The Costs of Production

Ayesha Afzal Assistant Professor Lahore School of Economics

Economic Costs
Economic Cost Opportunity Cost Explicit Costs Implicit Costs Normal Profit as a Cost Economic or Pure Profit
Economic Profit

Total Revenue

Economic Cost

Profits Compared
Economic Profit Versus Accounting Profits
Economics
Implicit Costs (Including a Normal Profit)

Accounting
Total Revenue Accounting Profit

Economic (Opportunity) Costs

Economic Profit

Explicit Costs

Accounting Costs (Explicit Costs Only)

Short Run and Long Run Short Run: Fixed Plant Long Run: Variable Plant

Short-Run Production Relationships

Total Product (TP) Marginal Product (MP) Average Product (AP)

Change in Total Product Marginal Product = Change in Labor Input

Average Product

Total Product Units of Labor

Law of Diminishing Returns Rationale

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

Law of Diminishing Returns

Total Product, TP 30 20 10 0 Marginal Product, MP TP

Increasing Marginal 20 Returns

Diminishing Marginal Returns

Negative Marginal Returns

10 1 2 3 4 5 6 7

AP 8 9 MP

Short-Run Production Costs

Fixed Costs Variable Costs Total Cost TC = TFC + TVC

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 = AFC + AVC ATC = Q Change in TC MC = Change in Q

Short-Run Production Costs

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

TC TVC

Costs

600 500 400 300 200 100 0 1 2 3 4 5 6 7

Fixed Cost

Total Cost

Variable Cost TFC

8 9 10

Short-Run Production Costs

Average and Marginal Costs
$200

MC
150

Costs

AFC
100

ATC AVC

50

AVC AFC
0 1 2 3 4 5 6 7 8 9 10

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

Short-Run Production Costs Production Curves

Average Product and Marginal Product

AP MP
Quantity of Labor

Cost Curves
Cost (Dollars)

MC

AVC

Quantity of Output

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

Long-Run Production Costs

Long-Run ATC Curve
Average Total Costs
ATC-1 ATC-2 ATC-3 ATC-4

ATC-5

Output

Any Number of Short-Run Optimum Size Cost Curves Can Be Constructed

Long-Run Production Costs

Long-Run ATC Curve
Average Total Costs
ATC-1 ATC-2 ATC-3 ATC-4

ATC-5

Long-Run ATC

Output

The Long-Run ATC Curve Just Envelopes the Short Run ATCs

Long-Run Production Costs

Long-Run ATC Curve
Average Total Costs
ATC-1 ATC-2 ATC-3 ATC-4

ATC-5

Long-Run ATC

Output

The Long-Run ATC Curve Just Envelopes the Short Run ATCs

Long-Run Production Costs

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

Long-Run ATC

q1 Output

q2

Long-Run ATC Curve Where Economies Of Scale Exist

Long-Run Production Costs

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

Long-Run ATC

Output

Long-Run ATC Curve Where Costs Are Lowest Only When Large Numbers Are Participating

Long-Run Production Costs

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

Long-Run ATC

Output

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