CHAPTER
7
The Cost of
Production
Prepared by:
Fernando & Yvonn Quijano
© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e.
CHAPTER 7 OUTLINE
7.1 Measuring Cost: Which Costs Matter?
7.2 Cost in the Short Run
Chapter 7 The Cost of Production
7.3 Cost in the Long Run
7.4 Long-Run versus Short-Run Cost Curves
7.5 Production with Two Outputs—Economies of Scope
7.6 Dynamic Changes in Costs—The Learning Curve
7.7 Estimating and Predicting Cost
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Costs: Explicit vs. Implicit
• Explicit costs require an outlay of money, e.g., paying
wages to workers.
Chapter 7 The Cost of Production
• Implicit costs do not require a cash outlay, e.g., the
opportunity cost of the owner’s time.
• Both matter for firms’ decisions.
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7.1
MEASURING COST: WHICH COSTS MATTER?
Economic Cost versus Accounting Cost
● accounting cost:
Actual expenses
Chapter 7 The Cost of Production
● economic cost: Costs to a firm of
utilizing economic resources in
production, including opportunity cost.
Opportunity Cost
● opportunity cost Cost associated with
opportunities that are forgone when a
firm’s resources are not put to their best
alternative use.
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EXAMPLE
 A man has a piece of land in his backyard. Decided to start a mango
farm and work on it himself.
 Cost of saplings, fertilizers etc : Rs 200/week
 Price of mangoes (P) : Rs 100/Kg; He produces (Q) 10Kg/week
His profit : Rs 1000-Rs 200 = Rs 800
Chapter 7 The Cost of Production
 Accounting
profit
 He has an alternative to earn money:
 Work at the nearby McDonald’s for Rs 500/week and
 Rent out the land for Rs 500/week
 If he considers his foregone income for growing mangoes, his profit:
Rs 1000 – Rs 200 – Rs 500 – Rs 500 = - Rs200
 Economic Profit
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Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
Chapter 7 The Cost of Production
– explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = $3000 (5%) interest on the loan
– implicit cost = $2000 (5%) foregone interest you could have
earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
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Economic Profit vs. Accounting Profit
• Accounting profit
= total revenue minus total explicit costs
Chapter 7 The Cost of Production
• Economic profit
= total revenue minus total costs (including
explicit and implicit costs)
• Accounting profit ignores implicit costs, so it’s higher
than economic profit.
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7.1
MEASURING COST: WHICH COSTS MATTER?
Sunk Costs
● sunk cost Expenditure that has
been made and cannot be
recovered.
Chapter 7 The Cost of Production
Because a sunk cost cannot be recovered, it should not
influence the firm’s decisions.
For example, consider the purchase of specialized
equipment for a plant. Suppose the equipment can be used
to do only what it was originally designed for and cannot be
converted for alternative use. The expenditure on this
equipment is a sunk cost. Because it has no alternative use,
its opportunity cost is zero. Thus it should not be included as
part of the firm’s economic costs.
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7.1
MEASURING COST: WHICH COSTS MATTER?
Fixed Costs and Variable Costs
Chapter 7 The Cost of Production
● total cost (TC or C) Total economic
cost of production, consisting of fixed
and variable costs.
● fixed cost (FC) Cost that does not
vary with the level of output and that
can be eliminated only by shutting
down.
● variable cost (VC)
as output varies.
Cost that varies
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7.1
MEASURING COST: WHICH COSTS MATTER?
Fixed Costs and Variable Costs
How do we know which costs are fixed and which are variable?
Chapter 7 The Cost of Production
Over a very short time horizon—say, a few months—most costs are fixed.
Over such a short period, a firm is usually obligated to pay for contracted
shipments of materials.
Over a very long time horizon—say, ten years—nearly all costs are variable.
Workers and managers can be laid off (or employment can be reduced by
attrition), and much of the machinery can be sold off or not replaced as it
becomes obsolete and is scrapped.
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7.1
MEASURING COST: WHICH COSTS MATTER?
Fixed versus Sunk Costs
Sunk costs are costs that have been incurred and cannot be
recovered.
Chapter 7 The Cost of Production
An example is the cost of R&D to a pharmaceutical company to
develop and test a new drug and then, if the drug has been
proven to be safe and effective, the cost of marketing it.
Whether the drug is a success or a failure, these costs cannot be
recovered and thus are sunk.
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7.1
MEASURING COST: WHICH COSTS MATTER?
It is important to understand the characteristics of production costs and to be able to
identify which costs are fixed, which are variable, and which are sunk.
Chapter 7 The Cost of Production
Good examples include the personal computer industry (where most costs are
variable), the computer software industry (where most costs are sunk), and the
pizzeria business (where most costs are fixed).
Because computers are very similar, competition is intense, and profitability
depends on the ability to keep costs down. Most important are the variable cost of
components and labor.
A software firm will spend a large amount of money to develop a new application.
The company can try to recoup its investment by selling as many copies of the
program as possible.
For the pizzeria, sunk costs are fairly low because equipment can be resold if the
pizzeria goes out of business. Variable costs are low—mainly the ingredients for
pizza and perhaps wages for a couple of workers to help produce, serve, and
deliver pizzas.
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Recap: MPL = Slope of Prod Function
Q
Chapter 7 The Cost of Production
(no. of (bushels MPL
workers) of wheat)
0
0
1
1000
2
1800
3
2400
4
2800
5
3000
1000
800
600
400
200
MPL
3,000
Quantity of output
L
equals the
slope of the
2,500
production function.
2,000
Notice that
MPL diminishes
1,500
as L increases.
1,000
This explains why the
500
production
function
gets
flatter
0
as L 0increases.
1
2
3
4
5
No. of workers
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Recap: Why MPL Is Important
• When Farmer Jack hires an extra worker,
Chapter 7 The Cost of Production
– his costs rise by the wage he pays the worker
– his output rises by MPL
• Comparing them helps Jack decide whether he
should hire the worker.
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EXAMPLE 1: Farmer Jack’s Costs
• Farmer Jack must pay $1000 per month for the land,
regardless of how much wheat he grows.
Chapter 7 The Cost of Production
• The market wage for a farm worker is $2000 per month.
• So Farmer Jack’s costs are related to how much wheat
he produces….
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EXAMPLE 1: Farmer Jack’s Costs
L
Q
Chapter 7 The Cost of Production
(no. of (bushels
workers) of wheat)
Cost of
land
Cost of
labor
Total
Cost
0
0
$1,000
$0
$1,000
1
1000
$1,000
$2,000
$3,000
2
1800
$1,000
$4,000
$5,000
3
2400
$1,000
$6,000
$7,000
4
2800
$1,000
$8,000
$9,000
5
3000
$1,000
$10,000
$11,000
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7.1
MEASURING COST: WHICH COSTS MATTER?
Marginal and Average Cost
Marginal Cost (MC)
Chapter 7 The Cost of Production
● marginal cost (MC) Increase
in cost resulting from the
production of one extra unit of
output.
Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in
total cost that results from an extra unit of output.
We can therefore write marginal cost as
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7.1
MEASURING COST: WHICH COSTS MATTER?
Marginal and Average Cost
Marginal Cost (MC)
TABLE 7.1
Chapter 7 The Cost of Production
Rate of
Output
(Units
per Year)
A Firm’s Costs
Fixed
Cost
(Dollars
per Year)
Variable
Cost
(Dollars
per Year)
Total
Cost
(Dollars
per Year)
Marginal
Cost
(Dollars
per Unit)
Average
Fixed Cost
(Dollars
per Unit)
Average
Variable Cost
(Dollars
per Unit)
Average
Total Cost
(Dollars
per Unit)
(FC)
(1)
(VC)
(2)
(TC)
(3)
(MC)
(4)
(AFC)
(5)
(AVC)
(6)
(ATC)
(7)
0
50
0
50
--
--
--
1
50
50
100
50
50
50
100
2
50
78
128
28
25
39
64
3
50
98
148
20
16.7
32.7
49.3
4
50
112
162
14
12.5
28
40.5
5
50
130
180
18
10
26
36
6
50
150
200
20
8.3
25
33.3
7
50
175
225
25
7.1
25
32.1
8
50
204
254
29
6.3
25.5
31.8
9
50
242
292
38
5.6
26.9
32.4
10
50
300
350
58
5
30
35
11
50
385
435
85
4.5
35
39.5
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--
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7.1
MEASURING COST: WHICH COSTS MATTER?
Marginal and Average Cost
Average Total Cost (ATC)
Chapter 7 The Cost of Production
● average total cost (ATC)
Firm’s total cost divided by its
level of output.
● average fixed cost (AFC)
Fixed cost divided by the level of
output.
● average variable cost (AVC)
Variable cost divided by the level of
output.
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You try…
Calculating costs
Fill in the blank spaces of this table.
Q
VC
Chapter 7 The Cost of Production
0
1
10
2
30
TC
AFC
AVC
ATC
$50
n/a
n/a
n/a
$10
$60.00
80
3
16.67
4
100
5
150
6
210
150
20
12.50
36.67
8.33
$10
30
37.50
30
260
MC
35
43.33
© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
60
20 of 49
You try..
Answers
Chapter 7 The Cost of Production
Use
AFC
== FC
///Q
ATC
AVC
TC
VC
Q
Q=
between
First,relationship
deduce
FC
$50 andMC
useand
FC TC
+ VC = TC.
Q
VC
TC
AFC
AVC
ATC
0
$0
$50
n/a
n/a
n/a
1
10
60
$50.00
$10
$60.00
2
30
80
25.00
15
40.00
3
60
110
16.67
20
36.67
4
100
150
12.50
25
37.50
5
150
200
10.00
30
40.00
6
210
260
8.33
35
43.33
© 2008 Prentice Hall Business Publishing • Microeconomics • Pindyck/Rubinfeld, 7e.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
MC
$10
20
30
40
50
60
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As Q rises:
$200
Initially,
falling AFC
pulls ATC down.
$175
Eventually,
rising AVC
pulls ATC up.
Efficient scale:
The quantity that
minimizes ATC.
$150
Costs
Chapter 7 The Cost of Production
EXAMPLE 2: Why ATC Is Usually U-Shaped
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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EXAMPLE 2: ATC and MC
When MC < ATC,
ATC is falling.
$175
$150
Costs
Chapter 7 The Cost of Production
When MC > ATC,
ATC is rising.
The MC curve
crosses the
ATC curve at
the ATC curve’s
minimum.
ATC
MC
$200
$125
$100
$75
$50
$25
$0
0
1
2
3
4
5
6
7
Q
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Chapter 7 The Cost of Production
Costs in the Short Run & Long Run
• Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
• Long run:
All inputs are variable (e.g., firms can build more
factories, or sell existing ones).
• In the long run, ATC at any Q is cost per unit using the
most efficient mix of inputs for that Q (e.g., the factory
size with the lowest ATC).
Diminishing Marginal Returns and Marginal Cost
Diminishing marginal returns means that the marginal product of labor
declines as the quantity of labor employed increases.
As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.
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7.2
COST IN THE SHORT RUN
The Shapes of the Cost Curves
Figure 7.1
Chapter 7 The Cost of Production
Cost Curves for a Firm
In (a) total cost TC is the
vertical sum of fixed cost
FC and variable cost VC.
In (b) average total cost
ATC is the sum of
average variable cost
AVC and average fixed
cost AFC.
Marginal cost MC crosses
the average variable cost
and average total cost
curves at their minimum
points.
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7.2
COST IN THE SHORT RUN
The Shapes of the Cost Curves
Chapter 7 The Cost of Production
The Average-Marginal
Relationship
Consider the line drawn from
origin to point A in (a). The
slope of the line measures
average variable cost (a total
cost of $175 divided by an
output of 7, or a cost per unit
of $25).
Because the slope of the VC
curve is the marginal cost ,
the tangent to the VC curve
at A is the marginal cost of
production when output is 7.
At A, this marginal cost of
$25 is equal to the average
variable cost of $25 because
average variable cost is
minimized at this output.
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Example: LRATC with 3 factory sizes
Chapter 7 The Cost of Production
Firm can choose
from three factory Avg
Total
sizes: S, M, L.
Cost
Each size has its
own SRATC curve.
ATCS
ATCM
The firm can
change to a
different factory
size in the long
run, but not in the
short run.
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ATCL
Q
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A Typical LRATC Curve
Chapter 7 The Cost of Production
In the real world,
factories come in
many sizes,
each with its own
SRATC curve.
ATC
LRATC
So a typical LRATC
curve
looks like this:
Q
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7.4
LONG-RUN VERSUS SHORT-RUN COST CURVES
Long-Run Average Cost
Figure 7.8
Chapter 7 The Cost of Production
Long-Run Average and
Marginal Cost
When a firm is producing at
an output at which the longrun average cost LAC is
falling, the long-run marginal
cost LMC is less than LAC.
Conversely, when LAC is
increasing, LMC is greater
than LAC.
The two curves intersect at A,
where the LAC curve
achieves its minimum.
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7.4
LONG-RUN VERSUS SHORT-RUN COST CURVES
Long-Run Average Cost
Chapter 7 The Cost of Production
● long-run average cost curve (LAC) Curve
relating average cost of production to output
when all inputs, including capital, are variable.
● short-run average cost curve (SAC) Curve
relating average cost of production to output when
level of capital is fixed.
● long-run marginal cost curve (LMC) Curve
showing the change in long-run total cost as
output is increased incrementally by 1 unit.
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How ATC Changes as
the Scale of Production Changes
Chapter 7 The Cost of Production
Economies of
scale: ATC falls
as Q increases.
ATC
LRATC
Constant returns
to scale: ATC stays
the same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
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Q
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7.4
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale
As output increases, the firm’s average cost of producing that output
is likely to decline, at least to a point.
This can happen for the following reasons:
Chapter 7 The Cost of Production
1. If the firm operates on a larger scale, workers can specialize
in the activities at which they are most productive.
2. Scale can provide flexibility. By varying the combination of
inputs utilized to produce the firm’s output, managers can
organize the production process more effectively.
3. The firm may be able to acquire some production inputs at
lower cost because it is buying them in large quantities and
can therefore negotiate better prices. The mix of inputs
might change with the scale of the firm’s operation if
managers take advantage of lower-cost inputs.
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7.4
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale
At some point, however, it is likely that the average cost of
production will begin to increase with output.
There are three reasons for this shift:
Chapter 7 The Cost of Production
1. At least in the short run, factory space and machinery may
make it more difficult for workers to do their jobs effectively.
2. Managing a larger firm may become more complex and
inefficient as the number of tasks increases.
3. The advantages of buying in bulk may have disappeared
once certain quantities are reached. At some point,
available supplies of key inputs may be limited, pushing
their costs up.
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7.4
LONG-RUN VERSUS SHORT-RUN COST CURVES
Economies and Diseconomies of Scale
Chapter 7 The Cost of Production
● economies of scale Situation
in which output can be doubled
for less than a doubling of cost.
● diseconomies of scale
Situation in which a doubling of
output requires more than a
doubling of cost.
Increasing Returns to Scale:
Output more than doubles when
the quantities of all inputs are
doubled.
Economies of Scale:
A doubling of output requires less
than a doubling of cost.
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