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.