CHAPTER 5
COST OF PRODUCTION
PART 1:
SHORT RUN PRODUCTION COST
 Chapter Summary
 Types of production cost in short run
 Apply the short run production cost formula
 Sketch short run production cost curves
 Describe the relationship between each types of short
run production cost
CHAPTER OBJECTIVES
 After this chapter, you will be able to:
 Classified the types of costs in the short run and long
run production
 Apply the short run production costs formula
 Sketch short run production and long run production
cost curves
 Explain the relationship between each types of short run
production costs
PART 2:
LONG RUN PRODUCTION COST
 Production cost in long run: Long Run Average Cost
(LRAC)
 The LRAC curve – Planning curve
 Optimum output level using Planning Curve
 Economies of scale and Diseconomies of scale
KEY TERMS
 Theory of Production
 Total Production (TP)
 Marginal Production (MP)
 Average Production (AP)
 Law of Diminishing
Returns
 Short run
 Long run
 Cost of Production
 Fixed cost
 Variable cost
 Total cost (TC)
 Average fixed cost (AFC)
 Average variable cost
(AVC)
 Average total cost (ATC)
 Marginal cost (MC)
 Diseconomies of scale
 Economies of scale
 Constant return to scale
Short run costs
 Cost is very important measurement for a producer to
achieve firm’s objectives
 In the short run production, the firm is facing 8 types of
costs
 Total cost (TC)
 Fixed cost (FC)
 Variable cost (VC)
 Average fixed cost (AFC)
 Average variable cost (AVC)
 Average total cost (ATC)
 Marginal cost (MC)
The various measures of cost:
Conrad’s coffee shop
Quantity
of coffee
(cups per
hour)
Total
cost
Fixed
cost
Variable
cost
Average Average
fixed
variable
cost
cost
Average Marginal
total
cost
cost
0
$3.00
$3.00
$0.00
-
-
-
1
3.30
3.00
0.30
$3.00
$0.30
$3.30
$0.30
2
3.80
3.00
0.80
1.50
0.40
1.90
0.50
3
4.50
3.00
1.50
1.00
0.50
1.50
0.70
4
5.40
3.00
2.40
0.75
0.60
1.35
0.90
5
6.50
3.00
3.50
0.60
0.70
1.30
1.10
6
7.80
3.00
4.80
0.50
0.80
1.30
1.30
7
9.30
3.00
6.30
0.43
0.90
1.33
1.50
8
11.00
3.00
8.00
0.38
1.00
1.38
1.70
9
12.90
3.00
9.90
0.33
1.10
1.43
1.90
Total cost
 The Total Cost of production may be divided into fixed
costs and variable costs.
 TC = FC + VC
Total Cost
Total-cost curve
$15.00
14.00
13.00
12.00
Quantity
of coffee
(cups per hour)
Total
Cost
0
1
2
3
4
5
6
7
8
9
10
$3.00
3.30
3.80
4.50
5.40
6.50
7.80
9.30
11.00
12.90
15.00
11.00
10.00
9.00
8.00
7.00
6.00
5.00
4.00
3.00
2.00
1.00
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Fixed cost
 Fixed costs are those costs that do not vary with the
quantity produced.
 Even though output is zero, fixed cost will be incurred
 Example: long term debts, salaries, wages of
permanent staff
Variable cost
 Variable costs are those costs that vary with the
quantity produced.
 When output is zero, variable cost also zero.
 As output increases, variable cost will also increase
 Example: supplies for raw materials, electricity power,
fuel, transportation
Costs (dollars)
Combining TVC
With TFC to get
Total Cost
Total
Cost
TVC
Fixed Cost
Variable Cost
TFC
Quantity
Average cost
 The average cost is also called the per-unit cost.
 Average costs can be determined by dividing the firm’s
total costs by the quantity of output it produces.
Average costs
Fixed cost FC
AFC 

Quantity
Q
Variable cost VC
AVC 

Quantity
Q
Total cost TC
ATC 

Quantity
Q
Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost
Curves
Costs
$3.50
AFC = FC/Q.
As FC is constant, FC/Q decreases as Q
increases.
Therefore, AFC decreases as Q increases
3.25
3.00
2.75
2.50
2.25
2.00
1.75
1.50
1.25
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Figure 4 Conrad’s Coffee Shop Average-Cost and
Marginal-Cost Curves
Costs
$3.50
1.
AFC decreases as Q increases,
3.25
2.
AVC increases as Q increases,
because of diminishing returns.
3.
As ATC = AFC + AVC, ATC is Ushaped: as Q increases, it
decreases initially and then
begins to increase.
3.00
2.75
2.50
2.25
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost
CurvesCosts
$3.50
The quantity at which ATC is lowest
is called the efficient scale output.
3.25
3.00
2.75
2.50
2.25
2.00
1.75
ATC
1.50
1.25
For Conrad’s Coffee Shop, the
efficient scale is 5 or 6 cups of
coffee per hour
1.00
0.75
0.50
0.25
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Cost Curves and Their Shape
 To look relationship between each types of short run
production cost
 Why ATC curve is U – shape?
 At very low levels of output average total cost (ATC) is high
because the fixed cost is spread over only the few units that
are produced.
 Average fixed cost declines as output increases.
 Average variable cost rises as output increases.
 These features of a firm’s costs explains the U-shape of
the ATC curve

Recall that ATC = AFC + AVC
Marginal Cost
 Marginal cost (MC) is the increase in total cost (TC)
that arises from an extra unit of production.
 The increase in cost that arises from an extra unit of
production is entirely due to the use of additional raw
materials and labor
 Therefore, marginal cost can also be defined as the
increase in total variable cost (VC) that arises from an
extra unit of production.
Marginal Cost
(change in total cost) TC
MC 

(change in quantity)
Q
increase in total variable cost VC
MC 

increase in production
Q
The various measures of cost:
Conrad’s Coffee Shop
Quantity
of coffee
(cups per
hour)
Total
cost
Fixed
cost
Variable
cost
Average Average
fixed
Variable
cost
cost
Average Marginal
total
cost
cost
0
$3.00
$3.00
$0.00
-
-
-
1
3.30
3.00
0.30
$3.00
$0.30
$3.30
$0.30
2
3.80
3.00
0.80
1.50
0.40
1.90
0.50
3
4.50
3.00
1.50
1.00
0.50
1.50
0.70
4
5.40
3.00
2.40
0.75
0.60
1.35
0.90
5
6.50
3.00
3.50
0.60
0.70
1.30
1.10
6
7.80
3.00
4.80
0.50
0.80
1.30
1.30
7
9.30
3.00
6.30
0.43
0.90
1.33
1.50
8
11.00
3.00
8.00
0.38
1.00
1.38
1.70
9
12.90
3.00
9.90
0.33
1.10
1.43
1.90
10
15.00
3.00
12.00
0.30
1.20
1.50
2.10
Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost
Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
Marginal cost rises with the
amount of output produced.
This reflects the assumption of
diminishing marginal product
1.75
1.50
1.25
1.00
0.75
0.50
0.25
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost
Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50
ATC
1.25
AVC
1.00
0.75
0.50
AFC
0.25
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Cost Curve and Their Shape
 Relationship Between Marginal Cost and Average Total
Cost
 Whenever marginal cost is less than average total cost,
average total cost must be decreasing.
 Whenever marginal cost is greater than average total
cost, average total cost must be increasing.
 MC< ATC, ATC decrease
 MC> ATC, ATC increase
Cost Curve and Their Shape
 Relationship Between Marginal Cost and Average Total
Cost
 The marginal-cost curve crosses the average-total-cost
curve at the efficient scale.

Efficient scale is the quantity that minimizes average total
cost.
Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost
Curves
Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
ATC
1.50
1.25
1.00
0.75
0.50
0.25
0
1
2
3
4
5
6
7
8
9
Quantity
of Output
(cups of coffee per hour)
10
Example of Typical Firm
Figure 5 Cost Curves of a Typical Firm
Total
Cost
(a) Total-Cost Curve
$18.00
TC
16.00
14.00
12.00
10.00
8.00
6.00
4.00
2.00
0
2
4
6
8
10
12
14
Figure 5 Cost Curves of a Typical Firm
Costs
(b) Marginal- and Average-Cost Curves
$3.00
2.50
MC
2.00
1.50
ATC
AVC
1.00
0.50
AFC
0
2
4
6
8
10
12
14
Quantity of Output
Cost Curves Shape Summary
 Three Important Properties of Cost Curves
 Marginal cost eventually rises with the quantity of
output.
 The average-total-cost curve is U-shaped.
 The marginal-cost curve crosses the average-total-cost
curve at the minimum of average total cost.
•Production cost in long run: Long Run Average Cost (LRAC)
•The LRAC curve – Planning curve
•Optimum output level using Planning Curve
•Economies of scale and Diseconomies of scale
Long-run Cost
 In the long-run there are no fixed inputs, and therefore no
fixed costs. All costs are variable.
 Another way to look at the long-run is that in the long-run
a firm can choose any amount of fixed costs it wants for
making short-run decisions.
Long-run Average Cost Curve
 The long-run average cost curve shows the minimum
average cost at each output level when all inputs are
variable, that is, when the firm can have any plant size it
wants.
 There is a relationship between the LRAC curve and the
firm's set of short-run average cost curves.
 Economists usually assume that plant size is
infinitely divisible (variable). In the case of finely
divisible plant size, the LRAC curve might look
like this:
Each small U-shaped
$/Q
curve is a SAC curve.
LRAC
The LRAC
curve.
Average costs for a
typical firm.
Q
Long-run Cost Curve
 If each plant size is associated with a different amount of
fixed costs, then each plant size for a firm will give us a
different set of short-run cost curves.
 As the fixed input amount increases in the long run, you
move to different SR cost curves, each one corresponding
to a particular plant size.
 Notice in the graphs of LRAC curves presented so far that
the curves have been drawn to be U-shaped. That is, when
output is increasing LRAC at first falls, and then eventually
rises.
Long-run Cost Curve
 The overall shape of the long-run average cost curve
depends on the technology of production.
 For example, advantages implicit in large scale production
(with large plants) may allow firms to produce large
outputs at lower cost per unit.
 On the other hand, firms may get so big that ever
increasing managerial and monitoring costs may cause unit
costs to rise.
ECONOMIES OF SCALE: When output
increases, long-run average costs decline.
$/Q
LRAC shows
economies of
scale here.
Average costs for a
typical pizza firm.
LRAC
Q
DISECONOMIES OF SCALE: When output
increases, long-run average costs increase.
$/Q
LRAC shows
diseconomies of
scale here.
Average costs for a
typical pizza firm.
LRAC
Q
Economies of Scale and
Diseconomies of Scale
 For the U-shaped long-run average cost curve, there are
economies of scale over small outputs, and diseconomies of
scale at larger outputs.
 Not all firms necessarily suffer from diseconomies of scale
at large outputs.
Economies of Scale
 The advantages of large scale production that result in
lower unit (average) costs (cost per unit)
 AC = TC / Q
 Economies of scale – spreads total costs over a greater
range of output
Economies of Scale
 Internal – advantages that arise as a result of the
growth of the firm
 Technical
 Commercial
 Financial
 Managerial
 Risk Bearing
Economies of Scale
 External economies of scale – the advantages firms can
gain as a result of the growth of the industry – normally
associated with a particular area
 Supply of skilled labour
 Reputation
 Local knowledge and skills
 Infrastructure
 Training facilities
Economies of Scale
Scale
Capital
Land
Labor
Output
Scale A
5
3
4
100
Scale B
10
6
8
300
TC
•Assume each unit of capital = RM5, Land = RM8 and
Labour = RM22
•Calculate TC and then AC for the two different ‘scales’
(‘sizes’) of production facility
•What happens and why?
AC
Economies of Scale
Scale
Capital
Land
Labor
Output
TC
AC
Scale A
5
3
4
100
57
0.57
Scale B
10
6
8
300
164
0.54
•Doubling the scale of production (a rise of 100%) has led to an
increase in output of 200% - therefore cost of production
•PER UNIT has fallen
•Don’t get confused between Total Cost and Average Cost
•Overall ‘costs’ will rise but unit costs can fall
•Why?
Economies of Scale
 Internal: Technical
 Specialisation – large organisations
can employ specialised labour
 Indivisibility of plant – machines can’t be broken down
to do smaller jobs!
 Principle of multiples – firms using more than one
machine of different capacities - more efficient
Economies of Scale
 Commercial
 Large firms can negotiate favourable prices as a result
of buying in bulk
 Large firms may have advantages in keeping prices
higher because
of their market power
Economies of Scale
 Financial
 Large firms able to negotiate cheaper finance deals
 Large firms able to be more flexible about finance –
share options, rights issues, etc.
 Large firms able to utilise skills of merchant banks to
arrange finance
Economies of Scale
 Risk Bearing
 Diversification
 Markets across regions/countries
 Product ranges
 R&D
Economies of Scale
 Managerial
 Use of specialists – accountants, marketing, lawyers,
production, human resources, etc.
Diseconomies of Scale
 The disadvantages of large scale production
that can lead to increasing average costs
 Problems of management
 Maintaining effective communication
 Co-ordinating activities – often across
the globe!
 De-motivation of staff