The document discusses various concepts related to production costs, including: 1) Definitions of production cost, total fixed cost, total variable cost, and total cost. Total cost is the sum of total fixed and total variable costs. 2) Short-run cost curves like average variable cost, average fixed cost, average total cost, and marginal cost are U-shaped. 3) In the long-run, the long-run average cost curve is also U-shaped due to economies and diseconomies of scale as a firm changes its size of production.

1. Theory of Cost Zulkhairi Nisa-Sg Petani Campus 1 CHAPTER 6

3. Interest on capital

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5. Cost Concepts Implicit cost (Economic Cost) The value of input services that are used in production which are not purchased in the market. Explicit cost (Economic Cost / Accounting Cost) The value of resources purchased for production Opportunity cost (Economic Cost) Value of the best alternative forgone Social cost (Economic Cost) The total cost of production of a product and includes direct and indirect costs incurred by the society. Ex: water pollution from industrial waste contaminating rivers. 3 Zulkhairi Nisa-Sg Petani Campus

6. Production Costs in The Short Run 4 Zulkhairi Nisa-Sg Petani Campus

8. TFC incurred before any production or business takes place. Examples rent on building.5 Zulkhairi Nisa-Sg Petani Campus

10. Refers to the cost of input that change with output.

11. When output is zero, total variable cost is also zero.

12. As the output increases, the TVC will also increases.

13. The TVC changes in response to a changes in quantity or output. Examples; raw materials, payment to workers.6 Zulkhairi Nisa-Sg Petani Campus

15. In other words, the total cost is an aggregate expenditure incurred by a firm in producing goods and services.

16. Total cost defined as = TFC +TVC7 Zulkhairi Nisa-Sg Petani Campus

17. Relationship between output, TFC, TVC and TC Cost Output 8 TC TVC K3 K2 K1 Zulkhairi Nisa-Sg Petani Campus TFC Q1

18. Important Concepts Average Variable Cost (AVC) is the variable cost per unit of output Average Fixed Cost (AFC) is the fixed cost per unit of output 9 AVC=TVC/Q; where Q is the quantity output AFC=TFC/Q; where Q is the quantity output Zulkhairi Nisa-Sg Petani Campus

19. Average Total Cost (ATC or AC) is the total cost incurred per unit output and it is also known as unit cost or average cost. or Marginal cost (MC) is the change in total cost associated with producing an additional unit of output. Since TC is a summation of TFC and TVC, any change in total cost necessarily emerges from changes in either fixed or variable cost. 10 ATC=TC/Q; where Q is the quantity output ATC=AVC + AFC MC=TC/Q = TVC/Q; where TFC=0 Zulkhairi Nisa-Sg Petani Campus

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22. Short run Average Total Cost Curve Cost / Price (RM) 15 (Q) Quantity (units) 13 MC ATC or AC Zulkhairi Nisa-Sg Petani Campus AVC 10 8 7 AFC

24. As more variable inputs are employed in order to increase the output, the APP will increase initially and the AVC curves decrease

26. The initial rise in AVC is not sufficient to offset the continuing decrease in AFC.

27. Eventually, AVC increase more than the decline in AFC, so that the ATC curves increases.

28. At relatively large quantities of output, ATC increase due to the MC and the law of diminishing marginal returns.14 Zulkhairi Nisa-Sg Petani Campus

29. The ATC curves reached it maximum point at output 0Q2 at which the firm operates most efficiently. If the firm produces output less than 0Q2 the inputs are not fully utilized at the ATC will be relatively higher. Contrary, if the firm produces more than the 0Q2, the inputs such as machineries are over utilized and it will increase the ATC. The vertical distance between ATC and AVC curves reflects the value of AFC. As output increases, the vertical distance diminishes and approaches to zero. It shows that the AFC curves falls continuously as output increased. It starts with relatively high cost but becoming smaller as output increases; such overhead cost fall continuously as they are spread across larger amount of output. The MC curves reflects the slope of TC curve Since there is no change in fixed cost, the MC must have increased due to the increase in TVC. 15 ZulkhairiNisa-SgPetani Campus

30. Relationship between MC, AVC and ATC The AFC curves falls as output expands, steeply at first but then more gradually When the ATC and AVC curves are rising, its corresponding MC curve is above it When the ATC and AVC curves are falling, its corresponding MC curve is below it The AVC curves fall initially, then reaches its minimum point and rises as output increases The MC curves intersects the lowest point of the ATC and AVC curves 16 Zulkhairi Nisa-Sg Petani Campus

31. Long run cost curves Is the curves that shows the minimum cost of producing any given output when all the inputs are variable The LRAC curve is derived by a series of short run average cost (SAC) curves Tangential points of the SAC are joined and make up the LRAC The long run is a period where firms plan how to minimize the average cost 17 Zulkhairi Nisa-Sg Petani Campus

32. Minimizing Cost of Production in The Long Run SRAC1 SRAC2 SRAC3 0 Q1 Q2 Q3 18 Cost (RM) C1 C2 C3 C4 C5 C6 Output Zulkhairi Nisa-Sg Petani Campus

33. The Shape of LRAC The LRAC is u-shaped because of the law of increasing returns to scale (economies of scale) and the law of decreasing returns to scale (diseconomies of scale) occurs The law of increasing returns to scale refers to, as output increases in the long run, the LRAC curve will fall due to internal and external economies of scale which would bring about increasing return to scale and decreasing cost The law of decreasing returns to scale refers to as output increases further in the long run, the LRAC curve will rise because of internal and external diseconomies of scale which will bring about decreasing return to scale and increasing cost Zulkhairi Nisa-Sg Petani Campus 19

34. LONG RUN AVERAGE COST (LRAC) CURVE Cost (RM) SRAC3 SRAC2 SRAC1 LRAC A C B Quantity (units) 0 Q1 Q2 Q3 Increasing returns to scale Decreasing returns to scale Constant returns to scale Diseconomies of scale Economies of scale 20

35. Economies of Scale Economies of scale refer to the advantages of large scale of production. It is used to explain why LRAC curve falls when the firm expands and increase its output. Increasing return to scale or decreasing cost industry is associated with economies of scale. Factors that influence the internal economies of scale: Labor specialization Financial economies Managerial economic Technological economics By products Zulkhairi Nisa-Sg Petani Campus 21

36. Diseconomies of Scale Diseconomies of scale refer to the disadvantages of large scale of production. It is used to explain why LRAC curve rise when the firm expands and increase its output. Decreasing return to scale or increasing cost industry is associated with diseconomies of scale. Factors that influence the internal diseconomies of scale are: Managerial difficulties Low morale Higher input prices Marketing diseconomies Zulkhairi Nisa-Sg Petani Campus 22

37. Concept of Revenue Total revenue Is the value of firm’s sales. Total revenue refers to the total amount of money that a firm can obtain from the sales of its product. TR=P*Q Average revenue Defined as the total revenue per unit output sold. AR=TR/Q Marginal revenue Refers to the change in total revenue resulting from one unit increase in quantity sold. An additional increase in total revenue when one unit increase in quantity sold. MR=TR/Q Zulkhairi Nisa-Sg Petani Campus 23