Cost of Productions

Kanika Talwar
Department of Economics
SGTB Khalsa College
§ In this chapter we will study the firm behavior and how firms decide how much to supply in the
market.

§ We will take the example of a cookie factory which procures inputs various inputs like flour, sugar
oven etc and then uses them to make inputs.

§ The amount a firm receives on selling output is defined as Total Revenue(TR)

§ The cost that firms incurs to produce the output or the market value of the the total inputs is called the
Total cost(TC)

§ At any given point of time an owner of the firm usually undertakes production to maximise his/her
profit.

§ Profits can be defined as total revenue – total cost

or
∏= TR - TC
§ Total revenue is easy to calculate. It is simply the quantity of output(Q) sold times
the price of the output(P). So if the quantity of cookies sold are 1000 @ Rs 2 per
unit.
TR = P X Q
2X 1000 = 2000
§ Under the total costs we have
1. Explicit costs: input costs that require an outlay of money by the firm
2. Implicit costs: input costs that do not require an outlay of money by the firm

§ Firms make production and pricing decisions based on both explicit and implicit
costs, thus economists include both when measuring a firm’s costs.
§ An accountant however only takes into consideration the explicit cost.
§ An important implicit cost of almost every business is the opportunity cost of the
financial capital that has been invested in the business. Suppose, for instance, that
Helen used $300,000 of her savings to buy her cookie factory from the previous
owner.
§ If Helen had instead left this money deposited in a savings account that pays an
interest
§ rate of 5 percent, she would have earned $15,000 per year. To own her cookie
§ factory, therefore, Helen has given up $15,000 a year in interest income. This
forgone
§ $15,000 is one of the implicit opportunity costs of Helen’s business.
§ economic profit is total revenue minus
total cost, including both explicit and
implicit costs
§ accounting profit is total revenue minus
total explicit cost.
§ Suppose the owner of the cookie factory
has $300000 as his saving. He could earn
an interest rate of 5% on it. The owner
uses $100,000 of his savings and borrows
200,000 for as loan from bank.
§ An accountant would calculate the cost
as $10,000 i.e. the interest paid to the
bank on the loan(the explicit cost)
§ An economist however would calculate
the cost as $15000 i.e. $10,000 interest
paid + $ 5000 interest that could be
earned on the savings used(implicit cost
or the opportunity cost)
§ production function: it is the relationship between quantity of inputs used to make a good and
the quantity of output of that good
§ Marginal product(MP) is the increase in
output that arises from an additional unit
of input

§ diminishing marginal product is the

property whereby the marginal product
of an input declines as the quantity of the
input increases
§ A total-cost curve shows the relationship
between the quantity of output produced and
total cost of production.

§ The total-cost curve gets steeper as the quantity

of output increases because of diminishing
marginal product.
 Marginal cost
the increase in total cost that Average Total Cost(ATC)
arises from an extra unit of Total Cost (TC) Total Cost dived by the
output quantity of output
MC= ∆TC/∆Q

Fixed Cost(FC)
costs that do not vary with Variable Cost(VC)
the quantity of output costs that do vary with the
produced quantity of output produced

Average Variable
Average Fixed Cost(AFC)
Cost(AVC)
Fixed cost divided by the
Variable Cost divided by the
quantity of output
quantity of output
FC/Q
VC/Q
§ The table gives us the cost of a lemonade stand
§ The average-total-cost curve is U-shaped. To understand why this is so, remember that average total
cost is the sum of average fixed cost and average variable cost.

§ Average fixed cost always declines as output rises because the fixed cost is getting spread over a
larger number of units.

§ Average variable cost typically rises as output increases because of diminishing marginal product.
Average total cost reflects the shapes of both average fixed cost and average variable cost.

§ At very low levels of output, such as 1 or 2 glasses per hour, average total cost is high because the fixed
cost is spread over only a few units. Average total cost then declines as output increases until the firm’s
output reaches 5 glasses of lemonade per hour, when average total cost falls to $1.30 per glass.

§ When the firm produces more than 6 glasses, average total cost starts rising again because average
variable cost rises substantially.

§ The bottom of the U-shape occurs at the quantity that minimizes average total cost. This quantity is
sometimes called the efficient scale of the firm
§ Whenever marginal cost is less than average total cost, average total cost is falling.

§ Whenever marginal cost is greater than average total cost, average total cost is rising.

§ The marginal-cost curve crosses the average-total-cost curve at the efficient scale. i.e.
the quantity of output that minimizes average total cost.

§ At low levels of output, marginal cost is below average total cost, so average total cost is
falling. But after the two curves cross, marginal cost rises above average total cost. For
the reason we have just discussed, average total cost must start to rise at this level of
output. Hence, this point of intersection is the minimum of average total cost.
§ Uptil now we have looked at examples where the firms exhibit diminishing
marginal product and, therefore, rising marginal cost at all levels of output.
However in reality it may not happen.

§ It depends upon the production process, the second or third worker might have
higher marginal product than the first because a team of workers can divide tasks
and work more productively than a single worker.

§ Such firms would first experience increasing marginal product for a while before
diminishing marginal product sets in.
§ Despite the differences there are some properties that are common

§ Marginal cost eventually rises with the quantity of output.

§ The average-total-cost curve is U-shaped.
§ The marginal-cost curve crosses the average-total-cost curve at the minimum of average total
cost.
§ The division between fixed costs and variable
costs technically depends on the time
horizon.
§ This graph shows how short-run and long-run
costs are related. The long-run average-total-
cost curve is a much flatter U-shape than the
short-run average-total cost curve. In
addition, all the short-run curves lie on or
above the long-run curve.
§ These properties arise because of the greater
flexibility firms have in the long run.
§ In essence, in the long run, the firm gets to
choose which short-run curve it wants to use.
But in the short run, it has to use whatever
short-run curve it chose in the past.
§ The shape of the long-run average-total-cost curve conveys important information about
the technology for producing a good.

§ economies of scale the property whereby long-run average total cost falls as the quantity
of output increases

§ diseconomies of scale the property whereby long-run average total cost rises as the
quantity of output increases

§ constant returns to scale the property whereby long-run average total cost stays the
same as the quantity of output changes
 No. of Output MP TC ATC MC
a) Fill in the column of marginal products. worke
b) What pattern do you see? How might you explain it? rs
c) A worker costs $100 a day, and the firm has fixed costs
of $200. Use this information to fill in the column for
total cost. 0 0
d) Fill in the column for average total cost. What pattern 1 20
do you see?
2 50
e) Now fill in the column for marginal cost. What pattern
do you see? 3 90
f) Compare the column for marginal product and the 4 120
column for marginal cost. Explain the relationship.
g) Compare the column for average total cost and the 5 140
column for marginal cost. Explain the relationship. 6 150
7 155
No. of Output Marginal Total Cost Average Mariginal
workers Product Total Cost Cost

0 0 0 200 - -
1 20 20 300 15 5
2 50 30 400 8 3.3
3 90 40 500 5.5 2.5
4 120 30 600 5 3.3
5 140 20 700 5 5
6 150 10 800 5.3 10
7 155 5 900 5.8 20