This document discusses key concepts in production costs, including: 1. Cost minimization occurs when the slope of the isocost curve equals the slope of the isoquant curve. 2. Firms should substitute cheaper inputs for more expensive inputs when input prices rise to minimize costs. 3. Economies of scale exist when average costs decrease with increased output due to factors like specialization and bulk purchasing. Diseconomies of scale occur when management becomes complex and average costs increase with more output. 4. Cost functions show the relationship between total, fixed, variable, average, and marginal costs as a firm's output changes. Marginal cost is the change in total cost from one additional unit of output.

1. MANAGERIAL ECONOMICS
MODULE 4
The Production Process and Cost
TOPICS:
Cost Minimization
Optimal Input Substitution
Economies & Diseconomies of Scale
Cost Function
Average & Marginal Costs
JOCIVIC F. BERTILLO
Reporter

2. Cost Minimization
• the process or goal of incurring the least possible
opportunity cost in the pursuit of a given activity
• the point of cost minimization occurs when the slope of
Isocost equals the slope of Isoquant.
Figure 1

3. Optimal Input Substitution
• to minimize the cost of producing a given level of output,
the firm should use less of an input and more of other
inputs when that input’s price rises.
Examples of Input Substitution:
1. Labor (L) & Capital (K) Substitution
3. Capital (K) and Energy (E) Substitution
2. Material Substitution
4. No substitution (fixed proportions)

4. Economies & Diseconomies of Scale
The scale of production means the size of the production
unit of a firm or business establishment
• Desire for economy: a large scale production is more economical.
• Desire for large profit: Business on a large scale yields more profits.
• Desire for economic power and prestige: A large firm can command
and control a large section of the business and has high reputation in
the market.
• Desire for increase of demand: When demand for a product
increases, the firm will have to positively respond by increasing the
scale of production.
• Desire for self-defence in a competitive market: Owing to cut throat
competition in business, the firm may be forced to enlarge its scale
of production for its very survival.

5. Economies of Scale
As output increases, the firm’s average cost of producing that output is
likely to decline, at least to a point.
Reasons:
1. If the firm operates on a larger scale, workers can specialize
in the activities at which they are most productive.
2. Scale can provide flexibility. By varying the combination of
inputs utilized to produce the firm’s output, managers can
organize the production process more effectively.
3. The firm may be able to acquire some production inputs at
lower cost because it is buying them in large quantities and
can therefore negotiate better prices. The mix of inputs
might change with the scale of the firm’s operation if
managers take advantage of lower-cost inputs.

6. Diseconomies of Scale
At some point, however, it is likely that the average cost of production will
begin to increase with output.
Reasons for this shift:
1. At least in the short run, factory space and machinery may
make it more difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and
inefficient as the number of tasks increases.
3. The advantages of buying in bulk may have disappeared
once certain quantities are reached. At some point,
available supplies of key inputs may be limited, pushing
their costs up.

7. ● economies of scale Situation in which output can be
doubled for less than a doubling of cost.
● diseconomies of scale Situation in which a doubling
of output requires more than a doubling of cost.
Economies & Diseconomies of Scale

8. Cost Function
Is a financial terms used by economists and managers within businesses to
understand how costs behave.
A cost function C(q) is a function of q, which tells us what the minimum cost
is for producing q units of output. We can also split total cost into fixed cost
and variable cost as follows:

9. Components of Cost Function
Total cost is defined as the Total actual
cost that must be incurred to produce a
given quantity of output.
Fixed costs are costs that must be paid
regardless of production or output.
Are cost incurred that does
not vary with the output
Average Fixed Cost (AFC) is defined as
Fixed costs (FC) divided by the quantity
produced
Variable costs are costs that change with the
level of production, usually costs that are in
some way directly associated with output, such
as electricity, paper, steal, packaging
Are cost that changes in
direct proportion to quantity
produce
Average Variable Cost (AVC) is defined
as Variable costs (VC) divided by the
quantity produced

10. Marginal and Average Cost
Average Total Cost (ATC)
● average total cost (ATC) Firm’s total cost
divided by its level of output.
● average fixed cost (AFC) Fixed cost divided
by the level of output.
● average variable cost (AVC) Variable cost
divided by the level of output.

11. Marginal and Average Cost
Marginal Cost (MC)
● Increase in cost resulting from the production of one extra unit of
output.
Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in
total cost that results from an extra unit of output.
We can therefore write marginal cost as

12. Marginal and Average Cost
TABLE 7.1 A Firm’s Costs
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Cost Variable Cost Total Cost
(Units (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars
per Year) per Year) per Year) per Year) per Unit) per Unit) per Unit) per Unit)
(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)
(1) (2) (3) (4) (5) (6) (7)
0 50 0 50 -- -- -- --
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Marginal Cost (MC)

13. The Shapes of the Cost Curves
Cost Curves for a Firm
In (a) total cost TC is the
vertical sum of fixed cost
FC and variable cost
VC.
In (b) average total cost
ATC is the sum of
average variable cost
AVC and average fixed
cost AFC.
Marginal cost MC
crosses the average
variable cost and
average total cost
curves at their minimum
points.
Figure 7.1