CHAPTER-6

THE COST OF PRODUCTION

MANAGERIAL ECONOMICS (BUS-525)

COURSE CONVENER:
DR. TAMGID AHMED CHOWDHURY
CHAPTER OUTLINE
 Measuring Cost: Which Costs Matter?
 Cost in the Short Run

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 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.

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● 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

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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
MEASURING COST: WHICH ONE
MATTERS
 marginal cost (MC): Increase in cost resulting from the
production of one extra unit of output.

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 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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 Managerial Economics
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COST CURVES
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.

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 What is the firm’s total cost function? Average cost?

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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

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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:

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C = wL + rK

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 SHORT RUN VS LONG RUN COST
 In the short-run one input
or factor of production
(usually capital) is

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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. 11
 INFLEXIBILITY OF SHORT-RUN
 Output is initially at level
q1. In the short run, output
q2 can be produced only by

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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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EXAMPLE
 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.
The firm is currently producing 100 units of output and

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a.
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.

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

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 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

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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
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and equipment.
 APPLICATION OF LEARNING
CURVE
 A firm’s average cost of
production can decline
over time because of

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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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