Chapter 5
The Production Process and
Costs
Learning Objectives
1. Explain the difference between and the
economic relevance of fixed costs, sunk costs,
variable costs, and marginal costs.
2. Calculate average and marginal costs from
algebraic or tabular cost data and illustrate the
relationship between average and marginal
costs.
3. Distinguish between short-run and long-run
production decisions and illustrate their impact
on costs and economies of scale.
2
The Cost Function
The Cost Function
5-3
The Cost Function
Average and Marginal Costs
• Average costs
𝐹𝐶
• Average fixed cost: 𝐴𝐹𝐶 =
𝑄
𝑉𝐶 𝑄
• Average variable costs: 𝐴𝑉𝐶 =
𝑄
𝐶 𝑄
• Average total cost: 𝐴𝑇𝐶 =
𝑄
• Marginal cost (MC)
• The (incremental) cost of producing an additional unit of
output.
∆𝐶
• 𝑀𝐶 =
∆𝑄
5-4
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The Cost Function
The Relationship between Average and Marginal Costs
ATC, AVC, AFC
and MC ($) 𝐴𝑇𝐶
𝑀𝐶 A𝑉𝐶
Minimum of ATC
Minimum of AVC
𝐴𝐹𝐶
0 Output
5-5
© 2017 by McGraw-Hill Education. All Rights Reserved.
The Cost Function
The Relationship between Average and Marginal Costs
ATC, AVC, AFC
and MC ($)
Minimum of ATC
Minimum of AVC
0 Output
5-6
The Cost Function
Fixed and Sunk Costs
• Fixed costs
• Cost that does not change with output.
• Sunk cost
• Cost that is forever lost after it has been paid.
• Irrelevance of Sunk Costs
• A decision maker should ignore sunk costs to maximize
profits or minimize loses.
5-7
© 2017 by McGraw-Hill Education. All Rights Reserved.
The Cost Function
Algebraic Forms of Cost Functions
• The cubic cost function: costs are a cubic function of
output; provides a reasonable approximation to
virtually any cost function.
C(Q) – F + aQ + bQ2 + cQ3
where a, b, c, and f are constants and f
represents fixed costs
• Marginal cost function is:
MC(Q) = a + 2bQ + 3cQ2
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The Cost Function
Algebraic Forms of Cost Functions
Marginal cost function is:
MC(Q) = a + 2bQ + 3cQ2
MC(Q) = dC/dQ
dC/dQ = a + 2bQ + 3cQ2
© 2017 by McGraw-Hill Education. All Rights Reserved. 9
The Cost Function
Long-Run Costs
• In the long run, all costs are variable since a manager
is free to adjust levels of all inputs.
• Long-run average cost curve
• A curve that defines the minimum average cost of
producing alternative levels of output allowing for optimal
selection of both fixed and variable factors of production.
5-10
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Long Run Production Costs
• The firm can change all input amounts, including plant size
• All costs are variable in the long run
• Long run ATC
• Different short run ATCs
LO4
Long-Run Average Cost
The Cost Function
Economies of Scale
• Economies of scale
• Declining portion of the long-run average cost curve as
output increase.
• Diseconomies of scale
• Rising portion of the long-run average cost curve as output
increases.
• Constant returns to scale
• Portion of the long-run average cost curve that remains
constant as output increases.
5-14
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The Cost Function
Economies and Diseconomies of Scale
LRAC ($)
Economies of scale Diseconomies of scale
0 Output
5-15
© 2017 by McGraw-Hill Education. All Rights Reserved.
The Cost Function
Constant Returns to Scale
LRAC ($)
0 Output
5-16
© 2017 by McGraw-Hill Education. All Rights Reserved.