This document discusses different types of costs involved in production, including: - Explicit costs which are actual payments, versus implicit costs which are work done without monetary payment - Private costs accrued by firms/individuals engaged in an activity, versus external/social costs passed to society - Sunk costs which cannot be recovered and should be ignored in decisions - Money costs which are payments to factors of production - Opportunity cost as the next best alternative foregone in producing something It also explains concepts like fixed costs, variable costs, total costs, average costs and marginal cost, and how they relate in the short-run and long-run, including economies and diseconomies of scale. Diagrams are used to depict

1. 1
COSTS OF PRODUCTION
Dr.Sunitha.S
Assistant Professor
School of Management Studies,
National Institute of Technology (NIT) Calicut

2. Explicit & Implicit Cost
2
 Explicit cost refers to the making of actual payments in
the process of production.
Whereas Implicit cost implies that although the work gets
done yet there is no corresponding payment for it in terms of
money.

3. Private and Social Cost
3
Private costs are those that accrue directly to the
individuals or firms engaged in relevant activity.
External costs on the other hand are are passed on to persons
not involved in the activity in any direct way (ie they are
passed to society at large)

4. Sunk Cost
4
A sunk cost is an expenditure that has been made and cannot
be recovered.
Since it cannot be recovered, it should be ignored while
taking economic decisions.
Eg: a firm buys a highly specialized machine for a plant. It can
be used only what it was designed for. That is, it cannot be put
in alternative uses. Its opportunity cost is zero.

5. Money cost
5
Money cost refers to the payments made to the factors of
production in terms of money proper in return for their
services enjoyed by the producer in his process of
production. For e.g. payments made for purchasing raw
material, rent of land, wages for labour.

6. Opportunity Cost (Alternative or
Transfer Cost)
6
“The opportunity cost of anything produced can thus be defined as
the next best alternative that can be produced instead by the same
factors or by an equivalent group of factors costing the same
amount of money.”
 Resources are limited and therefore they cannot be used for
more than one purpose at the same time. E.g. If land is used for
building a house, the same land cannot be used for agricultural
purpose. In general terms, if a resource can produce either ‘A’ or
‘B’, then the opportunity cost of producing ‘A’ is the loss of ‘B’.

7. Discussion
7
Three Industries
Personal computers
Software
Restaurant

8. Costs
8
Total fixed costs (TFC)
Average fixed costs (AFC)
Total variable costs (TVC)
Average variable cost (AVC)
Total cost (TC)
Average total cost (ATC)
Marginal cost (MC)

9. Short-Run & Long-Run
9
“Time concepts” rather than fixed periods.
Short-run:
One or more production input is fixed:
Increasing cropland?
One crop or livestock production cycle.
Long-run:
The quantity of all necessary production inputs can
be changed.
Expand or acquire additional inputs.

10. Fixed Costs
(Overhead costs)
10
Result from owning a fixed input or resource.
Incurred even if the resource isn’t used.
Don’t change as the level of production changes
(in the short run).
Exist only in the short run.
Not under the control of the manager in the
short run.
The only way to avoid fixed costs is to sell the
item.

11. Fixed cost
11
Examples:
Taxes on property
Interest
Depreciation
Rent
Insurance

12. Important Fixed Costs
12
Total fixed cost (TFC):
All costs associated with the fixed input.
Average fixed cost per unit of output:
AFC = TFC
Output

13. Variable Costs
13
Can be increased or decreased by the manager.
Variable costs will increase as production increases.
Variable costs exist in the short-run
and long-run:
In fact, all costs are considered to be
variable costs in the long run.

14. Variable Costs
14
Total Variable cost (TVC) is the summation of
the individual variable costs.
VC = (the quantity of the input) X (the input’s
price).

15. Variable Costs
15
Total variable cost (TVC):
All costs associated with the variable input.
Average variable cost per unit of output:
AVC = TVC
Output

16. Total Cost
16
The sum of total fixed costs and total
variable costs:
TC = TFC + TVC
In the short run TC will only
increase as TVC increases.

17. Total Cost Schedule
Output TFC TVC TC
0 20 0 20
1 20 10 30
2 20 17 37
3 20 22 42
4 20 25 45
5 20 27 47
17 6 20 33 53

18. Total Cost Curves
18

19. Typical Total Cost Curves
(selected attributes)
19
TFC is constant and unaffected by output level.
TVC is always increasing:
First at a decreasing rate.
Then at an increasing rate.
TC is parallel to TVC:
TC is higher than TVC by a distance equal to TFC.

20. Short Run Cost Analysis
Cost Schedule
Output TFC TVC TC AFC AVC AC MC
1 20 10 30 20 10 30 ----
2 20 18 38 10 9 19 8
3 20 25 45 6.6 8.8 15 7
4 20 28 48 5 7 12 3
5 20 30 50 4 6 10 2
6 20 52 72 3.33 8.7 12 22
7 20 85 105 2.9 12.1 15 33
8 20 140 160 2.5 17.5 20 55
20

21. Average Total Cost
21
Average total cost per unit of output:
AFC + AVC
ATC = TC
Output

22. Average Fixed Cost (AFC)
22

23. Average Variable Cost (AVC)
23

24. Short run cost curve
24
The AC curve is the lateral summation
of the average fixed and variable cost
curves.
AC = AFC + AVC

25. Marginal Cost
25
The additional cost incurred from producing an
additional unit of output:
MC = D TC
D Output

26. Discussion
26
Three Industries
Personal computers
Software
Restaurant

27. Economies of Scale
27
Economies arise from the firm increasing its plant size.
Classified into
Real economies
Benefits that cannot be measured in monetary terms which
accrue to the firm when it expands its scale of operations eg:
goodwill of a firm
Pecuniary economies
These are benefits /economies accruing to the firm due to discounts that
it can obtain due to its large scale operations.

28. Diseconomies of scale
28
Losses or increase in costs of production for a firm when it
expands its scale of operation.

29. 29
Short-run and long-run increases in output

30. Production and Cost in the Long
Run
The key difference between the short run and the long run
is that there are no diminishing returns in the long run.
 Diminishing returns occur because workers
share a fixed facility. In the long run the firm can
expand its production facility as its workforce
grows.
 Short run average cost curves are U shaped
owing diminishing marginal returns while long
run average cost curves are U shaped due to
economies of scale.

31. Deriving long-run average cost curves: factories of
fixed size
fig
SRAC3
Costs Output
O
SRAC5
SRAC4
5 factories
2 factories
3 factories4 factories
1 factory
SRAC1 SRAC2

32. Deriving long-run average cost curves: factories of
fixed size
fig
SRAC1
SRAC2 SRAC4
SRAC3
SRAC5
LRAC
Costs Output
O

33. Deriving long-run average cost curves: factories of
fixed size
fig
SRAC1
SRAC2 SRAC4
SRAC3
SRAC5
LRAC
Costs Output
O

34. Deriving a long-run average cost curve: choice of
factory size
fig
LRAC
Costs Output
O
Thank You

35. A typical long-run average cost curve
Economies Constant
LRAC
of scale
costs
fig Output OCosts
Diseconomies
of scale