7 Cost of Production

Managerial Economics Thomas
Managerial Economics Maurice

ninth edition
Cost of Production
McGraw-Hill/Irwin
Managerial Economics, 9e Copyright © 2008 by the McGraw-Hill Companies, Inc. All rights reserved.
Managerial Economics
Cost
• Cost is the sacrifice or foregoing that has
occurred or has potential to occur in future,
measured in monetary terms.
• Cost is a function of output, technology and
prices of input.
• C= f(Q,T,P)
Types of Cost
• Accounting Costs
• Explicit Costs
• Opportunity costs
• Implicit Costs
• Social Costs
• Replacement Costs
• Direct and Indirect Costs
• Production and Selling Costs
Case
• Linda Wheeler earns $50,000 a year as
an aeronautical engineer with the
Skyhigh Aircraft Corporation. On her way
home from work one day, she gets an
idea for a rounder, more
friction-resistant airplane wheel. She
decides to quit her job and start a
business, which she calls Wheeler Dealer.
Case
• To buy the necessary machines and
equipment, she withdraws $20,000 from her
savings account that earned interest of $1000
a year. She hires and assistant (and paid
$21,000 a year) and starts producing the
wheel using the spare space in her garage,
which she had been renting to a neighbour for
$100 a month. Revenue totaled $105,000 in
the first year.
Case
• People kept telling her that she is trying to
reinvent the wheel and this business idea is
not very profitable. Linda decides to review
her firm’s performance.
• Can you help her to decide what should she

do? Continue or Quit?
Short Run Production Costs

• Total variable cost (TVC)
– Total amount paid for variable inputs
– Increases as output increases
• Total fixed cost (TFC)
– Total amount paid for fixed inputs
– Does not vary with output
• Total cost (TC)
– TC = TVC + TFC
8-7
Short-Run Total Cost Schedules
Output (Q) Total fixed cost Total variable cost Total Cost
(TFC) (TVC) (TC=TFC+TVC)
0 $6,000 $ 0 $ 6,000
100 6,000 4,000 10,000
200 6,000 6,000 12,000
300 6,000 9,000 15,000
400 6,000 14,000 20,000
500 6,000 22,000 28,000
600 6,000 34,000 40,000
8-8
Total Cost Curves (Figure 8.3)
8-9
Average Costs
•
8-10
Short Run Marginal Cost

• Short run marginal cost (SMC) measures rate
of change in total cost (TC) as output varies
8-11
Average & Marginal Cost Schedules
Output Average Average Average total Short-run

(Q) fixed cost variable cost cost marginal cost
(AFC=TFC/Q) (AVC=TVC/Q) (ATC=TC/Q= (SMC=ΔTC/ΔQ)
AFC+AVC)
0 -- -- -- --
100 $60 $40 $100 $40
200 30 30 60 20
300 20 30 50 30
400 15 35 50 50
500 12 44 56 80
600 10 56.7 66.7 120
8-12
Average & Marginal Cost Curves
8-13
Short Run Average & Marginal Cost Curves
8-14
Short Run Cost Curve Relations

• AFC decreases continuously as output
increases
– Equal to vertical distance between ATC &
AVC
• AVC is U-shaped
– Equals SMC at AVC’s minimum
• ATC is U-shaped
– Equals SMC at ATC’s minimum
8-15
Short Run Cost Curve Relations

• SMC is U-shaped
– Intersects AVC & ATC at their minimum
points
– Lies below AVC & ATC when AVC & ATC
are falling
– Lies above AVC & ATC when AVC & ATC
are rising
8-16
Points to Remember
• AC falls when MC < AC
• AC rises when MC > AC
• AC is minimum when MC = AC
Revenue
• Total Revenue
• TR = Q.P
• Average Revenue
• AR = TR/Q
• MR = TRQ – TRQ-1
Cost/Revenue TC
FC
TR
Output/Sales
Rules of Profit Maximization

• Supernormal Profit is the accounting profit
that occurs when total revenue exceeds total
cost
• Normal profit is that amount of return which
must be earned to keep the entrepreneur in
that business activity
Break Even Analysis

• Breakeven Point is the point where total cost
just equals the total revenue; it is the no profit
no loss point.
• Breakeven point is the point of intersection of
total revenue and total cost curves.
• BEP = TFC/(P-AVC)
• Example: Future Group
Economies of Scale
• Economies of Scale means lowering costs of
production by producing in bulk.
• Internal economies: cost per unit depends on
the size of the firm
• External economies: cost per unit depends on
the size of the industry, not the firm.
• Example: Amul
Long Run Average Cost Curve

Economies of Scope
• Economies of scope arises with lower average
costs of manufacturing a product when two
complementary products are produced by a
single firm.
• Example: Amul
Case Let 1
• The cost of attending a private college for one
year is $6000 for tuition, $2000 for the room,
$1500 for meals and $500 for books and
supplies. The student could have earned
$15000 by getting a job instead of going to
college and 10 per cent interest on expenses
he or she incurs at the beginning of the year.
Calculate explicit and implicit cost and
economic cost of attending college.
Case Let 2
• Mr. Rodrigues runs a grocery shop in a house
that he owns in Panjim. Recently, the shipping
company that he used to work for earlier for
R. 95,000 per year, made him an offer for
employment. Mr. Rodrigues annual income
statement is as follows:
Revenue Interest
Rs. 6,25,000 Rs. 5,000
Cost of Goods sold Other Expenses
Rs. 3,25,000 Rs.15,000
Wages (of assistants) Profit
Rs.75,000 Rs. 1,75,000
Taxes
Rs. 30,000
• The market value of the shop is Rs. 3,50,000.

That is, if he wishes, he could sell the shop for
this amount and rent out the building for Rs.
50,000/- per year. If he sells the business, he
can invest and earn an annual return of 9 per
cent. Should Mr. Rodrigues continue in his
business or should join the shipping company?
THANK YOU

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Managerial Economics Thomas

Managerial Economics Maurice

• Can you help her to decide what should she

Short Run Production Costs

Short-Run Total Cost Schedules

Total Cost Curves (Figure 8.3)

Short Run Marginal Cost

Average & Marginal Cost Schedules

Output Average Average Average total Short-run

Average & Marginal Cost Curves

Short Run Average & Marginal Cost Curves

Short Run Cost Curve Relations

Short Run Cost Curve Relations

Rules of Profit Maximization

Break Even Analysis

Long Run Average Cost Curve

• The market value of the shop is Rs. 3,50,000.

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