The Cost of Production
Each firm uses various inputs (resources) in its production activity.
Commonly used inputs: labor and capital
Prices of inputs (wages, rents) Cost of Production
Measuring Cost: Which Costs Matter?
It is clear that if a firm has to rent equipment or buildings, the
rent they pay is a cost
What if a firm owns its own equipment or building?
How are costs calculated here?
Accounting Cost – actual expenses plus depreciation charges
for capital equipment.
Economic Cost – cost to a firm of utilizing economic resources
in production, including opportunity cost.
Opportunity cost – the value of a highest forgone alternative;
– cost associated with opportunities that are forgone when a
firm’s resources are not put to their highest-value use.
Example when economic cost differs from accounting cost:
-shop owner who does not pay herself a salary and/or
owns the building
Some costs vary with output, while some remain the same no
matter amount of output
Fixed Cost (FC) – cost that does not vary with the level of output.
- have to be paid as long as the firm stays in business (even if
output is zero)
Variable Cost (VC) – cost that varies as the level of output varies.
Total Cost (TC or C) – total economic cost of production,
consisting of fixed and variable costs.
Which costs are variable and which are fixed depends on the
Short time horizon – most costs are fixed
Long time horizon – many costs become variable
In determining how changes in production will affect costs, we
must consider if it affects fixed or variable costs
Cost Curves for a Firm
0 1 2 3 4 5 6 7 8 9 10 11 12 13
the rate varies with
is the vertical
sum of FC
Fixed cost does not
vary with output
• Costs that are fixed in the short run may not be
fixed in the long run
• Typically in the long run, most if not all costs
Per-Unit, or Average, Costs
Average Total cost – firm’s total cost divided by its level of output
(average cost per unit of output)
Average Fixed cost – fixed cost divided by level of output (fixed
cost per unit of output)
Average variable cost – variable cost divided by the level of
Marginal Cost – change (increase) in cost resulting from the
production of one extra unit of output
Denote “∆” - change. For example ∆TC - change in total cost
Example: when 4 units of output are produced, the cost is 80,
when 5 units are produced, the cost is 90. MC=(90-80)/1=10
since TC=(FC+VC) and FC does not change with Q
Marginal Product and Costs
Suppose a firm pays each worker $50 a day.
MP VC MC
0 0 10 0 5
1 10 15 50 3.33
2 25 20 100 2.5
3 45 15 150 3.33
4 60 10 200 5
5 70 5 250 10
6 75 300
Short-run Costs and Marginal Product
• production with one input L – labor; (capital is fixed)
• Assume the wage rate (w) is fixed
• Variable costs is the per unit cost of extra labor times the
amount of extra labor: VC=wL
Denote “∆” - change. For example ∆VC is change in variable cost.
MC=∆VC/∆Q ; MC =w/MPL,
With diminishing marginal returns: marginal cost increases as
Shifts of the Cost Curves
Changes in resource prices or technology will cause costs to chan
Cost curves shift
FC increases by 100
In the short run, the total cost of any level of output is the sum of fixe
and variable costs: TC=FC+VC
Average fixed (AFC), average variable (AVC), and average total cos
(ATC) are fixed, variable, and total costs per unit of output; margina
cost is the extra cost of producing 1 more unit of output.
AFC is decreasing
AVC and ATC are U-shaped, reflecting increasing and then diminish
Marginal cost curve (MC) falls and then rises, intersecting both AVC
and ATC at their minimum points.