Costs of Production
What factors affect costs
What do we need to
consider in costs
Wherever production takes place,
costs follow. One has to make
payments for all factors of
production, i.e. incur certain costs
Cost curves show the minimum cost of
producing various levels of output
Explicit vs Implicit cost
• Explicit costs are actual, out of pocket
expenditures for factors hired or
purchased e.g. rent.
• Implicit costs are costs of factors owned
by firm and used in its own production
process.
COSTS= EXPLICIT + IMPLICIT
SUNK COSTS
Time period and costs
Short Run costs
• Total fixed cost (TFC)– cost which firm
incurs for fixed inputs, whether there is
output or not. eg. Rent
• Total variable cost (TVC) –cost incurred by
firm for variable input eg raw material
TOTAL COST = TFC + TVC
Long run costs All costs are variable
Numerical
Q TFC TVC TC • Plot in the form of
0 60 0 a graph.
1 60 30
2 60 40 • What is the shape
of cost curve
3 60 45
4 60 55
• New image 1
5 60 75
6 60 120
FIGURE 6-7 Short-Run Total Cost, Total Variable Cost, and
Total Fixed Cost
Short run units costs
Average fixed costs (AFC)=TFC/output
Average variable costs (AVC)=TVC/output
Average cost =Total cost/output
AC = AVC +AFC
Marginal cost (MC)= change in TC per unit of
output
(Calculate and Plot all costs on a graph……)
Fill in blanks
Q TC TFC TVC ATC AFC AVC MC
0 125
10 5
20 10.5
30 110
40 255
50 3
60 3
70 5
Short run unit costs
Shape of MC,AVC and AC
curve
• Why are MC, AVC and AC curve U shaped?
• Why does AC reach its lowest point to
right of point at which AVC curve is
lowest?
• Why does the MC curve intersect the AVC
and AC curves at their respective lowest
point?
Long Run costs
• In long run, all factors are variable. The firm can
build a plant of any size.
• The long run average cost (LAC) curve shows the
minimum per unit cost of producing each level of
output when any desired scale of plant can be
built. LAC is given by a curve tangent to all SAC
curves representing all alternative plant sizes
that the firm can build in the long run.
• Mathematically, LAC is envelope of SAC curves.
Relationship Between Short-Run Average Cost Curves and the
Long-Run Average Cost Curve
Economies of Scale
• Why does LAC fall in beginning
- Economies of scale (Internal vz
external economy)
- Why does LAC rise eventually
- Diseconomies of scale (internal vz
external)
Long-Run Average Cost and Returns to Scale
Learning curves
• As firm gain experience in production
of a commodity, the average cost of
production declines. For a given level
of output, cost per unit decreases.
the learning curve shows decline in
average input cost of production with
rising cumulative total output over
time.
Estimating and using cost
functions
• Find minimum total cost function
given
TC = 1000 + 10 Q _ .9Q² + .04Q³
Find rate of output that results in
minimum average variable cost
Profit = Revenue -
Cost
Revenue concepts = TR, MR, AR
Total Revenue (TR): The sum total of sale
proceeds from no. of units sold. TR= P.Q
Average Revenue: This is TR/ quantity
Marginal Revenue: This is change in total
revenue when there is change in quantity
sold of a product. MRn = TRn – TRn-1.
International applications
of cost minimisation
• Growing importance of international
trade i.e. theory of comparative
advantage
• MNC which have production plants
throughout the world
International applications
contd…
• Ability on part of some firms to
satisfy their needs for some skilled
labour from abroad
• Brain drain
• Outsourcing trends – bpo, kpo, lpo
Break even analysis
• The break even point is that
point of activity (sales volume)
where total revenue and total
expenses are equal. It is point of
zero profit.
1. Breakeven point in units
2. Breakeven point in sales
3. Breakeven point in percentage
Break-Even Analysis
• At the Break-even point TR =
but
TC, TR TVC TFC
or
P(Q) AVC(Q) TFC
TFC
therefore: QBEP
P AVC
(P - AVC) is known as the unit
contribution margin.
[1-(AVC/P)] is known as the
contribution margin ratio and indicates
the fraction of the price that covers
fixed cost and profit
Break even analysis
• S b = TFC
1- ( TVC/ TR)
% b = TFC * 100
( P- AVC) * Q (cap)