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?
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.
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
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 time
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 are
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 output.
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
MC= TC/ Q∆ ∆
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
MC= TVC/ Q∆ ∆
since TC=(TFC+TVC) and TFC does not change with Q
Marginal Product and Costs
Suppose a firm pays each worker $50 a day.
MP VC MC
0 0 0 0
1 10 10 50 5
2 25 15 100 3.33
3 45 20 150 2.5
4 60 15 200 3.33
5 70 10 250 5
6 75 5 300 10
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:
D Denote “∆” - change. For example ∆VC is change in variable cost.
MC=∆VC/∆Q ; MC =w/MPL,
With diminishing marginal returns: marginal cost increases as output
Shifts of the Cost Curves
Changes in resource prices or technology will cause costs to
⇒ Cost curves shift
FC increases by 100
In the short run, the total cost of any level of output is the sum
of fixed and variable costs: TC=FC+VC
Average fixed (AFC), average variable (AVC), and average total
costs,(ATC) are fixed, variable, and total costs per unit of output;
cost is the extra cost of producing 1 more unit of output.
A FC is decreasing
AVC and ATC are U-shaped, reflecting increasing and then
Marginal cost curve (MC) falls and then rises, intersecting
both AVC and ATC at their minimum points.
Q1: Those things that must be forgone to
acquire a good are called
b. opportunity costs.
c. explicit costs.
Q2: Explicit costs
a. require an outlay of money by the firm.
b. include all of the firm's opportunity costs.
c. include income that is forgone by the
d. Both b and c are correct.
Q4: An example of an explicit cost of
production would be
a. the cost of forgone labour earnings for an
b. the lost opportunity to invest in capital
markets when the money is invested in one's
c. lease payments for the land on which a
firm’s factory stands.
d. Both a and c are correct.
Q5: The amount of money that a wheat farmer
could have earned if he had planted barley
instead of wheat is
a. an explicit cost.
b. an accounting cost
c. an implicit cost.
d. forgone accounting profit.