COST OF PRODUCTION

Prof. Prabha Panth,Osmania University,

Hyderabad

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Costs• A Rational Firm tries to minimise its costs of

production.• Costs include “Explicit Costs” and “Implicit Costs.”• Explicit or Money costs: actual money expenditure

on factors of production, raw material, etc.• Implicit or Real costs: includes the value of the inputs

owned by the firm, and used by it for production.• Implicit costs are not in money terms.• They are the “Opportunity Costs”, the value of the

opportunities or alternatives given up to produce this product, instead of another.

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Money Costs: Fixed and Variable Costs

• Output is produced with the help of fixed and variable inputs.

• The cost of hiring/using these are the fixed and variable costs to the firm.

• Fixed Costs: on fixed inputs that cannot be changed in the short run. o Includes: rent, interest and normal profits.

• Variable Costs: on inputs that change as output increases.o Includes wages, raw material costs, other costs such as on

power, water, transport, etc.

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Short Run Costs of a Firm

• Total cost (TC) = Total Fixed Cost + Total Variable Cost.• Total Fixed Cost (TFC): in the short run, cost of fixed

factors remain constant.Fixed costs do not change with increase in output.

• Total Variable Cost (TVC): change as output increases. • As output does not increase at a constant rate in the

short run, TVC also does not increase at a constant rate as Q increases.

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Q (Kgs) TFC (Rs) TVC (Rs) TC (Rs)

0 60 0 60

1 60 30 90

2 60 40 100

3 60 45 105

4 60 55 115

5 60 75 135

6 60 120 180

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Total Cost Curves

Costs

0Quantity of output

Total Fixed Cost=TFC

Total Variable Cost=TVC

Total Cost=TC

TFC

F

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TC, TFC and TVC

• Fixed costs have to be paid even when no output is produced.oSo TFC starts from F, when Q = 0.o It remains constant as Q increases.oFor instance, rent or interest is not increased

depending on output produced.oSo TFC is a straight line parallel to X – axis.

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TC, TFC and TVC• Total Variable Cost: is zero, when Q =0. It increases as Q

increases. But not at a constant rate.• Initially it increases at a decreasing rate, then at a constant

rate, and finally at an increasing rate. • This is because of the operation of the Law of Variable

Proportions.• Initially, when the fixed and variable proportions become

optimum, costs increase slowly.• In the third stage of production, fixed factors become a

constraint, and costs increase rapidly.• This gives the peculiar shape of the TVC. (Inverted S-

shape).

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Total Cost

• TC = TFC + TVC,• When Q = 0, TVC = 0, but TFC = 0F. So TC also

starts at F, and not from the origin as TVC.• As Q increases, TVC also increases, but TFC

remains constant.• So the shape of the TC resembles the TVC, as Q

increases,• But it lies above the TVC, the difference being

TFC.

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• Average Cost: AC = TC/Q• TC = TFC + TVC

• Average Fixed Cost, AFC, i.e. Total Fixed Cost/Q.• Average Variable Cost, AVC = Total Variable Cost/Q• Therefore AC = AFC + AVC• Marginal Cost, MC = ∆TC/∆Q = ∆TVC + ∆TFC

∆Q• As ∆TFC = 0, therefore MC = ∆TVC/ ∆Q = ∆TC/ ∆Q

AC = TC = TFC + TVCQ Q Q

Average Costs

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Q (Kgs)

TFC (Rs)

TVC (Rs)

TC (Rs) AFC AVC AC MC

0 60 0 60 -- -- -- --

1 60 30 90 60 30 90 30

2 60 40 100 30 20 50 10

3 60 45 105 20 15 35 5

4 60 55 115 15 13.75 28.75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45

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Cost

s

0Output (Q)

AFC

AVC

ACMCTHE SHORT RUN COST CURVES

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Shapes of the Per unit cost curves• Average Fixed Cost: AFC: always falls as Q

increases. Rectangular Hyperbola: area under AFC is always constant. AFC × Q = TFC, at any point on the curve.

• Average Variable Cost: AVC: U-shaped curve. As Q increases, AVC first falls, reaches a minimum, and then rises.

• This is due to the Law of Variable Proportions.

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Shapes of the Per unit cost curves• Average Cost: AC: also U-shaped. AC = TC/Q. Or sum

of AFC+AVC, AC lies above AVC. Initially both are falling, so AC also falls,

• Reaches a minimum, then as AVC rises, AC also rises.• Marginal Cost: MC: is the rate of change in TC due to

change in Q. Since TFC does not change, MC is affected only by TVC.

• It is also U-shaped. It falls when AVC falls, • It cuts AVC first at its minimum point, then AC at its

minimum point, and then rises steeply.

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Long Run Cost Curves

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The Long Run

• The Long Run refers to the period of time when all factors are variable.

• When it is possible to increase the scale of operation by investing in more machinery, buildings, plant size, and so on.

• Thus the Long Run is a series of short runs.• In the Long Run, as the scale of production

increases, it affects the Long Run Costs as well.

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Long Run Costs

• The Long Run cost curves are a series of short run cost curves.

• As output increases it is more economical to increase the scale of production.

• By installing new plant, machinery, buildings, more output can be produced with lower costs.

• So the firms start expanding in the long run.

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Short Run and Long Run CostsCo

sts

0 Q

SAC1

C0

Q1 Q2

C1SAC2

C2C3

SAC3

Q3

LRAC

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Returns to Scale

• Initially, in the long run, as the size of production increases, the long run Average Costs start falling.

1. This is called the period of Decreasing Costs or Increasing Returns to Scale. Due to:o Cheaper inputs with bulk purchase, o Availability of loans easier for large scale units,o Cheaper transport, in railways, trucks,

2. After a certain scale is reached, AC does not change with increase in Q. This is the period of Constant Costs, or Constant Returns to Scale.

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Returns to Scale

3. Further expansion of the firm, leads to increase in managerial costs, and external costs (pollution, over crowding, etc.), competition for labour, raw material, etc.. So LRAC starts rising.

• This is known as Increasing Costs, or Decreasing Returns to Scale.

• When the firm expands, it goes through all the three types of Returns to Scale – Decreasing costs, Constant Costs and Increasing costs.

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Cost

s

0 Output

LRACLMAC

Q1

C1

Decr

easin

g Co

sts o

r Inc

reas

ing

Retu

rns t

o Sc

ale

Q2

C2

Constant Costs or Constant Returns to Scale

Incr

easin

g Co

sts o

r De

crea

sing

Retu

rns t

o Sc

ale

E

QE

Minimum LRAC, efficient level of output

Returns to Scale

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Long Run Cost

• The LRAC is called the “envelope” curve, as the SAC curves lie within it.

• It is the outer envelope of the SAC curves.• An optimum firm will operate at the lowest

LRAC, at the point where LRAC = LRMC.• This point of lowest LRAC indicates the

“efficiency” of the firm.

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Questions

• Short Answer Questions (one page answers):1. Distinguish between Explicit and Implicit costs of

a firm.2. Depict AFC, AVC, AC, and MC in a diagram, and

explain the reason for their shapes.3. What are the main differences between the

Short run and the Long run Costs of a firm?4. What is the point of efficient production? Depict

it with the help of a diagram.

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Questions

• Essay type Questions (3-5 page answers):1. Explain how the Law of Variable Proportions affects the

shape of the SAC.2. Draw the following cost curves, and state reasons for their

shapes: a) TFC, b) TVC, c)TC, d) AFC, e) AVC, f) AC, and g) MC.

3. What is an “envelope curve”? How is it derived, and what is its significance?

4. Explain what is meant by the following: a) Decreasing Costs, b) Constant Costs, and c) Increasing

Costs. Draw diagrams to illustrate the above concepts. Why do they occur?