The Cost of Production
Each firm uses various inputs (resources) in its production activity.
Commonly used inputs: labor and capital
Prices of inputs (wages, rents) Cost of Production
Measuring Cost: Which Costs Matter?
It is clear that if a firm has to rent equipment or buildings, the rent they pay is a cost.
What if a firm owns its own equipment or building?How are costs calculated here?
Measuring cost:
Opportunity cost – the value of a highest forgone alternative;– cost associated with opportunities that are forgone when a firm’s resources are not put to their highest-value use.
Economic cost.
Some costs vary with output, while some remain the same ,no matter amount of output.
Fixed Cost (FC) – cost that does not vary with the level of output.- have to be paid as long as the firm stays in business (even if output is zero)
Variable Cost (VC) – cost that varies as the level of output varies.
Total Cost (TC or C) – total economic cost of production, consisting of fixed and variable costs.
TC=FC+VC
Which costs are variable and which are fixed depends on the time horizon
Short time horizon – most costs are fixedLong time horizon – many costs become variable
In determining how changes in production will affect costs, we must consider if it affects fixed or variable costs
A Firm’s Short Run Costs
Cost in the Short run
Cost Curves for a Firm
Output
Cost($ peryear)
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
TVC
Variable costincreases with production and
the rate varies withincreasing &
decreasing returns.
TC
Total costis the vertical
sum of FC and VC.
TFC50
Fixed cost does notvary with output
Costs that are fixed in the short run may not be fixed in the long run.
Typically in the long run, most if not all costs are variable.
Per-Unit, or Average, Costs
Average Total cost – firm’s total cost divided by its level of output (average cost per unit of output) ATC=AC=TC/Q
Average Fixed cost – fixed cost divided by level of output (fixed cost per unit of output)AFC=FC/Q
Average variable cost – variable cost divided by the level of output.AVC=VC/Q
Marginal Cost – change (increase) in cost resulting from the production of one extra unit of output
Denote “∆” - change. For example ∆TC - change in total cost
MC=∆TC/∆Q
Example: when 4 units of output are produced, the cost is 80, when 5 units are produced, the cost is 90. MC=(90-80)/1=10
MC=∆TVC/∆Q
since TC=(TFC+TVC) and TFC does not change with Q
A Firm’s Short Run Costs
Cost Curves
0
20
40
60
80
100
120
0 12
Output (units/yr)
Co
st (
$/u
nit
) MC
ATC
AVC
AFC
Marginal Product and Costs Suppose a firm pays each worker $50 a day.
Units of Labor
Total Product
MP VC MC
0 0 0 0
1 10 10 50 5
2 25 15 100 3.33
3 45 20 150 2.5
4 60 15 200 3.33
5 70 10 250 5
6 75 5 300 10
Short-run Costs and Marginal Product production with one input L – labor; (capital is fixed)
Assume the wage rate (w) is fixed Variable costs is the per unit cost of extra labor times the amount
of extra labor: VC=wL
D Denote “∆” - change. For example ∆VC is change in variable cost.
MC=∆VC/∆Q ; MC =w/MPL,
where MPL=∆Q/∆L
With diminishing marginal returns: marginal cost increases as output increases.
Shifts of the Cost CurvesChanges in resource prices or technology will cause costs to change
Cost curves shift
FC increases by 100
Shift of FC curve
Output
Cost($ peryear)
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
VC
TC
FC50
FC’150
TC’
Summary
In the short run, the total cost of any level of output is the sum of fixed and variable costs: TC=FC+VC
Average fixed (AFC), average variable (AVC), and average total costs,(ATC) are fixed, variable, and total costs per unit of output; marginal cost is the extra cost of producing 1 more unit of output.
A FC is decreasing
AVC and ATC are U-shaped, reflecting increasing and then diminishing return Marginal cost curve (MC) falls and then rises, intersecting both AVC and ATC at their minimum points.
Closing Questions:
Q1: Those things that must be forgone to acquire a good are called
a. substitutes. b. opportunity costs. c. explicit costs. d. competitors.
Q2: Explicit costs a. require an outlay of money by
the firm. b. include all of the firm's
opportunity costs. c. include income that is forgone
by the firm's owners. d. Both b and c are correct.
Q4: An example of an explicit cost of production would be
a. the cost of forgone labour earnings for an entrepreneur.
b. the lost opportunity to invest in capital markets when the money is invested in one's business.
c. lease payments for the land on which a firm’s factory stands.
d. Both a and c are correct.
Q5: The amount of money that a wheat farmer could have earned if he had planted barley instead of wheat is
a. an explicit cost. b. an accounting cost c. an implicit cost. d. forgone accounting profit.