Cost of Production

Cost function
• It shows the relationship between cost and output
• It depends on production conditions and price of the factors of
production
• Costs of production are a major force deciding the supply of the
product
Types of Cost
• Opportunity cost- of a producing a good / service is all that has been forgone
to produce that good
Opportunity cost = explicit cost + implicit cost
• Explicit cost and Implicit cost
• Explicit costs---- contractual cash payments to other factor owners for
purchasing or hiring the various factors- actual or business costs entered in
the books of accounts eg payments on account of wages, salaries, utility
expenses, interest, rent, purchase of materials, license fee, insurance
premium and depreciation charges
• Implicit / imputed cost ----there are certain other costs which do not take the
form of cash outlays nor do they appear in the accounting system. eg return
on money capital invested by entrepreneur – wages or salary forgone
• Accounting cost and Economic cost
 Accounting cost are explicit concept
Economic cost = Accounting cost + Implicit cost
Economic profit = Total Revenue – Total Economic Costs
Accounting profit = Total Revenue – Accounting costs
Eg. An owner of a drug store had the following information about her
receipts and expenditures per year:
Income= $10,00,000 , Wages = $3,00,000
Utilities = $20,000 , Raw materials =$ 5,00,000
She could work elsewhere earning $2,00,000. Find her accounting
profit? What would you advise her ?
• Accounting cost = 3,00,000 + 20,000 + 5,00,000 = 8,20,000
Implicit cost = 2,00,000
Accounting profit = 10,00,000 – 8,20,000 = 1,80,000
Economic costs = 8,20,000 + 2,00,000 = 10,20,000
Economic Profit = 10,00,000 – 10,20,000 = - 20, 000
loss, Advice ?
• Fixed / Overhead cost – cost of fixed factors – do not change with
output – cannot be altered in short run- Fixed costs include interest
on borrowed capital, rent for equipment or factory building,
depreciation charges on machinery, and salaries of permanent
employees
• Variable cost – cost of variable factors eg raw material, labour–
change with change in the level of output- are nil at zero level of
output – can be altered in short run
•  Semi variable cost – have elements of both fixed and variable costs-
they are fixed for a certain level of production and become variable
after this level is exceeded eg. Cost of electricity telephone bill, costs
of operating certain equipments or vehicles, ( air crafts on lease by
air lines, cranes, road rollers etc)

• Total cost – TFC + TVC

• Marginal cost – addition to the total cost when an additional unit of
the output is produced
• MC =
MCn = TCn – TCn-1
 No. of TFC TVC TC
units of
output

0 50 0 50
1 50 20 70
2 50 35 85
3 50 60 110
4 50 100 150
5 50 145 195 50
6 50 190 240
7 50 237 287
8 50 292 342
Short Run Average Cost Curves
•  Average fixed Cost : AFC =
• Average Variable Cost : AVC =
• Average total Cost : ATC = AC = AFC + AVC
AC =
• Marginal cost : MC = = = ( = 0)
(fixed costs do not change in the short run)
Units of TFC TVC TC AFC AVC ATC MC
output
0 50 0 50 -- --- --- --
1 50 20 70 50 20 70
20
2 50 35 85 25 17.50 42.50
15
3 50 60 110 16.67 20 36.67
25
4 50 100 150 12.50 25 37.50
5 50 145 195 10 29 39 40
6 50 190 240 8.33 31.67 40 45
7 50 237 287 7.14 33.86 41 45
8 50 292 342 6.25 36.50 42.75 47
55
 Cost curves in the short run
Relation between MC and ATC, AVC
MC intersects ATC and AVC at their lowest
points
When MC < AVC , AVC falls
When MC > AVC , AVC rises
When MC = AVC , AVC is minimum
J
When MC < ATC , ATC falls
A
D When MC > ATC , ATC rises
H When MC = ATC , ATC is minimum
K
Vertical distance between ATC and AVC = the
vertical distance between AFC and x axis
B M N
F
The “U” shape of ATC, AVC, SMC is due to the
G E Law of Diminishing Marginal Returns

AFC falls continuously as output increases

Q1 Q2
A
Relationship between cost
curves and product curves
Cost curves are the mirror
images of the product curves
As MP rises each additional
unit of labour is being more
productive– thus marginal
cost per unit of output falls
As AP rises ie each unit of
labour is more productive
Cost per unit of output falls

A’
Relationship between cost and productivity
•  Relation between AVC and •  Relation between MC and
Average Product Marginal Product
AVC = = MC = =
( Q = AP L ) ( TFC = 0 , = w L )
AVC = = MC = =
AVC = w() ( MPL = )
MC = w()
Find FC, VC, MC, AVC, AFC, ATC/AC

Units of Total cost Fixed cost Variable cost Marginal cost

output
0 50 50 0 ---
1 70 50 20 20
2 85 50 35 15
3 110 50 60 25
4 150 50 100 40
5 195 50 145 45
6 240 50 190 45
7 287 50 237 47
8 342 50 292 55
 Long Run Average Cost Curve
• Long Run Average Cost Curve – depicts the least possible average cost
for producing various levels of output when all factors including the
size of the plant have been adjusted
• It is also called the Envelope curve as it supports all the short run
curves from below
Envelope curve-Long Run Average Cost
Curve
LAC curve and LMC curve
 Minimum Efficient Scale(MES)

• MES – LRAC is minimum , LRAC = LRMC at pt. L

• A firm’s minimum efficient scale (MES) is the lowest
scale necessary for it to achieve the economies of
scale required to operate efficiently and competitively in
its industry. No further significant economies of scale
can be achieved beyond this scale.
• Minimum efficient scale affects the number of firms
that can operate in a market, and the structure of
markets.
• When minimum efficient scale is low, relative to the size
of the whole industry, a large number of firms can
operate efficiently, as in the case of most retail
businesses, like corner shops and restaurants.

• However, if minimum efficient scale can only be

achieved at very high levels of output relative to the
whole industry, the number of firms in the industry will
be small. This is the case with natural monopolies, such
as water, gas, and electricity supply.
Shape of the LAC -- Reasons

Per unit

IRS CRS DRS

Economies and Diseconomies of scale
• Economies of Scale - types:
• Internal economies of scale: These are the advantages to the firm due to
its large scale of production.
• External economies of scale: These refer to the benefits enjoyed by all
firms in the industry when the industry expands.
• Diseconomies of Scale - types:
• Internal diseconomies of scale: These are the disadvantages to a firm due
to its large scale of operation.
• External diseconomies of scale: These are the disadvantages to firms due
to expansion of the industry
 INTERNAL ECONOMIES :
• Labour Economies : benefits of specialisation of skills and division of
labour , thus improving their efficiency and saving time and cost.
• Managerial Economies: benefits enjoyed by large firm when it
delegates the different branches of management like finance,
marketing, administration etc to specialised managers.it improves the
efficiency of the firm.
• Technical Efficiencies: benefits enjoyed by a large firm due to efficient
utilisation of machinery, superior technology, use of wastes to
produce by-products, use assembly-line production, integrating
successive production processes under one unit etc.
• Marketing Economies: benefits due to bulk purchases of raw
materials and sale of the finished products in the market - large scale
purchases - better bargaining position and maintain stock of
inventories - can undertake expenditure on advertisement
• Financial Economies: easier for large firms to obtain finance from the
financial system as considered less risky in comparision to smaller
firms by banks and various financial institutions - can also raise funds
from the domestic and foreign capital markets.
• Network Economies occur primarily in online businesses. As firms
cater to more customers with the existing infrastructure, their per
unit cost reduces
 INTERNAL DISECONOMIES
• Very large scale of production can lead to issues related to
coordination, supervision and management and lack of
personal relations with the work force & inefficiencies of
management offset the economies of scale
• Entrepreneur is a fixed indivisible factor – once the abilities
of this fixed factor are best utilised, further increases in scale
of operation by increasing other inputs causes cost per unit
of output to rise
 EXTERNAL ECONOMIES:
• Cheaper Raw Material and Capital Equipment: As an industry expands
the demand for various types of inputs and capital equipment
required by it increases which leads to their production on a larger
scale, thereby lowering their cost of production and hence their
prices.
• Development of Skilled Labour: An expanding industry increases the
demand for labour force equipped with specific skills required by the
industry. Thus, encouraging the workers to adopt the specific skills
and also encouraging educational institutes to impart education
regarding the specific skills
• Research and Information Economies: expansion of industry
investment in R & D, reducing costs for individual firms -
industrial trade associations distribution of information,
technical knowledge, market possibilities - publishing
journals, setting up research labs and organising exhibitions
etc.
• Advantages of localisation: firms situated in a particular
area or zone, take advantage of common facilities like
transportation, communication, infrastructure, research labs,
sharing of skilled work force and even marketing facilities
etc.
• Growth of Subsidiary and Correlated Industries: Such
industries specialise in the production of raw materials,
tools, equipments etc required by the main industry - some
may use the waste products of the main industry
 EXTERNAL DISECONOMIES:
• Rise in prices of factor inputs: Expansion of an industry would lead to
increase in demand for scarce resources and skilled work force which
in turn can push up their prices, till the time their supply increases
sufficiently to match the demand.
• Promotional expenditure: Increased competition among the
expanding firms will require additional expenditure on promotional
activities like advertisements, discounts etc to increase their market
share.
Economies of Scope
• Situation
  in which joint output of a single firm is greater than output that
could be achieved by two different firms when each produces a single
product.
• Degree of economies of scope - percentage of the cost of production that
is saved when two (or more) products are produced jointly rather than
individually.
SC =
C(q1) = cost of producing only output q1, C(q2) = cost of producing only q2,
C(q1, q2) = joint cost of producing both the points, SC is the percentage
cost saving when the goods are produced together.
SC > 0 (economies exist), SC < 0 (diseconomies exist)
• Example of Economies of Scope
• For example, a restaurant produces both hamburgers and sandwiches. The cost of
separately producing 1,000,000 hamburgers is $0.50 each, if 4,000,000
sandwiches are produced separately, the cost is $0.30 each. If 1,000,000
hamburgers and 4,000,000 sandwiches are produced together (by using the same
preparation and storage facility), the total cost is $1,500,000.
• To determine the economies of scope:
C(q1) = 1,000,000 x 0.50 = $500,000
C(q2) = 4,000,000 x 0.30 = $1,200,000
C(q1+q2) = $1,500,000

• ($500,000 + $1,200,000 – $1,500,000) / $1,500,000 = 13.33%. Therefore, the cost

of producing hamburgers and sandwiches together is 13.33% less than the cost of
producing them separately.
• How to attain economies of scope – flexible manufacturing,
specialisation & diversification – mergers

• Advantages - allow a company to gain efficiency from producing a

larger variety of products - sell a greater range of products - respond
to changes in consumer preferences - reduces risks for a company by
allowing for related diversification, the company can adapt to market
changes
• If Boeing produces 9 jets per month, its long-run total cost is $9.0
million per month. If it produces 10 jets per month, its long-run total
cost is $9.5 million per month. Does Boeing exhibit economies or
diseconomies of scale?

Ans = with 9 jets, AC = 9,000,000/9 = 1,000,000

With 10 jets, AC = 9,500,000/10 = 950,000
• Consider the following table of long-run total costs for three different
firms, Does each of these firms experience economies of scale or
diseconomies of scale?

Quantity Firm A Firm B Firm C

1 60 11 21
2 70 24 34
3 80 39 49
4 90 56 66
5 100 75 85
6 110 96 106
7 120 119 129
• The city government is considering two tax proposals: • A lump-sum
tax of $300 on each producer of hamburgers. • A tax of $1 per burger,
paid by producers of hamburgers. a. Which of the following curves—
average fixed cost, average variable cost, average total cost, and
marginal cost—would shift as a result of the lump-sum tax? Why?
Show this in a graph.
• b. Which of these same four curves would shift as a result of the per-
burger tax? Why? Show this in a new graph.
• Lumpsum tax- a fixed tax that has to be paid irrespective of the level
of output – increase fixed cost – total cost will also increase – so AFC,
ATC increases
• Per unit tax will have no effect on fixed cost , but AVC, MC, ATC(AC)
will shift up by the amount of the tax ($1)