Unit 5B Cost of Production (Part 1)

Summary MapFirms and How They Operate

Objectives of Firms• Profit Maximization• Other Objectives of Firms

Production Costs in the Short Run

Production Costs in the Long Run

Growth of Firms

Survival of Small Firms

Production Costs in the Short Run

Objectives of Firms• Profit Maximization• Other Objectives of Firms

• Explicit Costs & Implicit Costs• The Law of Diminishing Marginal

Returns• Fixed Costs of Production• Variable Costs of Production• Total Costs of Production

Lesson Objectives

At the end of the lecture, you should be able to:• Explain the concepts of average fixed cost,

average variable cost, average total cost and marginal cost;

• Explain that total cost incorporates a necessary minimum economic reward for firms to remain in the market;

Basic DefinitionsA plant is a geographical location where

production or distribution of a product occurs for example a factory.

A firm is an organization that hires factor factors and combines them to create the goods and services. A firm can be made up of one or

more plants. e.g. SIA, Yeo’s.

An industry is a group of firms producing similar goods and services.

e.g. the beverage industry composing of Yeo’s, F&N and Coca-cola

Lecture Notes Unit 5B Page 2

The Concept of COSTS

Opportunity Costs and Decisions

• Explicit costs are opportunity costs of resources or factors not owned by the firm. They are actual payments made for using such factors. E.g. wages of workers and cost of raw materials.

• Implicit costs are opportunity costs of using resources or factors already owned by the firm itself as well as the cost of bearing uncertainty. They are equal to what these resources or factors could earn in the next best alternative use.

Lecture Notes Unit 5B Page 3

Accounting Costs v.s. Economic Costs

Lecture Notes Unit 5B Page 3

Production Costs at Aunty Wendy’s Snack Stall

Revenue $100,000Explicit Cost $60,000Depreciation (reduction in the value of equipment)

$5000

Accounting cost $65,000Accounting Profit $35,000

Economic Profit = Total Revenue -

Total Cost (Explicit costs + Implicit costs)

?

Implicit cost of business

Income Aunty Wendy could have earned on capital used in the best way

$3000

Income Aunty Wendy could have earned as a baker in someone else’s bakery shop

$32,000

Revenue $100,000Explicit Cost − $60,000Depreciation (reduction in the value of equipment)

− $5000

Accounting Profit $35,000Implicit cost of businessIncome Aunty Wendy could have earned on capital used in the best way

Income Aunty Wendy could have earned as a baker in someone else’s bakery shop

Economic Profit

Production Costs at Aunty Wendy’s Snack Stall

Revenue $100,000Explicit Cost − $60,000Depreciation (reduction in the value of equipment)

− $5000

Accounting Profit $35,000Implicit cost of businessIncome Aunty Wendy could have earned on capital used in the best way

− $3000

Income Aunty Wendy could have earned as a baker in someone else’s bakery shop

− $32,000

Economic Profit 0

Opportunity cost

Accountant Economist

Accountingcost

Accountingcost

Economic Costs

The Production Function

• Fixed factors are factors of production that cannot be increased or decreased in quantity within a given time period. Examples are land and machines.

• Variable factors are factors of production that can be increased or decreased in quantity within a given time period. Examples are labour and raw materials.

• Short-run - It is a time period during which there is at least one fixed factor. Thus output can only be increased by using more variable factors.

• Long-run - It is a time period long enough for all factors to be varied, except for technology. In the example above, the firm can now increase output by both increasing the number of workers and building a new factory.

Lecture Notes Unit 5B Page 2

How long is a typical short run period?

From Production Function to Cost Curves

• In order for a firm to maximize profits, the firm must know how much to pay for its inputs (fixed factors and variable factors).

Total Fixed Cost Total Variable Cost

• Fixed & does not vary with the level of output

• Varies directly with the level of output• When output is zero, TVC is zero

• Exists only in the short run• Will be incurred even if firm choose to shut down temporarily or stop production

• Exists in both SR & LR

• Rent (land), interest payments (capital)

• Wages (labor), cost of raw materials

Lecture Notes Unit 5B Page 3

TFC, TVC & TC CurvesTFC + TVC = TC

TVC

TFC

TCNote: TC curve has the same shape as TVC curve but is higher at each output by $12

12

Output TFC TVC TC

0 12 01 12 102 12 163 12 214 12 285 12 406 12 607 12 91

Costs ($)

Output0

Output TFC TVC TC

0 12 0 121 12 10 222 12 16 283 12 21 334 12 28 405 12 40 526 12 60 727 12 91 103

A. The short run period of a neighborhood bakery shop is shorter than hyper-marts like Giant

B. An example of implicit cost is rent paid by the owner for the shop space he rented

C. Total fixed cost at zero output is zeroD. As long as there is one fixed factor, the firm is

considered to be in the SR periodE. An example of fixed cost is advertisement cost

T

T

T

F

F

True or False?

Types of Costs in the Short Run

Marginal Cost (MC)

Change in total cost as a result of producing an additional unit

of output

MC = TC / QMC = TVC / Q

Lecture Notes Unit 5B Page 4

Short Run - The Law of Diminishing Marginal Returns

Fixed factors: canteen space & baking equipmentVariable factor: Labors (workers) are equally productive

Quantity of labors,

L (workers)

Quantity of Apple

Strudels (output),

Q

Marginal Product of

labor MPL = ∆Q/∆L

(apple strudels per worker)

Marginal Cost

(assume each labor costs $10)

0 01 102 233 304 335 33

fixed factor is underutilized10

1373

increasing specialization and division of labor productivity↑

Diminishing specialization and division of labor

0

Additional worker is redundant

1

0.771.43

3.33N.A.

Table 2: Marginal Cost ConceptsOutput TC MC =

TC /Q

0 12 -

1 22

2 28

3 33

4 40

5 52

6 72

7 103

10

65

7

12

20

31

Costs ($)

Quantity of spectacles0

MC

1 2 3 4 5 6 7

↑ scope of specialization & division of laborEfficient factor combination

↓ scope of specialization & division of laborInefficient factor combination

X

Types of Costs in the Short Run

Average Cost (AC)

Total Cost per unit of output

AC = TC/QAC = AFC + AVC

Marginal Cost (MC)

Change in total cost as a result of producing an additional unit

of output

MC = TC / QMC = TVC / Q

Table 2: Total Cost and Average Cost ConceptsOutput TC AC =

TC/Q

0 12 -

1 22

2 28

3 33

4 40

5 52

6 72

7 103

22

1411

10

10.4

12

14.7 1 2 3 4 5 6 7

Costs ($)

Quantity of spectacles0

AC

Types of Costs in the Short Run

Average Cost (AC)

Total Cost per unit of output

AC = TC/QAC = AFC + AVC

Average Fixed Cost (AFC)

Total Fixed cost per unit of

output

AFC = TFC/QAFC = AC - AVC

Average Variable Cost

(AVC)

Total Variable Cost per unit of

output

AVC = TVC/QAVC = AC - AFC

Marginal Cost (MC)

Change in total cost as a result of producing an additional unit

of output

MC = TC / QMC = TVC / Q

Table 2: Total Cost and Average Cost ConceptsOutput TFC TVC TC AFC =

TFC/QAVC = TVC/Q

0 12 0 12 - -

1 12 10 22

2 12 16 28

3 12 21 33

4 12 28 40

5 12 40 52

6 12 60 72

7 12 91 103

12

6

4

3

2.4

2

1.7

10

8

7

7

8

10

13

A simple math problem

• Imagine that in a group of Ten Vibrant Children (TVC), the Average height of the Vibrant Children (AVC) is 1.6m

• If I add 1 More Child (MC) of 1.5m to the group of average height 1.6m, what will be the new AVC?– AVC <1.6m (fall in AVC)

• What if the height of 1 More Child (MC) is 1.6m?– AVC =1.6m (no change)

• What if the height of 1 More Child (MC) is 1.7m? – AVC >1.6m (rise in AVC)

+

If MC >AVC, my new AVC will

increase. The

converse holds

true.

Relationship between AVC and MCCosts ($)

Quantity0

MCAVC

AVC1AVC2

MC1

MC2

AVC4

AVC3

• AVC is at minimumMC = AVC

• AVC will fallMC < AVC

• AVC will riseMC >AVC

AFC, AVC & AC Curves

AFC

ACMC AVC

X

Y

Z

1 2 3 4 5 6 7

Costs ($)

Quantity of spectacles0

Spreading of overhead Effect: fixed cost is spread over greater output lower AFC

AC

Lecture Notes Unit 5B Page 4

Summary MapFirms and How They Operate

Objectives of Firms• Profit Maximization• Other Objectives of Firms

Production Costs in the Short Run

Production Costs in the Long Run

Growth of Firms

Survival of Small Firms

Production Costs in the Short Run

Objectives of Firms• Profit Maximization• Other Objectives of Firms

• Explicit Costs & Implicit Costs• The Law of Diminishing Marginal

Returns• Fixed Costs of Production• Variable Costs of Production• Total Costs of Production