This document discusses the costs of production for a firm. It begins by defining a firm and its goal of profit maximization. It explains that a firm faces constraints from technology, information, and markets. It also discusses the five basic decisions a firm must make: what and how much to produce, how to produce, how to organize workers, how to market and price products, and what to produce internally vs externally. The document then explains the differences between short-run and long-run time frames. In the short-run, capital is fixed while variable inputs can change, while in the long-run all inputs are variable. It introduces the concepts of total, average, and marginal costs. Finally, it discusses how

1. THE COSTS OF
PRODUCTION

2. Objectives
2-2
Enabling the students to learn about
 Cost of Production.
 Define and explain various types of costs
and their application.
 The graphical representation of these
costs.

3. The Firm and Its Economic Problem
 A firm is an institution that hires factors of
production and organizes them to produce
and sell goods and services.
 The Firm’s Goal
 A firm’s goal is to maximize profit.
 If the firm fails to maximize its profit, the firm
is either eliminated or bought out by other
firms seeking to maximize profit.

4. The Firm and Its Economic Problem
The Firm’s Decisions
 To maximize profit, a firm must make five
basic decisions:
 1. What to produce and in what quantities
 2. How to produce
 3. How to organize and compensate its
managers and workers
 4. How to market and price its products
 5. What to produce itself and what to buy
from other firms

5. The Firm and Its Economic Problem
 The Firm’s Constraints
 The firm’s profit is limited by three
features of the environment:
 Technology constraints
 Information constraints
 Market constraints

6. The Firm and Its Economic Problem
 Market Constraints
 What a firm can sell and the price it can obtain
are constrained by its customers’ willingness to
pay and by the prices and marketing efforts of
other firms.
 The resources that a firm can buy and the prices
it must pay for them are limited by the
willingness of people to work for and invest in
the firm.
 The expenditures a firm incurs to overcome
these market constraints will limit the profit the
firm can make.

7. The Firm and Its Economic
Problem
Accounting Profit
Accountants measure a firm’s profit to
ensure that the firm pays the correct amount
of tax and to show its investors how their
funds are being used.
Profit equals total revenue minus total cost.
Accountants use Internal Revenue Service
rules based on standards established by the
Financial Accounting Standards Board to
calculate a firm’s depreciation cost.

8. Firm
2-8
The Firm
(Management)
Owners
Input
Suppliers Government
Customers
Initial Financing Profit After Taxes
Input Costs
Inputs
Taxes
Output Revenue
Government Services
Government Regulations

9. Implicit costs
2-9
 A cost that is represented by lost opportunity in the
use of a company's own resources, excluding
cash.
 Example of a firm sitting on an expensive plot
worth £10,000 a month in rent which it bought for a
mere £50 a hundred years before. If the firm
cannot obtain a profit after deducting £10,000 a
month for this implicit cost, it ought to move
premises (or close down completely) and take the
rent instead.
 When a firm uses its own capital
 Uses its owner’s time

10. Explicit Cost
2-10
 A business expense that is easily
identified and accounted for. Explicit costs
represent clear, obvious cash outflows
from a business that reduce its bottom-
line profitability.
 Example: The monetary payments out of
pocket or cash expenditures
 Material ,fuel, transportation expenditures
etc.

11. Decision Time Frames
 The firm makes many decisions to achieve its
main objective: pro fit m axim izatio n.
 Some decisions are critical to the survival of the
firm.
 Some decisions are irreversible (or very costly to
reverse).
 Other decisions are easily reversed and are less
critical to the survival of the firm, but still influence
profit.
 All decisions can be placed in two time frames:
 The short run
 The long run

12. Decision Time Frames
 The Short Run
 The short run is a time frame in which the
quantity of one or more resources used in
production is fixed.
 For most firms, the capital, called the firm’s
plant, is fixed in the short run.
 Other resources used by the firm (such as
labor, raw materials, and energy) can be
changed in the short run.
 Short-run decisions are easily reversed.

13. Decision Time Frames
 The Long Run
 The long run is a time frame in which the
quantities of allresources—including the plant
size—can be varied.
 Long-run decisions are not easily reversed.
 A sunkcost is a cost incurred by the firm and
cannot be changed.
 If a firm’s plant has no resale value, the amount
paid for it is a sunk cost.
 Sunk costs are irrelevant to a firm’s current
decisions.

14. Short-Run Cost
 To produce more output in the short run, the
firm must employ more labor, which means
that it must increase its costs.
 We describe the way a firm’s costs change
as total product changes by using three cost
concepts and three types of cost curve:
 Total cost
 Marginal cost
 Average cost

15. 7 Cost Concepts (Short-run)
2-15
1. Total Fixed Cost (TFC)
2. Total Variable Cost (TVC)
3. Total Cost
(TC=TVC+TFC)
4. Average Cost (TC/Q)
5. Average Fixed Cost (AFC=TFC/Q)
6. Average Variable Cost
(AVC=TVC/Q)
7. Average Total Cost
(AC=AFC+AVC)

16. Activity
2-16
Think about some business to launch
and jot down all expenses that you
would do.
What things do you think should
remain the part of business no matter
it doesn’t make profit.
What are the things which could be
varied or added.

17. Short-Run Cost
 Figure shows a
firm’s total cost
curves.Total fixed cost is the same at
each output level.
Total variable cost increases as
output increases.
Total cost, which is the sum of TFC
and TVC also increases as output
increases.

18. Short-Run Cost
 Redraw the graph with
cost on the y-axis and
output on the x-axis,
and you’ve got the TVC
curve drawn the usual
way.
 Put the TFC curve back in
the figure,
 and add TFC to TVC, and
you’ve got the TC curve.

19. Short-Run Cost
 Marginal Cost
 Marginal cost (MC) is the increase in total
cost that results from a one-unit increase
in total product.
 Over the output range with incre asing
m arg inalre turns, marginal cost falls as
output increases.
 Over the output range with dim inishing
m arg inalre turns, marginal cost rises as
output increases.

20. Short-Run Cost
 Average Cost
 Average cost measures can be derived from
each of the total cost measures:
 Average fixed cost (AFC) is total fixed cost per
unit of output.
 Average variable cost (AVC) is total variable
cost per unit of output.
 Average total cost (ATC) is total cost per unit
of output.
 ATC = AFC + AVC.

21. Calculating costs
Units of
Labor
Total
Product
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Marginal
Cost
Average
Cost
L TPL TFC TVC TC MC AC
0 0 100 0 100 - -
1 6 30
2 10 50
3 12 60
4 13 65
5 15 75
6 19 95
7 25 125
8 33 165
9 43 215
10 55 275
2-21

22. Average Costs
 Average fixed cost (AFC)
 Total fixed cost per unit of output produced
2-22
• Average variable cost (TVC)
– Total variable cost per unit of output produced
• Average total cost (TC)
– Total cost per unit of output produced
Q
TFC
AFC =
Q
TVC
AVC =
Q
TC
ATC =

23. Short-Run Cost
 Technology
 Technological change influences both the
productivity curves and the cost curves.
 An increase in productivity shifts the average
and marginal product curves upward and the
average and marginal cost curves
downward.
 If a technological advance brings more
capital and less labor into use, fixed costs
increase and variable costs decrease.
 In this case, average total cost increases at
low output levels and decreases at high
output levels.

24. Short-Run Cost
Prices of Factors of Production
An increase in the price of a factor of
production increases costs and shifts the
cost curves.
An increase in a fixe d cost shifts the total
cost (TC ) and average total cost (ATC )
curves upward but does no t shift the
marginal cost (MC ) curve.
An increase in a variable cost shifts the total
cost (TC ), average total cost (ATC ), and
marginal cost (MC ) curves upward.

25. Long-Run Cost
 In the long run, all inputs are variable and all
costs are variable.
 The Production Function
 The behavior of long-run cost depends upon
the firm’s production function.
 The firm’s pro ductio n functio n is the
relationship between the maximum output
attainable and the quantities of both capital
and labor.

26. Long-Run Cost
 Table 11.3 shows a
firm’s production
function.
 As the size of the
plant increases, the
output that a given
quantity of labor can
produce increases.
 But as the quantity of
labor increases,
diminishing returns
occur for each plant.

27. Long-Run Cost
Diminishing Marginal Product of Capital
The m arg inalpro duct o f capitalis the increase in
output resulting from a one-unit increase in the
amount of capital employed, holding constant the
amount of labor employed.
A firm’s production function exhibits diminishing
marginal returns to labor (for a given plant) as well as
diminishing marginal returns to capital (for a quantity
of labor).
For e ach plant, diminishing marginal product of labor
creates a set of short run, U-shaped costs curves for
MC, AVC, and ATC.

28. Long-Run Cost
 Short-Run Cost and Long-Run Cost
 The average cost of producing a given output varies
and depends on the firm’s plant.
 The larger the plant, the greater is the output at
which ATC is at a minimum.
 The firm has 4 different plants: 1, 2, 3, or 4 knitting
machines.
 Each plant has a short-run ATC curve.
 The firm can compare the ATC for each output at
different plants.

29. ATC1 is the ATC curve for a plant with 1 knitting machine.
Long-Run Cost

30. ATC2 is the ATC curve for a plant with 2 knitting machines.
Long-Run Cost

31. ATC3 is the ATC curve for a plant with 3 knitting machines.
Long-Run Cost

32. ATC4 is the ATC curve for a plant with 4 knitting machines.
Long-Run Cost

33. Long-Run Cost
The long-run average cost curve is made up
from the lowest ATC for each output level.
So, we want to decide which plant has the
lowest cost for producing each output level.
Let’s find the least-cost way of producing a
given output level.
Suppose that the firm wants to produce 13
sweaters a day.

34. 13 sweaters a day cost $7.69 each on ATC1.
Long-Run Cost

35. 13 sweaters a day cost $6.80 each on ATC2.
Long-Run Cost

36. 13 sweaters a day cost $7.69 each on ATC3.
Long-Run Cost

37. 13 sweaters a day cost $9.50 each on ATC4.
Long-Run Cost

38. Long-Run Cost
 Long-Run Average Cost Curve
 The long-run average cost curve is the relationship
between the lowest attainable average total cost and
output when both the plant and labor are varied.
 The long-run average cost curve is a planning curve
that tells the firm the plant that minimizes the cost of
producing a given output range.
 Once the firm has chosen its plant, the firm incurs
the costs that correspond to the ATC curve for that
plant.

39. Figure 11.8 illustrates the long-run average cost (LRAC) curve.
Long-Run Cost

40. Long-Run Cost
 Economies and Diseconomies of Scale
 Economies of scale are features of a firm’s
technology that lead to falling long-run average cost
as output increases.
 Diseconomies of scale are features of a firm’s
technology that lead to rising long-run average cost
as output increases.
 Constant returns to scale are features of a firm’s
technology that lead to constant long-run average
cost as output increases.

41. Figure 11.8 illustrates economies and diseconomies of scale.
Long-Run Cost

42. Long-Run Cost
 Minimum Efficient Scale
 A firm experiences economies of scale up to some
output level.
 Beyond that output level, it moves into constant
returns to scale or diseconomies of scale.
 Minimum efficient scale is the smallest quantity of
output at which the long-run average cost reaches
its lowest level.
 If the long-run average cost curve is U-shaped,
the minimum point identifies the minimum efficient
scale output level.

43. Formulas
2-43
 Accounting Profit=TR-TC(explicit)
 Economic Cost=
Accounting cost(explicit) –
Implicit cost
 Economic profit=TR-Explicit-Implicit

44. Answer now!
2-44
 Gomez runs a small pottery firm. He hires one
helper at $12,000 per year pays annual rent of
$5,000 for his shop, and materials cost $20,000
per year. Gomes has $40,000 of his own funds
invested in equipment (pottery wheels, kilns,
and so forth) which could earn him $4,000 per
year if alternatively invested. Gomez has been
offered $15,000 per year to work as a potter for
a competitor. He estimates his entrepreneurial
talents are worth $3,000 per year. Total annual
revenue from pottery sales is $72,000. Calculate
accounting profits for Gomez's pottery.

45. Answer
2-45
 Explicit Costs :$ 37,000
 Implicit Costs:$ 22,000
 Accounting Costs=$ 35,000
 Economic Profit=$ 13,000

46. 2-46
Which of the following are short-run and
which are long-run adjustments?
a Wenndy`s builds a new restaurant;
b Acme Steel Corporation hires 200 more
workers;
c A farmer increases the amount of
fertilizer used on his corn crop; and
d An Alcoa plant adds a third shift of
workers.

47. 
Use the following
data to calculate
marginal product
and average
product .
Inputs of
labor
Total
product
Marginal
product
Average
product
O 0 _____ _____
1 15 _____ _____
2 34 _____ _____
3 51 _____ _____
4 65 _____ _____
5 74 _____ _____
6 80 _____ _____
7 83 _____ ______
2-47

48. Answer the following!
2-48
 Why can the distinction between fixed and
variable costs be made in the short run? Classify
the following as fixed or variable costs;
 Advertising expenditure ,fuel, interest on
company-issued bond, shipping charges,
payments for raw material, real estate taxes,
executive salaries insurance premiums, wage
payments, depreciation and obsolescence
charges, sales taxes, and rental payments on
leased office machinery" There are no fixed costs
in the long run; all costs are variable,” Explain.

49. Suppose if fixed cost is $60 do the
calculations.
Total
product
Total
fixed
costs $
Total
Variable
Costs $
Total
costs$
AFC
$
AVC
$
ATC
$
MC
$
0 0
1 45
2 85
3 120
4 150
5 185
6 225
7 270
8 325
9 390
2-49