Costs of production
Outline
1. The economic concept of cost and profit
2. Fixed and sunk cost
3. Profit maximization with limited capacity
4. The cost of production
5. Long run cost
6. Economies of scale
7. Economies of scope
8. The learning curve
9. Cost analysis and optimal decisions
Opportunity cost
What is the true cost of
pursuing a MBA degree?
Economists would count the following
as a part of cost:
•Explicit, out-of-pocket costs such as
tuition, books, and fees
•Implicit, or opportunity, cost, --i.e.,
the income (or utility) lost by not
pursuing your next best alternative,
such as a fulltime job.
Entrepreneurs have
opportunity costs as
well. For example , if I
put my energy and talent
into the restaurant
business, I am giving up
profits I could earn
somewhere else.
Normal profit
A normal profit is the minimum profit sufficient to
compensate entrepreneurs for profits lost by not
pursuing their next best business opportunity
Economists treat a normal
profit as an implicit cost—
that is, the cost of
attracting
entrepreneurship.
Accounting Profit
We accountants would
subtract explicit, or
accounting cost, from
revenues to compute profit.
Accounting  = Revenues – Explicit (Accounting) Cost
Economic Profit
Economists would
subtract economic cost
(including a normal
profit) from revenues to
compute an economic
profit
Economic  = Revenues – (Explicit + Implicit Cost)
Fixed and Sunk Costs
•Fixed costs (FC) are elements of cost
that do not vary with the level of output.
Examples: Interest payments on bonded
indebtedness, fire insurance premiums,
salaries and benefits of managerial staff.
•Sunk costs are costs already
incurred and hence non-recoverable.
Examples: Research & development
costs, advertising costs, cost of
specialized equipment.
-maximization with limited
capacity: Ordering a best seller
Suppose the bookseller’s
estimated (inverse) demand
equation is given by:
P = 24 – Q,
where P is dollars and Q is
quantity in hundreds of
copies per month.
The cost to the bookseller is
$12 per copy.
Consider a bookseller
with a limited amount
of shelf space. How
many copies of a best
seller should be
ordered?
3 questions
1. How many copies of the bestseller should the merchant order, and
what price should she charge, assuming there is unlimited shelf
space to stock the bestseller?
2. Now suppose shelf space is limited, so that carrying the bestseller
means “crowding out” other books? Assuming the average profit on
books already shelved is $4, what is the optimal price and quantity of
the bestseller?
3. What if actual demand is less than estimated demand, say:
P = 18 – 2Q. The publisher is obligated to refund returned copies for
$6 each. How many copies should be returned (if any), and how
many should be sold and at what price?
An Optimal Book Order
Price
Sales
Revenue
Cost
Forgone
Final
Profit Net Profit
(a)
QS = 600
$18
$10,800
$7,200
$0
$3,600
(b)
QS = 400
20
8,000
4,800
1,600
1,600
[QS = 600]
18
10,800
7,200
2,400
1,200
QS = 200
14
2,800
4,800
800
-1,600
Qr = 200
6
1,200
[QS = 400]
10
4,000
[Qr = 0]
6
0
[c]
[QS = 0]
[Qr = 400]
0
6
2,400
0
4,800
1,600
-2,400
0
4,800
0
0
-2,400
Problem 2
The key to 2nd problem is
in understanding that the
$4 in profit lost for
stocking each unit of the
bestseller is an implicit
cost
Hence marginal cost is
given by:
MC = $12 + $4 = $16
Problem 3
To solve problem 3 you need
to recognize 2 things: (1)
Since the books have already
been ordered, the $12 price
is a sunk cost; and (2) the $6
return charge is an implicit
cost of stocking the
bestseller
Thus marginal cost is
given by:
MC = $4 + $6 = $10
Firm’s Costs in the Short Run
Annual Output
Total Cost Fixed Cost Variable Cost
(Thousands of Repairs)
($000s)
($000s)
(000s)
0
270.0
270
0.0
5
427.5
270
157.5
10
600.0
270
330.0
15
787.5
270
517.5
20
990.0
270
720.0
25
1207.5
270
937.5
30
1440.0
270
1170.0
35
1687.5
270
1417.5
40
1950.0
270
1680.0
45
2227.5
270
1957.5
50
2520.0
270
2250.0
55
2827.5
270
2557.5
60
3150.0
270
2880.0
Figure 7.1
T ota l C ost (T housands of D olla rs)
3,000
2,000
C ost function
1,000
0
5 1 0 1 5 20 25 30 35 40 45 50 55 6 0
O utput (T housands of Units)
Definitions
Variable cost (VC) is the sum of the
firm’s expenditure for variable inputs such
as hourly employees, raw materials or
semi-finished articles, or utilities.
Average total cost (SAC) is total cost
divided by the quantity of output.
Average variable cost (AVC) is
variable cost divided by the quantity of
output.
Marginal cost (SMC) is the addition to
total cost attributable to the last unit
produced
Annual Output
Total Cost
(Thousands of Repairs)
($000s)
0
270.0
5
427.5
10
600.0
15
787.5
20
990.0
25
1207.5
30
1440.0
35
1687.5
40
1950.0
45
2227.5
50
2520.0
55
2827.5
60
3150.0
Ave. Cost Marginal Cost
($000s)
($000s)
85.5
60.0
52.5
49.5
48.3
48.0
48.2
48.8
49.5
50.4
51.4
52.5
31.5
34.5
37.5
40.5
43.5
46.5
49.5
52.5
55.5
58.5
61.5
64.5
Figure 7.2
C o s t/Unit (T ho us a nd s o f D o lla rs )
64
SM C
60
56
52
SAC
48
44
0
5 10 15 20 25 30 35 40 45 50 55 60
O utp ut (T ho us and s o f Units )
Relationship between Average
and Marginal
When average cost is falling, marginal cost lies
everywhere below average cost.
When average cost is rising, marginal cost lies
everywhere above average cost.
When average cost is at its minimum, marginal
cost cost is equal to average cost.
If your most recent
(marginal) grades are higher
than your GPA at the start of
the term, your GPA will rise
What explains rising (short-run)
marginal cost?
If labor is the only variable input then marginal cost
can be expressed by:
PL
SMC 
MPL
[7.1]
Recall that the marginal
product of labor will begin
to fall at some point due to
the law of diminishing
returns.
Behavior of Average Fixed Cost
Fixed Cost Per Unit
300.0
250.0
As output increases, fixed
cost can be spread more
thinly
200.0
150.0
100.0
50.0
0.0
1
11
21
31
Output (Q)
41
51
Production costs is the long run
•In the long run there are no fixed inputs;
hence all costs are “variable.”
•The long run average cost curve shows the
minimum average cost achievable at each level
of output in the long run—that is, when all
inputs are variable.
Constant Returns to Scale
L o ng - R un A ve r a g e C o s t
$5
SAC 1
SAC 2
( 9 ,0 0 0 - s q ua r e - ( 1 8 ,0 0 0 - s q ua r e SAC 3
fo o t p la nt)
fo o t p la nt) ( 2 7 , 0 0 0 - s q ua r e f o o t p la nt)
4
LAC = LM C
SM C 1
0
SM C 2
SM C3
72 108 144
216
O ut p ut ( T ho us a nd s o f Units )
The U-Shaped Long Run Average Cost Function
Long-Run Average Cost
LMC
LAC
SAC 1
SAC2
SMC 1
LMC
SMC 2
SAC 3
SMC3
Decreasing returns
Increasing returns
Qmin
Output
Notice on the previous slide
that up to a scale of QMIN,
the firm experiences
decreasing (long run) unit
cost. Economies of scale are
exhausted at the point
Minimum Efficient Scale (QMES)
QMES is the minimum scale
of operation at which long
unit production costs can be
minimized.
Cost per unit
QMES is large relative to he
“size of the market.”
Demand
To produce on an
efficient scale, you
must supply 50% of
the product
demanded at a price
equal to minimum
unit cost
LAC
0
1000
2000
Q
How large do you have to be to
minimize unit costs?1
Not very large (as a percent of U.S. consumption) :
Bricks, flour milling, machine tools, cement, glass
containers, cigarettes, shoes, bread baking.
Fairly large (as a percent of U.S. consumption): Synthetic
fibers, passenger cars, household refrigerators and freezers,
commercial aircraft.
Very large (as a percent of U.S. consumption): Turbine
generators, diesel engines, electric motors, mainframe
computers.
1F.M.
Scherer and D. Ross. Industrial Market Structure
and Performance, 3rd edition, 1990, pp. 115-116.
Figure7.5a
Long-Run Average Cost
Qmin
Output
(a)
Figure 7.5b
Long-Run Average Cost
Qmin
(b)
Output
Figure 7.5c
Long-Run Average Cost
Local telephone service,
electricity distribution, and
cable TV distribution are
well represented by this
cost function.
(c)
Output