The costs of Production
What does supply curve represent?
How does a firm take its supply decisions?
Before we start this chapter let us ask ourselves one
Why do organizations do business?
-The Answer is obvious, for profit.
- How do you earn profit?
- By selling goods and services.
- By selling goods and services, what do you get?
- Revenue or Profit?
- Revenue of Course.
- Then how do you get profit?
- By Deducting Total Costs from Total Revenue.
Hence we study this chapter that will teach us the
costs of production and the various kinds of costs of
Understanding what revenue is, is a trivial. Simply P X
But understanding all costs of production is a
Hence keep your ears, eyes and brains open.
Total COST IS Total DETERMINANT OF
A FIRM’S Revenue, A KEYcost and Total ProfitA
FIRMS PRICING AND PRODUCTION
DECISIONS. The total amount the firm
receives for its output.
Total Cost: Total amount a firm pays for its
Total Profit = Total Revenue- Total Cost
Total revenue= P x Q. If Dhruvraj produces
10000 units and sells them at Rs.2. Total
revenue is 20,000.
Do You think that the costs
you incur in your business
has an opportunity cost?
Costs as opportunity costs
Suppose Onkar pays Rs.1,000 for flour, that Rs.1000 is an opportunity cost because Onkar can
no longer use that amount to buy something else. Similarly when Onkar pays for labor, is a
part of the companies cost. Because these costs require the company to pay some money,
they are called explicit costs.
But some opportunity costs do not require a cash outlay and are called implicit costs.
The total costs would include both EXPLICIT COSTS AND IMPLICIT COSTS.
This distinction helps us understand how economists and accountants analyze a business.
Economists consider both the explicit and implicit costs to study a firms production and
pricing decisions while accountants consider only explicit costs.
The Cost of capital as an opportunity costs.
An important implicit cost of any business is the opportunity cost of the
financial capital that has been invested in the business.
Suppose Siddhi uses 3,00,000 of her savings to start a business. Instead if
Siddhi had left the same amount with the savings account that could earn her
5% interest, the opportunity cost would be the interest of 15,000 that she
could have earned by depositing the money in the bank.
This income of 15,000 is one of the implicit costs for Siddhi.
Suppose Siddhi does not have the entire 3,00,000 to do the business. She has
only 2,00,000 and the rest 1,00,000 she borrows from a bank, and has to pay
What is the total cost of siddhi as an economist’s point of view and from an
accountant’s point of view?
Economic Profit Versus Accounting Profit
Because economists and accountants treat costs differently, they also treat
Economists treat economic profit as the difference between total revenue minus
total costs ( Explicit and Implicit costs ).
Accountants treat accounting profit as the difference between total revenue
minus explicit costs.
The Production FUNCTION
The Production function shows the relationship between quantity of inputs and quantity of output.
One of the ten principles of economics is that rational people
always think about margin. A firm would be interested in knowing
that with an additional unit of input how much output can it
The production function is used to understand the decisions of a firm with regards to the output it wants to
produce and the inputs it will use.
A Production function and Total Cost
Marginal Product of
Total Cost of
( 10 / hour)
As the number of workers increase the
output increases but only upto a certain
extent after which the marginal product
falls, this shoes the principle of diminishing
Number of Workers
As the quantity rises so does the cost.
Total Cost Curve
20 40 60 80 100 120 140 160
The various measures of cost
The firms total cost can be divided into FIXED
COSTS AND VARIABLE COSTS.
Fixed Cost: These are costs that do not vary with output. They have to be
incurred when there is no production.
Eg. Rent, Book keepers salary etc.
Variable Cost: These are costs that vary with output. As the production
increases, even these costs increase.
Eg, Raw material cost, cost of electricity etc.
QUANTITY OF OUTPUT
The various measures of cost
AVERAGE AND MARGINAL COSTS
As an owner of a firm one has to decide what will the total produce be. A key
part of this decision is how will costs vary with production.
While deciding this two questions have to be asked?
What will be my cost of producing one unit of output?
What will be the change in cost for increasing the output by one unit?
The answer of the first question is ATC.
ATC = TC/Q or ATC= AFC + AVC ( Where AFC= FC/Q and AVC= VC/Q)
The answer of the second question is MC.
MC= Δ TC / Δ Q
Cost Curves and their Shapes
As in the previous chapters we analyzed the supply and demand curves to analyze the
behavior of markets, we will use the cost curves to analyze the behavior of firms.
On the X axis we have the quantity of output produced, and on the Y axis we have the
Cost curves shown ahead have three common
features, which we will examine:
1) The shape of the Marginal Cost Curve
2) The shape of the Average Total Cost Curve
3) The relationship between ATC and MC.
The shape of the MC curve: The rising Marginal Cost
According to the law of Diminishing Marginal
When Production is low the MARGINAL PRODUCT is
large ( Because of full capacity utilization) , and the
MARGINAL COST is less.( Less production less
When production is increased the MARGINAL
PRODUCT is less. ( Because of limited capacity), and
the MARGINAL COST increases due to increase in
The shape of the ATC curve: The U-shaped ATC
The ATC is u-shaped. Please note that ATC is a sum of AFC and AVC.
Hence it reflects the behavior of both these curves.
The AFC is high when the quantity produced is less, because the
FIXED COST gets spread over less number of units. But when the
quantity produced rises the AFC falls.
Hence initially the ATC is high. ( Because AFC is high)
The AVC is low initially as the quantity produced is less, but when the
quantity produced rises the AVC rises.
Hence later the ATC rises. ( Because AVC is high )
Relationship Between MC AND ATC.
When MC is less than ATC, ATC is falling.
When MC is greater than ATC, ATC rises.
This is true for all firms and not a coincidence.
To understand this consider your Scoring system of your examination, where
ATC is the average percentage and MC is the score of every subject.
Now when the score of your subjects ( MC ) is less then Your Average
There is another point to be noted and i.e the MC curve intersects the ATC
at its minimum point. Because at low levels of output MC is below
ATC, hence ATC is falling. At higher levels of output ie after intersection MC
rises above ATC, hence ATC is rising. Hence the point of intersection is where
ATC is lowest.
From a firms total cost, we can we can derive several related measures of cost.
Quantity of furniture
Onkar might produce
QUANTITY OF OUTPUT
Till Now we have studied that a firm faces diminishing marginal
returns hence we see marginal cost rising all the time.
But in reality a firm faces Diminishing marginal returns only
after a level. Hence initially the MARGINAL PRODUCT is high
and MARGINAL COST is falling. ( Hence a change in the
diagram) and after the firm starts facing diminishing marginal
returns the MC rises.
The cost curves share three properties that we need to
1) Marginal cost eventually increases with increase in output.(
Because of law of diminishing returns which firms face only
after some time.).
2) The ATC is U-shaped.
3) The MC curve cuts the ATC at the minimum level of ATC.
In the short run, Because of the Law of diminishing returns if a firm wants to increase its
production from 1,000 to 1,200 unit the MC rises as the MP is less as production
increase due to limited capacity.
And so the ATC also rises from 10,000 to 12,000.In the short run a firm cannot increase
But in the long run since the capacity can be increased the ATC will remain at 10,000, as
MP goes up AND MC comes down.
Therefore the ATC in the long run is lower than the ATC in the short run.
ATC in Short
ATC in long
Quantity of output
Economies of Scale And Diseconomies of Scale
As we have just seen that the ATC curve in the
long run declines as output increases, it shows
us economies of scale.
When ATC rises as output increases there is
said to be diseconomies of scale.
When ATC does not vary with output there is
said to be Constant returns to Scale.
Economies of Scale And Diseconomies of Scale
Economies of scale arise usually when the
outputs increase at a faster rate than the
inputs. It means if output increases more than
inputs the cost gets spread to a higher number
of units. It occurs at small levels of output.
Diseconomies of scale arises when inputs rise
faster than outputs. It occurs at large level of
What causes economies and diseconomies:
Economies and Diseconomies of scale occur due to two reasons:
Mainly because of technological and financial reasons.
At technological level it takes place because as output increases a greater
division of labor takes place and specialization takes place.
At financial level, as output increases purchases of raw materials are done in
bulk and hence the firm receives quantity discounts, which can be passed on to
Economies of Scope takes place when the production of two different units
brings down the cost of production.
Eg. A small communter airline can easily extend to cargo services.
ECONOMIES OF SCALE: Suppose if a firm produces 100 units its
cost of production is 1,00,000. And when it increases the
production to 1000 units the total cost will come down to
It happens due to specialization and finance. When a firm
increases its production, workers specialize in their jobs, they
become experts and hence now they are able to produce
more, hence there cost will come down.
If the firm increases its production, now it purchases raw
materials in bulk and hence it can avail quantity discounts and
hence cost will come down.
DISECONOMIES OF SCALE: In the above example now the
firm increases its production to 2,000 units how much
should its cost increase to 20,00,000. (When production was
1,000 units the cost was 8,00,000). This happens because
now as the production increases coordination problems
But SIR YOU SAID THAT IN THE LONG RUN A FIRM CAN
MY ANSWER TO YOU STUDENTS IS YES, CAPACITY CAN
INCREASE BUT UPTO AN EXTENT, BUT BEYOND THAT IT
The Various types of Cost
FC- Fixed Cost
VC- Variable Cost
TC- Total Cost = FC+VC
AFC- Average Fixed Cost = FC/Q
AVC- Average Variable Cost= VC/Q
ATC- Average total Cost= TC/Q OR AFC+ AVC
AC= Average Cost- Cost of Producing One Unit of Output
MC= Marginal cost- Change in Cost for producing one extra unit
AR= Average Revenue- Revenue of one unit of output
MR= Marginal Revenue- Change in Revenue for selling one extra
unit of output
In the chapter Cost of Production we studied all types of Cost because
they will help us in understanding the pricing and production decisions
of firms in competitive markets, monopoly, monopolistic competition