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cost of production
1.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 1
2.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 2 CHAPTER 6 COST OF PRODUCTION
3.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 3 COST CONCEPTS COST CONCEPTS COST CONCEPTS IMPLICIT COST Value of input services that are used in production but not purchased in a ma IMPLICIT COST Value of input services that are used in production but not purchased in a ma EXPLICIT COST Value of resources purchased for productio EXPLICIT COST Value of resources purchased for production OPPORTUNITY COST The value of a resource in its next best us OPPORTUNITY COST The value of a resource in its next best use SOCIAL COST Total cost of production of a good tha includes direct and indirect costs. SOCIAL COST Total cost of production of a good that includes direct and indirect costs. SUNK COST The cost that a firm cannot recover from the expenditure it has ma SUNK COST The cost that a firm cannot recover from the expenditure it has ma
4.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 4 COST OF PRODUCTION A production period in which at least one of the input is fixed*. A production period in which all the inputs are variable**. * A fixed input is an input which the quantity does not change according to the amount of output. E.g. machinery ** A variable input is an input which the quantity varies according to the amount of output. E.g. labour SHORT RUN LONG RUN
5.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 5 SHORT-RUN PRODUCTION COST TOTAL COST (TC) The sum of cost of all inputs used to produce goods and services. Total cost (TC ) also defined as total fixed cost (TFC) plus total variable cost (TVC). TOTAL COST (TC) The sum of cost of all inputs used to produce goods and services. Total cost (TC ) also defined as total fixed cost (TFC) plus total variable cost (TVC). TC = TFC + TVC TOTAL FIXED COST (TFC) The cost of inputs that are independent of output. Examples: Factory, machinery and etc. TOTAL VARIABLE COST (TVC) The cost of inputs that changes with output. Example: Raw materials, labours, etc.
6.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 6 SHORT-RUN PRODUCTION COST (cont.) AVERAGE TOTAL COST (ATC) The total cost per unit of output. The formula for average total cost (ATC) is the total cost (TC) divided by the output (Q). ATC = TC Q TC = TVC + TFC
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 7 SHORT-RUN PRODUCTION COST (cont.) AVERAGE FIXED COST (AFC) Total fixed cost (TFC) divided by total output: AFC = TFC Q AVERAGE VARIABLE COST (AVC) Total variable cost (TVC) divided by total output: AVC = TVC Q MARGINAL COST (MC) The change in total cost that results from a change in output; the extra cost incurred to produce another unit of output: MC = ∆TC ∆ Q
8.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 8 SHORT-RUN COST CURVES TFC COST QUANTITY TVC TC TOTAL FIXED COST (TFC) The cost of inputs that is independent of output. TOTAL FIXED COST (TFC) The cost of inputs that is independent of output. TOTAL VARIABLE COST (TVC) The cost of inputs that changes with output. TOTAL VARIABLE COST (TVC) The cost of inputs that changes with output. TOTAL COST (TC) The sum of cost of all inputs used to produce goods and services. Also defined as TFC plus TVC TOTAL COST (TC) The sum of cost of all inputs used to produce goods and services. Also defined as TFC plus TVC TC = TVC + TFC
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All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 9 SHORT-RUN COST CURVES (cont.) COST QUANTITY AVERAGE FIXED COST (AFC) Total fixed cost (TFC) divided by total output AFC = TFC Q AVERAGE FIXED COST (AFC) Total fixed cost (TFC) divided by total output AFC = TFC QAFC AVC ATCMC AVERAGE VARIABLE COST (AVC) Total variable cost (TVC) divided by total output AVC = TVC Q AVERAGE VARIABLE COST (AVC) Total variable cost (TVC) divided by total output AVC = TVC Q AVERAGE TOTAL COST (ATC) Total cost per output ATC = TC ATC = AFC + AVC Q AVERAGE TOTAL COST (ATC) Total cost per output ATC = TC ATC = AFC + AVC Q MARGINAL COST (MC) Change in total cost that results from a change in output MC = ∆ TC ∆ Q MARGINAL COST (MC) Change in total cost that results from a change in output MC = ∆ TC ∆ Q
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All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 10 Total costs Average costs (1) Quantity (Q) (2) Total fixed cost (TFC) (3) Total variable cost (TVC) (4) Total cost (TC) TC=TFC +TVC (2)+(3) (5) Average fixed cost (AFC) AFC = TFC/Q (2)/(1) (6) Average variable cost (AVC) AVC = TVC/Q (3)/ (1) (7) Average total cost (ATC) ATC = TC/Q (4)/(1) or (5)+(6) (8) Marginal cost (MC) MC = ∆TC/∆Q ∆(4) /∆(1) 0 20 0 20 - - - - 1 20 15 35 20 15 35 15 2 20 25 45 10 12.50 22.50 10 3 20 30 50 6.67 10 16.67 5 4 20 35 55 5 8.75 13.75 5 5 20 45 65 4 9 13 10
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All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 11 SHORT-RUN COST CURVES (cont.) COST QUANITTY SAFC SAVC SATC STAGE I AFC begins to fall with an increase in output and AVC decreases. As long as the falling effect of AFC is higher than the rising effect of AVC, the ATC tends to decrease. STAGE I AFC begins to fall with an increase in output and AVC decreases. As long as the falling effect of AFC is higher than the rising effect of AVC, the ATC tends to decrease. ATC curve is “U-Shaped” because of the combined influences of AFC and AVC.ATC curve is “U-Shaped” because of the combined influences of AFC and AVC. STAGE I STAGE II STAGE III STAGE II AFC continuous to decline and SATC will become minimum. ATC remains constant at this stage since the falling effect of AFC and rising effect of AVC is balanced. . STAGE II AFC continuous to decline and SATC will become minimum. ATC remains constant at this stage since the falling effect of AFC and rising effect of AVC is balanced. . STAGE III The falling effect of AFC is lower than rising effect of AVC, therefore ATC begins to increase. STAGE III The falling effect of AFC is lower than rising effect of AVC, therefore ATC begins to increase.
12.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 12 RELATIONSHIP BETWEEN MC AND ATC Cost MC ATC Quantity ATC falling, MC curve lies below ATC curve. ATC is at minimum point, ATC curve and MC curve are equal. ATC starts to increase, MC curve lies above ATC curve.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 13 RELATIONSHIP BETWEEN PRODUCTIVITY AND COST When its AP is equal to MP, AP curve is at maximum. When its AVC is equal to MC, AVC curve is at minimum. MP AP MC AVC Labour Production Cost Quantity
14.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 14 ISOCOST An isocost line shows various combinations of two inputs, capital and labour, which can be purchased with a given amount of money for a given total cost. An isocost equation shows the relationship between the inputs (capital and labour) used in the production and the given total cost by a firm. The isocost equation can be written as: TC = wL + rk Where: TC = Total Cost L = Labour K = Capital (fixed) w = Price of labour r = Price of capital
15.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 15 ISOCOST (cont.) Isocost line shows the various combinations of labour and capital with given total cost for a firm in the production of shoes. Isocost Line 0 1 2 3 4 5 6 1 2 3 4 5 Capital Isocost Labour
16.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 16 ISOCOST MAP An isocost map is a number of isocost lines that show different levels of total cost in one diagram. An isocost map is a number of isocost lines that show different levels of total cost in one diagram. Isocost Map 0 1 2 3 4 5 6 7 1 2 3 4 5 6 7 Capital Isocost (RM100) Isocost (RM120) Labour
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All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 17 COST MINIMIZING TECHNIQUES At point y, the slope of isoquant curve is equal to that of isocost line and this is the most efficient technique for production. At point y, the slope of isoquant curve is equal to that of isocost line and this is the most efficient technique for production. Points x and z are not efficient because the cost of production is exceeding RM120.Points x and z are not efficient because the cost of production is exceeding RM120. The cost minimizing technique is selecting combinations of inputs that minimize the total cost at the given level of output. Isocost (RM100) Isocost (RM120) Isoquant Labour0 1 2 3 4 5 6 7 Capital x y z
18.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 18 COST CURVES IN THE LONG RUN Long run is a period where there are only variable factors and no fixed cost involved. Long run total cost (LRTC) starts from origin because of the absence of total fixed cost. LONG RUN AVERAGE COST CURVE (LRAC) Shows the minimum cost of producing any given output when all of the inputs are variable. Long run is a period where firms plan how to minimize average cost.
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 19 LONG-RUN PRODUCTION COST SRAC1 SRAC2 SRAC3 SRAC4 SRAC5 COST QUANTITY LRAC LRAC curve are derived by a series of short run average cost curvesLRAC curve are derived by a series of short run average cost curves Tangential point of the SAC are joined and made up the LRAC.
20.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 20 LONG-RUN PRODUCTION COST (cont.) Long run average cost curve (LRAC) is “U–Shaped” due to the Law of Returns to Scale. Law of Returns to Scale states that as the firm expand its size or scale of production, its long run average cost (LRAC) will decrease and increase at later stage. Increasing Return to Scale Constant Return to Scale Decreasing Return to Scale LRAC Quantity Cost
21.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 21 LONG-RUN PRODUCTION COST (cont.) ECONOMIES OF SCALE Advantages and benefits of a firm as it becomes larger and larger. Reduce long run average cost (LRAC). Marketing economies, financial economies, labour economies, technical economies, managerial economics. DISECONOMIES OF SCALE Problems faced by a firm as it becomes larger and larger. Decrease long run average cost (LRAC). Mismanagement, competition, labour diseconomies.
22.
All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 22 ECONOMIES OF SCALE Economies of scale are benefits and advantages of a firm as it expands its production. • Reduce the average cost. Economies of scale are benefits and advantages of a firm as it expands its production. • Reduce the average cost. INTERNAL Internal economies happen inside an organization INTERNAL Internal economies happen inside an organization EXTERNAL Advantages of the industry as a whole
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 23 ECONOMIES OF SCALE (cont.) Diseconomies of scale are problems and disadvantages faced by a firm when it expands production. • Increase the average cost. Diseconomies of scale are problems and disadvantages faced by a firm when it expands production. • Increase the average cost. INTERNAL Raise the cost of production of a firm as the firm expands INTERNAL Raise the cost of production of a firm as the firm expands EXTERNAL The disadvantages faced by the industry as a whole
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 24 ECONOMIES AND DISECONOMIES OF SCOPE Economies of scope appear when an individual firm’s output for two different products is higher than the output reached by two different firms each produce a single product. The diseconomies of scope appear in the productions of an individual firm’s because the production of one product might inconsistent with the production of another product.
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All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 25 CONCEPT OF REVENUE TOTAL REVENUE (TR) The total amount received from the sale of a firm’s goods and services Total Revenue (TR) = Price (P) x Quantity (Q) TOTAL REVENUE (TR) The total amount received from the sale of a firm’s goods and services Total Revenue (TR) = Price (P) x Quantity (Q) AVERAGE REVENUE (AR) Average revenue is the total revenue per unit output sold. Average revenue (AR) is also equal to the price (P) of the good. Average Revenue (AR) = Total Revenue (TR) Quantity (Q) AR = P x Q = PRICE Q AVERAGE REVENUE (AR) Average revenue is the total revenue per unit output sold. Average revenue (AR) is also equal to the price (P) of the good. Average Revenue (AR) = Total Revenue (TR) Quantity (Q) AR = P x Q = PRICE Q
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 26 CONCEPT OF REVENUE (cont.) MARGINAL REVENUE (MR) The change in total revenue resulting from one unit increase in quantity sold. Marginal Revenue (MR) = Change in Total Revenue Change in Quantity MR = ∆ TR/ ∆ Q MARGINAL REVENUE (MR) The change in total revenue resulting from one unit increase in quantity sold. Marginal Revenue (MR) = Change in Total Revenue Change in Quantity MR = ∆ TR/ ∆ Q
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 27 CONCEPT OF REVENUE (cont.) Case 1: Under Perfect Market Quantity Price Total Revenue (TR) Average Revenue (AR) Marginal Revenue (MR) 1 10 10 10 10 2 10 20 10 10 3 10 30 10 10 4 10 40 10 10 5 10 50 10 10 AR, MR and price are same when the price is constant. The graph Shows the horizontal line at price of RM10 which indicates that MR = AR = Price. Quantity 0 5 10 15 10 20 30 40 50 AP,MP Price AR=MR=DD
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OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 28 CONCEPT OF REVENUE (cont.) Case 2: Under Imperfect Market Quantity Price Total Revenue (TR) Average Revenue (AR) Marginal Revenue (MR) 1 10 10 10 10 2 9 18 9 8 3 8 24 8 6 4 7 28 7 4 5 6 30 6 2 AR equal to but MR is less than price when price changes. The graph shows the AR and MR downward sloping and MR curve lies below AR curve. Quantity0 5 10 15 10 20 30 40 50 AP,MP Price AR=DD MR
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All Rights ReservedPRINCIPLES
OF ECONOMICS Third Edition © Oxford Fajar Sdn. Bhd. (008974-T), 2013 6– 29 CONCEPT OF REVENUE (cont.) Concept of Revenue by Equation Given demand curve as: P = a – bQ (b is the slope) TR = P x Q = (a – bQ) x Q = aQ – bQ2 Derivation of MR from demand curve MR = dTR/dQ MR = a – 2bQ (MR is ½ of the slope of DD)
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