Chapter 4

The costs of
production

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Learning objectives
1. Define economic and other categories of costs.
2. Examine how various cost concepts vary in the short
and long run.
3. Develop cost-analysis tools that will be useful in later
chapters.

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Economics costs
Economic costs are opportunity costs.
– They are the amount of other products that must be
foregone or sacrificed to obtain a unit of any product.
• Explicit costs
– Monetary payments to non-owners of the firm for resource
supplies
• Implicit costs
– Money payments that the self-employed resource could
have earned in their next best alternative employment
• Normal profits as a cost
– Minimum payment for entrepreneurship required to retain
the entrepreneur in a given line of production

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Economic, or pure, profits
• Economic profit
– The difference between total revenue and opportunity
cost of all inputs
– Accounting profit equals total revenue less explicit costs
• Accounting profit includes economic profit and all
implicit costs:

Economic = Total – Opportunity cost

profit revenue of all inputs

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 Summary of costs and profits

Economic (opportunity) costs

Economic
profits
Accounting
Implicit costs profits
(including a Total
normal profit) revenue

Explicit Accounting
costs (explicit
costs
costs only)

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 Short and long run
• Variable resources
– Factors of production whose quantity can be
increased or decreased during a particular period
• Fixed resources
– Factors of production whose quantity cannot be
increased or decreased during a particular period

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Short and long run (cont.)
• Short run
– A period of time where at least one factor is variable
and all others fixed
• Long run
– A time period where all factors can be varied

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Short-run production costs
• Law of diminishing returns
– As successive units of a variable resource (say, labour) are
added to a fixed resource (say, capital), beyond some point
the extra, or marginal, product attributable to each additional
unit of the variable resource, labour, will decline.

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 Law of diminishing returns
Inputs of
the Extra or
variable Total marginal Average
resource product product product

0 0
] 10 10.0
1 10
2 25 ] 15 12.5
3 37 ] 12 12.3
4 47 ] 10 11.8
5 55 ] 8 11.0
6 60 ] 5 10.0
7 63 ] 3 9.0
8 63 ] 0 7.9
9 62 ] –1 6.9

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Short-run production costs (cont.)
• Total product (TP)
– The total output of a good produced by a firm
• Marginal product (MP)
– Additional output resulting from the addition of an
extra unit of a resource (labour)
• Average product (AP)
– The total output per unit of resource employed
– Total product divided by number of workers

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Law of diminishing returns

Total product, TP
Total output

Average product, AP, and

Quantity of labour
Marginal product, MP

Average
product

Marginal
Quantity of labour product
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 Relationship between AP and MP
Subject Marks in Total Marks Average
each subject marks
/ 50
1 45 45 45

2 48 93 46.5

3 41 134 44.6

4 38 172 43

AP must rise when MP rises

AP declines when MP falls
AP intersects MP , when AP is highest
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Fixed, variable and total costs
• Fixed costs
– Do not vary with changes in output
• Variable costs
– Vary with changes in output
• Total costs
– The sum of fixed and variable costs at each level
of output

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4- 14
Total costs = FC + VC
TC
800
Costs (dollars) TVC
700

600
Fixed cost
500

400

300
Total Variable cost
200 cost
100 TFC

0 1 2 3 4 5 6 7 8 9 10 Quantity
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Average costs
• Average fixed cost
TFC
AFC =
Q

• Average variable cost

TVC
AVC =
Q

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Average costs (cont.)
• Average total cost

Total cost
ATC = = AFC + AVC
Quantity

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The average cost curves
200
Short-run average costs (dollars)

150 ATC
AVC
100

50

AFC
0 1 2 3 4 5 6 7 8 9 10 Quantity
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Marginal costs
• Marginal cost (MC)
– The extra, or additional cost of producing one more
unit of output

Change in total costs

Marginal cost =
Change in quantity

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Marginal costs, ATC and AVC
200 MC
Short-run average costs (dollars)

150 ATC
AVC
100

50

AFC
0 1 2 3 4 5 6 7 8 9 10 Quantity

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 Marginal costs and marginal
products
• Given the price of the variable resource,
increasing returns to the variable input, labour
(marginal product) will be reflected in a declining
marginal cost, and diminishing returns (marginal
product) in a rising marginal cost.

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 Marginal cost relationships
• When MC > ATC
– ATC increases
• When MC < AC
– ATC falls
• When ATC = MC
– ATC is at its minimum

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Shifts in the cost curves
• Total and per unit cost curves developed so far are
based on the assumption that technology is fixed.
• If technology changes, and more efficient technology
comes into operation, the productivity of all inputs
would improve. The marginal and average cost
curves would move downwards.

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Production costs in the long run
• All factors are variable in the long run
– All costs are variable
• Long-run cost curve
– Shape depends on economies of scale
– Scale is defined as different levels of plant utilisation
• The long-run ATC shows the lowest per-unit cost at
which any output can be produced after the firm has
had time to make all appropriate adjustments in its
plant size.

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Long-run AC curve: 5 possible plant sizes
For every plant capacity size ...
there is a short-run ATC curve,
and every ATC has a minimum cost
ATC-5
Unit costs

ATC1 ATC-4
ATC-3
ATC-2

20 30 40 50 60
Output
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Long-run AC curve: unlimited
number of plant sizes
The long-run ATC just
‘envelops’ all the short-run ATC
curves
Unit costs

Long-run
ATC

Output
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 Economies and diseconomies
of scale
• Economies of scale
– ATC falls as plant size increases
• Diseconomies of scale
– ATC increases as plant size increases
• Constant returns to scale
– ATC constant as plant size increases

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 Economies and diseconomies of
scale (cont.)
Economies of scale arise from:
• labour specialisation
• managerial specialisation
• efficient capital
• by-products.
Diseconomies of scale arise from:
• Impaired efficiency due to managerial coordination
problems and bureaucratic ‘red tape’.

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Shape of long-run costs
• May take on many shapes
• U-shaped curve would initially involve falling ATC
then increasing ATC as diseconomies of scale set in
• Other shapes possible

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Long-run ATC curves

Economies Constant returns Diseconomies

of scale to scale of scale
Unit costs

Long-run ATC

q1 q2
Output
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Long-run ATC curves (cont.)
Unit costs

Long-run ATC

Output
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Long-run ATC curves (cont.)

Unit costs

Long-run ATC

Output
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 Minimum efficiency scale (MES)
and industry structure
• MES is the smallest level of output at which a firm
can minimise long-run average costs.
• Natural monopoly
– A market situation in which unit costs are minimised
by having a single firm produce the particular good
or service.
– MES cannot be achieved in the market due to the
size and cost of capital stock required for operation.

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 Next chapter

Pure competition

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