f(Q Q^2 Q^3)
 First we assume the cost function as
TC = c0+c1Q + c2Q2 +c3Q3
 Results
TC= 954.29 -2.46Q +0.02Q2 -.0002Q3
(5.9) (-0.75) (1.04) (-0.07)
R2 = 0.99 F = 197.78
 Comments: t-statistics are not acceptable though R2 and F are good.
 Second, we assume the cost function as
TC = c0+c1Q + c2Q2
Results
 TC = 944.29 -2.24Q + 0.02Q2
t Stat (12.51) (-2.58) (8.45)
R2 = 0.99 F = 394.86
 Comments: t-statistics are acceptable and R2 and F are good.
 b)
 AC = TC/Q= 944.29/Q -2.24 + 0.02Q
= 944.29Q-1 – 2.24 +0.02q
dAC/dq = -944.29Q-1-1+0.02 =0
-944.29/q2 + 0.02 = 0
-944.29+0.02q2 = 0
0.02q2 = 944.29; q2=
Q = 217.29
AC(Q = 217.29) = TC/Q= 944.29/Q -2.24 + 0.02Q
AC(min)= 944.29/217.29 – 2.24 +0.02*217.29 = Taka 6.45
Price = Taka 6; your AC = Taka 6.45; should you produce?
Decision: WE should not produce.
……………………………………………………………………….

THE COSTS OF PRODUCTION 37

Answer (a) contd.
 Answer (b) contd.

Sign mistake
 Answer (c)
 Because the lowest possible cost is Tk. 6.45 per
unit, which is above the market price of Tk. 6.00,
the production should not be continued.
 Learning Curve
12. A computer company’s cost function, which relates its
average cost of production AC to its cumulative output in
thousands of computers Q and its plant size in terms of
thousands of computers produced per year q, within the
production range of 10,000 to 50,000 computers is given by
AC = 10 - 0.1Q + 0.3q
As Q (cumulative output ) goes up, AC is going
down [ look at the sign of Q, which is negative]; so
learning curve is present

THE COSTS OF PRODUCTION 41

(c). During its existence, the firm has produced a
total of 40,000 [= Q] computers and is producing
10,000 computers this year [ =q]. Next year it plans
to increase its production to 12,000 computers. Will
its average cost of production increase or
decrease? Explain.
 First, calculate average cost this year:
AC1 = 10 - 0.1Q + 0.3q = 10 - (0.1) (40) + (0.3) (10) = $9.
Second, calculate the average cost next year:
AC2 = 10 - (0.1)*50 + (0.3)(12) = $8.6.

THE COSTS OF PRODUCTION 42