Costs of Production
Jan 03, 2016
Costs of
Production
Costs of
Production
The Meaning of CostsThe Meaning of Costs
• Opportunity costs– meaning of opportunity cost
– examples
• Measuring a firm’s opportunity costs– factors not owned by the firm: explicit costs
– factors already owned by the firm: implicit costs
– irrelevance of:• historic costs
• replacement costs
• Opportunity costs– meaning of opportunity cost
– examples
• Measuring a firm’s opportunity costs– factors not owned by the firm: explicit costs
– factors already owned by the firm: implicit costs
– irrelevance of:• historic costs
• replacement costs
Production in the Short runProduction in the Short run
• Production functions
– factors of production
• labour
• land and raw materials
• capital
• entrepreneurship
– the relationship between inputs and output
• TPP = ƒ(F1, F2, F3, … Fn)
• Production functions
– factors of production
• labour
• land and raw materials
• capital
• entrepreneurship
– the relationship between inputs and output
• TPP = ƒ(F1, F2, F3, … Fn)
Production in the Short runProduction in the Short run
• Long-run and short-run production – fixed and variable factors
– distinction between short run and long run
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP, APP and MPP
• Long-run and short-run production – fixed and variable factors
– distinction between short run and long run
• The law of diminishing returns
• The short-run production function:– total physical product (TPP)
– average physical product (APP)
– marginal physical product (MPP)
– the graphical relationship between TPP, APP and MPP
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
Wheat production per year from a particular farmWheat production per year from a particular farmT
onn
es
of w
he
at p
rod
uce
d p
er
yea
r
Number of workers
012345678
TPP 0 310243640424240
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar
Number of workers
012345678
TPP 0 310243640424240
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
Wheat production per year from a particular farmWheat production per year from a particular farm
Number of farm workers
To
nne
s o
f wh
eat
pro
du
ced
pe
r ye
ar TPP
b
Diminishing returnsset in here
d
Maximum output
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Number offarm workers (L)
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
Number offarm workers (L)
TPP = 7
L = 1
MPP = TPP / L = 7
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
MPP
Number offarm workers (L)
Number offarm workers (L)
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
APP = TPP / L
Number offarm workers (L)
Number offarm workers (L)
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
b
b
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
Diminishing returnsset in here
Number offarm workers (L)
Number offarm workers (L)
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Maximumoutput
b
Wheat production per year from a particular farmWheat production per year from a particular farm
0
10
20
30
40
0 1 2 3 4 5 6 7 8
c
c
-2
0
2
4
6
8
10
12
14
0 1 2 3 4 5 6 7 8
Ton
nes
of w
heat
per
yea
r
TPP
Ton
nes
of w
heat
per
yea
r
APP
MPP
b
b
d
d
Number offarm workers (L)
Number offarm workers (L)
Slope = TPP / L= APP
Wheat production per year from a particular farmWheat production per year from a particular farm
Costs in the Short runCosts in the Short run
• Costs and inputs
– costs and the productivity of factors
– costs and the price of factors
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
• TVC and the law of diminishing returns
– total cost (TC = TFC + TVC)
• Costs and inputs
– costs and the productivity of factors
– costs and the price of factors
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
• TVC and the law of diminishing returns
– total cost (TC = TFC + TVC)
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
Output(Q)
01234567
TFC(£)
1212121212121212
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TFC
Output(Q)
01234567
TFC(£)
1212121212121212
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TFC
Total costs for firm XTotal costs for firm XOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TVC
Output(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TFC
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TVC
TFC
Total costs for firm XTotal costs for firm XOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TC(£)
12222833405272
103
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TCOutput
(Q)
01234567
TFC(£)
1212121212121212
TVC(£)
010162128406091
TC(£)
12222833405272
103
TVC
TFC
Total costs for firm XTotal costs for firm X
0
20
40
60
80
100
0 1 2 3 4 5 6 7 8
TC
TVC
TFC
Total costs for firm XTotal costs for firm X
Diminishing marginalreturns set in here
Costs in the Short runCosts in the Short run
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
Output (Q)
Co
sts
(£)
MC
x
Average and marginal costsAverage and marginal costs
Diminishing marginalreturns set in here
Costs in the Short runCosts in the Short run
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between MC and TC curves
• Marginal cost
– marginal cost (MC) and the law of diminishing returns
– the relationship between MC and TC curves
Output (Q)
Co
sts
(£)
MC
x
Average and marginal costsAverage and marginal costs
Costs in the Short runCosts in the Short run
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
• Relationship between average and marginal cost
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
• Relationship between average and marginal cost
Output (Q)
Co
sts
(£)
AFC
AVC
MC
x
AC
z
y
Average and marginal costsAverage and marginal costs
Production in the Long runProduction in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
Short-run and long-run increases in outputShort-run and long-run increases in output
Short-run and long-run increases in outputShort-run and long-run increases in output
Short-run and long-run increases in outputShort-run and long-run increases in output
Short-run and long-run increases in outputShort-run and long-run increases in output
Production in the Long runProduction in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
Production in the Long runProduction in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• Returns to scale and economies and diseconomies of scale
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• Returns to scale and economies and diseconomies of scale
Production in the Long runProduction in the Long run
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
• Economies of scope
• Economies of scale– specialisation & division of labour
– indivisibilities
– container principle
– greater efficiency of large machines
– by-products
– multi-stage production
– organisational & administrative economies
– financial economies
• Economies of scope
Production in the Long runProduction in the Long run
• Diseconomies of scale– managerial diseconomies
– effects of workers and industrial relations
– risks of interdependencies
• External economies of scale
• External diseconomies of scale
• Location– balancing the distance from suppliers and
consumers
– importance of transport costs
• Diseconomies of scale– managerial diseconomies
– effects of workers and industrial relations
– risks of interdependencies
• External economies of scale
• External diseconomies of scale
• Location– balancing the distance from suppliers and
consumers
– importance of transport costs
Production in the Long runProduction in the Long run
• Optimum combination of factors
– MPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Decision making in different time periods– very short run
– short run
– long run
– very long run
– decisions can be made for all time periods at the same time
• Optimum combination of factors
– MPPa/Pa = MPPb/Pb ... = MPPn/Pn
• Decision making in different time periods– very short run
– short run
– long run
– very long run
– decisions can be made for all time periods at the same time
Costs in the Long runCosts in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
Alternative long-run average cost curvesAlternative long-run average cost curves
OutputO
Co
sts
LRAC
Economies of Scale
OutputO
Co
sts
LRAC
Alternative long-run average cost curvesAlternative long-run average cost curves
Diseconomies of Scale
OutputO
Co
sts
LRAC
Alternative long-run average cost curvesAlternative long-run average cost curves
Constant costs
A typical long-run average cost curveA typical long-run average cost curve
OutputO
Co
sts
LRAC
A typical long-run average cost curveA typical long-run average cost curve
OutputO
Co
sts
LRACEconomiesof scale
Constantcosts
Diseconomiesof scale
Costs in the Long runCosts in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
Long-run average and marginal costsLong-run average and marginal costs
OutputO
Co
sts
LRAC
LRMC
Economies of Scale
OutputO
Co
sts
LRAC
Long-run average and marginal costsLong-run average and marginal costs
LRMC
Diseconomies of Scale
OutputO
Co
sts
LRAC
Long-run average and marginal costsLong-run average and marginal costs
= LRMC
Constant costs
OutputO
Co
sts
Long-run average and marginal costsLong-run average and marginal costs
LRMC
LRAC
Initial economies of scale,then diseconomies of scale
Costs in the Long runCosts in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs
Costs in the Long runCosts in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size
SRAC3
Co
sts
OutputO
SRAC4
SRAC5
5 factories
4 factories3 factories2 factories
1 factory
SRAC1 SRAC2
SRAC1
SRAC3
SRAC2 SRAC4
SRAC5
LRAC
Co
sts
OutputO
Deriving long-run average cost curves: factories of fixed sizeDeriving long-run average cost curves: factories of fixed size
Deriving a long-run average cost curve: choice of factory sizeDeriving a long-run average cost curve: choice of factory sizeC
ost
s
OutputO
Examples of short-runaverage cost curves
LRAC
Co
sts
OutputO
Deriving a long-run average cost curve: choice of factory sizeDeriving a long-run average cost curve: choice of factory size
Costs in the Long runCosts in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice
Costs in the Long runCosts in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
Costs in the Long runCosts in the Long run
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
– minimum efficient plant size
• Long-run average costs– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and short-run average costs– the envelope curve
• Long-run cost curves in practice– the evidence
– minimum efficient plant size