Costs of Production

Costs of Production
Costs of Production
Short run Cost Curves
• Cost curves show the minimum cost of producing various
levels of output
• Both explicit and implicit costs are included
• Explicit costs refer to the actual expenditures of the firm
to purchase or hire the inputs it needs
• Implicit costs refer to the value of inputs owned by the
firm and used by the firm in its own production process
• The value of these owned inputs should be imputed or
estimated from what they could earn in their best
alternative use
Costs of Production
Short run
• In the short run, one or more (but not all) factor(s) of
production are fixed in quantity
• In the short run there are total fixed costs, total variable
costs and total costs
Total fixed costs (TFC) are the costs that the firm incurs in the
short run for its fixed inputs
These are constant regardless of the level of output and of whether it
produces or not
An example of TFC is the rent that a producer must pay for the factory
building over the life of a lease
Costs of Production
• Total variable costs (TVC) are costs incurred by the
firm for the variable inputs it uses
• These vary directly with the level of output and are zero
when no output is produced e.g. raw material costs, labour
costs
• Total costs (TC) are equal to the sum of total fixed costs
and total variable costs
• Though total Costs are very important, average costs are
even more important in the short-run analysis of the firm
Costs of Production
Short run Average Cost Curves
• The short run per unit costs that we consider the average
fixed costs, the average variable cost and the average cost
• Average fixed cost (AFC) equals total fixed costs divided
by output
• Average variable cost (AVC) equals total variable costs
divided by output
• Average cost (AC) equals total costs divided by output
(also equals AFC plus AVC
• Marginal Cost (MC) equals the change in TC, or the
change in TVC per unit change in output
Short Run Costs
• Example
Short Run Costs
• From the table above we get the following graphs
Long Run Costs
• In the long run, there are no fixed factors, and a
firm can build a plant of any size
• Once a frim has constructed a particular plant, it
operates in the short run
• A plant size can be represented by its short run
average cost (SAC) curve
Long Run Costs
• Larger plants can be represented by SAC curves
which lie further to the right
• The LAC curve shows the minimum per unit costs of
producing each level of output when any desired
plant can be built
• The LAC curve is thus formed from the relevant
segments of the SAC curves
Long Run Costs
• When we sketch these 5 SAC curves on the same set of

axes, we can derive the LAC
Long Run Costs
To produce up to 3
units of output the
firm should utilize
plant 1 (given by
SAC1)
From 3 to 5.5 units of output it should build the larger plant

given by SAC2 etc.
Note that the firm could produce 4 units with plant 1 but at
a higher cost than with plant 2
Long Run Costs
The irrelevant portions
of the SAC curves are
dashed
The undashed portions
form the LAC curve
So the LAC curve is obtained by joining points A, B, C, D, E, F,

G, H, M, N and R
By drawing many more SAC curves, we would get a smoother
LAC curve
Long Run Costs
At point F on the LAC
curve, the firm would
be operating at its
optimum rate of
output
To produce outputs less than 7 units (point F) the firm would

underutilize its potential, i.e . Produce less than the optimum
rate of output with a smaller than the optimum scale of plant
in the long run
Long Run Costs
If the firm were
utilizing the plant
indicated by SAC1
curve at point B, and
wanted to expand
output from 2 - 4 units
In the short run it would have to produce the optimum rate
of output with plant 1, but in the long run the firm would
build a larger scale plant SAC2 and operate at point D
Plant 2 is smaller than the optimum scale of plant
Long Run Costs
To produce more than
seven units of output
per time period, the
firm would overutilize
(be larger than
optimum) its potential
The firm may know the approximate shape of the alternative
SAC curves either from experience or from engineering
studies
Long Run Costs
• While the shapes of the SAC and the LAC curve are
U-shaped the reason for their shapes is quite
different
• The SAC curves decline first, but eventually rise
because of the operation of the law of diminishing
returns (resulting from the existence of fixed inputs
in the short run)
• In the long run there are no fixed inputs, and the
shape of the LAC is determined by economies and
diseconomies of scale
Long Run Costs
• As output expands from very low levels, increasing
returns to scale cause the LAC curve to decline
initially
• But as output becomes greater and greater
diseconomies of scale may become prevalent,
causing the LAC to start rising
The Long Run Marginal Cost Curve
• Long run marginal cost (LMC) measures the change in the
long run total cost (LTC) per unit change in output
• The LTC for any level of output can be obtained by
multiplying output by the the LAC level of output
• By plotting the LMC values midway between the
successive levels of output and joining these points we get
the LMC curve
• The LMC curve is U-shaped and reaches its minimum at
the point before the LAC curve reaches the minimum point
• The rising portion of the LMC goes through the lowest LAC
curve.
• Note that when the LAC is declining, the LMC curve is
below it
• When the LAC is rising the LMC is above it
• When the LAC is at its minimum point LMC=LAC
• The reason is that for the LAC to fall, the addition to the
LTC to produce one more unit of output (LMC) must be
less than the previous LAC
• Similarly, for the LAC to rise, the addition to LTC to
produce one more unit of output (LMC) must be greater
than the previous LAC
• For LAC to remain unchanged, the LMC must equal the LAC
Technological Progress
• Refers to an increase in the productivity of inputs
and can be represented by a shift toward the origin
of the isoquant referring to any level of output
This means that
• any level of output can be produced with fewer
inputs, or
• more outputs can be produced with the same inputs
Neutral technological progress
The figure shows neutral technological
progress.
Here technological progress increases
MPK and MPL in the same proportion
Here MRTSLK = MPL/MPK = the slope of
isoquant remains constant at point E1
and E2 along the original K/L=1 ray
Q=100 can now be produced with 2L
and 2K instead of 4L and 4K
K-based technological progress
The figure shows K-using technological
progress.
MPK proportionately more than MPL
The absolute slope of the isoquant
declines as it shifts towards the origin
along the K/L=1 ray.
L-based technological progress
The figure shows L-using technological
progress.
MPL proportionately more than MPK
The absolute slope of the isoquant
increases as it shifts towards the origin
along the K/L=1 ray.
The Average Revenue Curve
• When a firm can sell all its extra output at the same price
AR curve will be a straight line on a graph
The marginal revenue

per unit from selling
extra unit must be the
same as the average
revenue
If the price per unit must be cut in order to sell more
units, then the marginal revenue per unit obtained from
selling extra unit will be less than the previous price per
unit In other words, when the AR is
falling as more units are sold,
the MR must be less than the
AR
This figure is very important in
the future discussions
Profit
• Profit is total revenue minus total cost
Profit Maximization
• As a firm produces and sells more units, its total costs will
increase and its total revenues will also increase
• Provided the extra cost of making an extra unit is less than
the extra revenue obtained from selling it, the firm’s profits
will increase by making and selling that extra unit
• If the extra cost of making that extra unit of output exceeds
the extra revenue obtained from selling it, profit declines
• Profit is maximized when MR = MC
Profit Maximization
• If MC is less than MR profits will be increased by making and selling more

• If MC is greater than MR, profits will fall if more units are made and sold
• If MC = MR, the profit-maximizing output has been reached, and so this is the
output quantity that a profit maximizing firm will decide to supply
Breakeven Point
• Breakeven occurs where total revenue equals total cost, and
therefore average revenue equals average cost
• We can illustrate graphically
Market Structure
• Market structure is the way the buyers and sellers align
in the market
• It depends especially on the number of buyers and
sellers and the product that is offered in the market
• Considerations of the freedom of entry and exit are
important as they determine the degree of competition
in the market
• Issues of information flow in the market are important
also, as they influence the decisions of the buyers
Perfect competition
A market is said to be perfectly competitive if
1. There are a great number of sellers and buyers of the
commodity, The action of an individual cannot affect
the price of the commodity
2. The products of all firms in the market are
homogeneous
3. There is perfect mobility of resources
4. Consumers, resource owners and firms have perfect
knowledge of the present and future prices and costs
5. There is freedom of entry and exit
Perfect competition
Explanation of the Characteristics
1. Many buyers and sellers
• Each seller or buyer is too small in relation to the
market to be able to affect the price of the commodity
by his/her own actions
• A change in output of a single firm will not at all affect
the market price of the commodity
• Similarly each buyer of the commodity is too small to
be able to extract from the seller such things as
quantity discounts and special credit terms
Perfect Competition
Explanation of characteristics
2. The product of each firm is homogeneous, identical
and standardized
• The buyer cannot distinguish between the output of
one firm and that of another firm
• So the buyer is indifferent as to the particular firm from
which to buy
• This refers not only to the physical characteristics of
the commodity but also the environment in which the
purchase is made
Perfect Competition
3. There is perfect mobility of resources
• Workers and other inputs can easily move
geographically and from one job to another, and
respond very quickly to monetary incentives
• No input required in the production is monopolized by
its owners or producers
4. Perfect knowledge of prices, cost and quality
• Consumers will not pay a higher price than necessary
for the commodity
Perfect Competition
4. Perfect knowledge
• Price differences will be eliminated quickly and single
price will prevail throughout the market
• Resources are sold to the highest bidder
• With the perfect knowledge of present and future
prices and costs, producers know exactly how much to
produce
Perfect Competition
5. Freedom of Entry and Exit
• In the long run firms can enter and leave the industry
without difficulty
• There are no patents or copyrights
• Big amounts of capital are not necessary to enter the
industry
• Established firms do not have any lasting cost
advantage over new entrants because of experience or
size
Perfect Competition
Perfect Competition in the Real world
• Perfect competition as defined above has never really
existed
• The closest we may have come to satisfying the first
three assumptions is the market for such agricultural
commodities as wheat and maize
Theoretical Importance
• The theory does give us some very useful explanations
and predictions of many real-world economic
phenomena when we come close to the characteristics
Perfect Competition
Theoretical Importance
• It helps us evaluate and compare the efficiency with
which the resources are used under the different forms
of market organization
Perfect Competition
Consequences of Perfect competition
• The price of the commodity is determined only by the
intersection of market demand curve and market
supply curve for the commodity
• The perfectly competitive firm is a price taker and can
sell any amount of the commodity at the established
price
Perfect Competition
Demand Curve of Perfectly competitive Firm
d is infinitely elastic, given by a horizontal line at the

market equilibrium price
Perfect Competition
A certain car manufacturer regards his business as highly
competitive, because he is keenly aware of his rivalry with
the other few car manufacturers in the market
Like the other car manufacturers, he undertakes vigorous
advertising campaigns seeking to convince potential
buyers of the superior quality and better style of his cars
and reacts very quickly to claims of superiority by rivals. Is
this the meaning of perfect competition from the
economist point of view? Explain.
Perfect Competition
Short Run Equilibrium of the Firm
• Total profit = Total Revenue – Total costs
• Total profits are maximized when the difference
between the total revenue and total cost is the greatest
• We can use the total approach to define the profit
maximizing output level
• The following table illustrates the point
Perfect Competition
• Quantity times price gives
us Total Revenue
• Total Revenue – total costs
gives us the total profit
• Total profits are
maximized at Q=650
where Total profits are
1690$
Perfect Competition
Graphically
• Total Revenue is a positively
sloped straight line through
the origin since P is constant
• At Q=100 the firm maximizes
losses
• At q=300 the firm breaks even
• At Q=650 the firm maximizes
total profits – TR and TC same
slope
Perfect Competition
Short Run Equilibrium of the Firm Marginal approach
• It is more useful to analyse the short-run equilibrium of
the firm with the marginal revenue-marginal cost
approach
Recall:
• Marginal Revenue (MR) is the change in total revenue
for one-unit change in quantity sold.
• Thus the MR equals the slope of the TR curve
• In perfect competition, P is constant for the firm
• So MR = P
Perfect Competition
Short Run Equilibrium of the Firm Marginal Approach
• The marginal approach tells us that the perfectly
competitive firm maximizes its short run total profits at
the output level, where MR or P equals marginal cost
(MC) and MC is rising.
• Here the firm is in its short run equilibrium, or the best,
or the optimum level of output
Perfect Competition
Q P=MR TR TC MC Av. profit Total profit
100 8 800 2000 -12 -1200
200 8 1600 2300 3 -3.5 -700
300 8 2400 2400 1 0 0
400 8 3200 2525 1.25 1.69 675
500 8 4000 2775 2.50 2.45 1225
600 8 4800 3200 4.25 2.67 1600
650 8 5200 3500 8 2.62 1700
700 8 5600 4000 8 2.29 1600
800 8 6400 6400 24 0 0
Perfect Competition
• The optimum level
ti of output in the
perfectly competitive
firm is given by point
D’ where MR=MC
and MC is rising.
• At this point the firm
is maximizing its
total profits ($1700)
and is in short run
equilibrium
Perfect Competition
• If the firm raises its
ti price it will lose its
all its customers
• If the firm lowers
the price it will
reduce its TR
unnecessarily, since
it can sell any
amount at the
market price of $8
per unit
Perfect Competition
• Note that at the level
ti of output of 600 the
Average profit is the
maximum
• But the firm is
interested to maximize
its total profit, not
average
Perfect Competition
• Note also that at A’,
ti MR=MC=P at 100 units
of output
• At this level of output,
however, the firm
maximizes total losses
a
Profit Maximization – Perfect Competition
• In the
short run
the firm
will set
MR=MC
and the
resultant
output
will be Q
• The firm will be making abnormal profit since AR is higher than AC

• The shaded area in a) will be the excess profit
• In the long run, due to entry and exit, the firm will be making normal profit
Monopoly
Monopoly Defined
• Pure monopoly refers to the case where
1. There is a single firm selling the commodity
2. There are no close substitutes for the commodity
3. Entry into the industry is very difficult or
impossible
4. If we further assume that the monopolist has
perfect knowledge of present and future prices
and costs, we have perfect monopoly
Monopoly
Conditions giving rise to monopoly
1. Control of the entire supply of raw materials
required to produce the commodity
2. Ownership of a patent which precludes other
firms from producing the same commodity
3. Government action to establish a sole producer of
a good or service
4. Natural monopolies: this is common in cases of
public utilities such as water supply, electricity
Monopoly
Are cases of pure monopoly common today
• Pure monopoly exists in public utilities, even
though they do not fulfill all the characteristics
Forces limiting Monopoly power
• Monopolist faces indirect competition for the
consumer’s money from other commodities
• Although there are no close substitutes for the
commodity sold by the monopolist, but those
other goods that attract the money to other uses
can be taken to be substitutes
Monopoly
Demand, Marginal Revenue and Elasticity
• In this table, columns (1) and
(2) give the demand schedule
faced by the monopolist
• The TR values are obtained
by multiplying each value of
(1) by the corresponding
value in (2).
• The MR values of (4) are
obtained from the difference
between successive TR values
Monopoly
• The D and MR schedules facing
the monopolist are plotted in
this figure.
• Note that MR
• Is positive as long as demand
is elastic
• Is zero when e=1
• Is negative when e<1
• This is because when D is
elastic, a reduction in the
commodity price will cause TR
to increase so MR is positive
Short run Equilibrium under Pure monopoly
Total Approach
• The short run equilibrium output of the monopolist is the
output at which either total profits are maximized or total
losses are minimized
Short run Equilibrium under Pure monopoly
Monopoly
Short run Equilibrium – Marginal approach
• The short-run equilibrium level of output for the
monopolist is the output at which MR=MC and the
slope of the MR is smaller than the slope of MC
curve (provided that P≥AVC)
Monopoly
• Here the monopolist maximizes
total profits when producing and
selling 2.5 units of output at the
price of $5.5
• At this level of output
MR=MC=$3, while MR is falling
and MC is rising
• So the negative slope of MR
curve is smaller than the
positive slope of MC curve
• As long as MR>MC, it pays for
the monopolist to expand Q
Monopoly
• The optimum level of output for
the monopolist is given by the
point where MC curve intersects
with MR curve from below
• Note that the best level of
output is associated with
minimum SAC and smaller than
the output level at which
P=SMC
Monopolistic Competition
• Monopolistic Competition is the market structure which
has the following characteristics:
1. There are many buyers and many sellers
2. The products sold are closely related but not identical
3. There is freedom of entry and exit in the long run
• Monopolistic competition is very common in retail and
service sector of our economy
Examples
• Petrol stations, different medicine, different brands of
soap and detergents, cigarette brands, mobile phone
providers etc.
• As the name suggests, in this market structure
there is a competitive element as well as the
monopolistic element
• The competitive element results from the presence
of many sellers so that the activities of each have
no perceptible effect on the other firms in the
market
• The monopolistic element results from the fact
that the products are differentiated products
• Since the products are differentiated, we cannot
define the market demand curve and market
supply curve
• We do not have a single equilibrium price, rather a
cluster of prices, each for the different product
produced by each firm.
• Thus whatever graphical analysis that we have is
confined to the typical or representative firm
Implication of the characteristics
• Because of product differentiation, sellers have
some degree of control over the prices they
charge and thus face a negatively sloped demand
curve
• However, the existence of many close substitutes
severely limits the sellers’ “monopoly” power, and
results in a highly elastic demand curve
• MR curve will lie below its demand curve
Short-run Equilibrium • The graph shows a highly
price elastic demand curve
faced by a typical
monopolistic competitor
and the corresponding MR
curve
• In the short run, the best
level of output is where
MR=MC given by point E
• Here P=$9 and Q=6 while
SAC = $7 (point B)
Short-run Equilibrium • So the monopolistic
competitor maximizes profit
ABCF =$12
Long-run Equilibrium
• If in the short run the firms in monopolistically
competitive market earned abnormal profits in the
short run, firms will enter the industry in the long run
• This shifts each firm’s demand curve down (since
each firm now has a smaller share of the market)
• This goes on until all abnormal profits are squeezed
out
• The opposite occurs if firms suffered losses in the SR
Long-run Equilibrium • Here d shifts
down to d’ so as
to be tangent to
LAC curve at the
output level of 4
units
• Here, MR’=LMC
and the firm
breaks even in
the LR
Oligopoly
• Oligopoly is the market organization in which there
are few interdependent sellers of a commodity
• If we have only two sellers we have duopoly
• If the product is homogeneous, such as steel,
copper, cement, we have a pure oligopoly
• This is the most prevalent form of market
organization in the manufacturing sector of
modern economies
• They arise because of economies of scale and
control of source of raw material and patents
Oligopoly
Interdependence of Oligopolies
• This is the most important characteristic of
oligopoly differentiating it from other market
structures
• The interdependence is the natural result of
fewness
• When one lowers its price the other reacts
• When one advertises successfully, the other follows
• When on introduces a better model the other reacts
Oligopoly
Kinked Demand Curve • The demand curve facing
the oligopolist is CEJ and
has a kink at the
prevailing level of sales of
200 units
• Above the kink d is more
elastic than below
• MR is CFGN with CF and
GN
• MC will be anywhere
within the discontinuous
section
Oligopoly
A Cartel
A cartel is a formal organization of producers within
the industry that determines the policies for all the
firms in the cartel with a view of increasing total
profits for the cartel
Types of Cartel:
1. Centralized cartel: Perfect collusion, where the
cartel makes all decisions for member firms
2. Market sharing model: member firms agree upon
the share of the market each is to have

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Costs of Production

• When we sketch these 5 SAC curves on the same set of

From 3 to 5.5 units of output it should build the larger plant

So the LAC curve is obtained by joining points A, B, C, D, E, F,

To produce outputs less than 7 units (point F) the firm would

The marginal revenue

• If MC is less than MR profits will be increased by making and selling more

d is infinitely elastic, given by a horizontal line at the

• The firm will be making abnormal profit since AR is higher than AC

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