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:

Accounting Cost – actual expenses plus depreciation charges for capital equipment.

Economic Cost – cost to a firm of utilizing economic resources in production, including opportunity 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.

Example when economic cost differs from accounting cost:- shop owner who does not pay herself a salary and/or owns the

building

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 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

VC

Variable costincreases with production and

the rate varies withincreasing &

decreasing returns.

TC

Total costis the vertical

sum of FC and VC.

FC50

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=∆VC/∆Q

since TC=(FC+VC) and FC 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)

Cos

t ($/

unit) 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 10 0 5

1 10 15 50 3.33

2 25 20 100 2.5

3 45 15 150 3.33

4 60 10 200 5

5 70 5 250 10

6 75 300

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

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

Þ 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 fixedand 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.

AFC is decreasing

AVC and ATC are U-shaped, reflecting increasing and then diminishingreturns.

Marginal cost curve (MC) falls and then rises, intersecting both AVC and ATC at their minimum points.