CHAPTER
4
Production and Cost
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Economic Cost


In economics, the notion of a firm’s
costs is based on the notion of
economic cost.
The key principle underlying the
computation of economic cost is
opportunity cost.
PRINCIPLE of Opportunity Cost
The opportunity cost of something is what
you sacrifice to get it.
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Accounting versus Economic Cost

An accountant’s notion of costs involves
only the firm’s explicit costs:
 Explicit costs: the firm’s actual cash
payments for its inputs.

An economist includes the firm’s implicit
costs:
 Implicit costs: the opportunity costs of
nonpurchased inputs.
Economic Cost = Explicit Cost + Implicit Cost
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Accounting versus Economic Cost
Accounting versus Economic Cost
Accounting
Approach
Explicit Cost (purchased inputs)
$60,000
Economic
Approach
$60,000
Implicit: opportunity cost of entrepreneur’s
time
30,000
Implicit: opportunity cost of funds
10,000
Total Cost
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______
______
$60,000
$100,000
4
Short-run versus Long-run Decisions

Short run (SR): a period of time over
which one or more factors of production
remains fixed.
 In the short run, a firm decides how much
output to produce in the current facility.

Long run (LR): a period of time long
enough that a firm can change all factors
pf production.
 In the long run, a firm decides what size and
type of facility to build.
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Production and Cost in the Short Run

The key principle behind the firm’s
short-run cost curves is the principle of
diminishing returns.
PRINCIPLE of Diminishing Returns
Suppose that output is produced with two or more
inputs and we increase one input while holding the
other inputs fixed. Beyond some point—called the
point of diminishing returns—output will increase at a
decreasing rate.
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The Firm’s Short-run Production Function
 The
short-run production
function, or total product
curve, shows the
relationship between the
number of workers and the
quantity of output
produced.
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Production and Marginal Product
0
1
2
3
4
5
6
7
8
9
10
Number
of
Workers
0
8
12
15
20
27
36
48
65
90
130
© 2005 Prentice Hall Business Publishing
Short-run Production Function
Total
product curve
R a k e s p e r m in u te
Rakes
Per
Minute
10
9
8
7
6
5
4
3
2
1
0
0
20
40
60
80
100
120
140
Labor: Number of workers
Total Product Curve: A curve showing
the relationship between the quantity of
Labor and the quantity of output
produced
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Production and Marginal Product
© 2005 Prentice Hall Business Publishing
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
The shape of the total
product curve between d &
e is explained by
diminishing returns.

Beyond 15 workers the total
product curve becomes
flatter, i.e., marginal product
of labor decreases. In other
words, output beyond 15
workers is increasing at a
decreasing rate.
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Short-run Production Costs

The short-run costs of production are a
reflection of the relationship between
labor and output in the short run under
diminishing returns.
In the short run, the firm has two types of costs:

Fixed cost (FC): the cost of the production
facility, which is independent of the amount of
output produced in it.

Variable costs (VC): the costs of labor and
materials associated with producing output.
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Short-run Production Costs
Q
0
1
2
3
4
5
6
7
8
9
10
FC
36
36
36
36
36
36
36
36
36
36
36
TVC
0
8
12
15
20
27
36
48
65
90
130
STC
36
44
48
51
56
63
72
84
101
126
166
TC  TFC  TVC
Cost
SMC
8
4150
3
5
7100
9
12
1750
25
40
0
Total Costs
SRTC
$
Fixed
Cost
Total
Variable Short-run
Cost
Total Cost
Total
+ Variable
Cost
TVC
C o s t in
Output:
Rakes per
Minute
Total
Fixed
Cost
Total
Short-run
=
Cost
Marginal
TFC
0
1
2
3
4
5
6
7
8
9
10
11
Output: Rakes per minute
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Short-run Average Cost Curves
Fixed cost FC
AFC=
=
Quantity
Q
Variable cost TVC
AVC=
=
Quantity
Q
Total cost TC
SRATC=
=
Quantity Q
Change in Total cost  TC
SRMC=
=
Change in Quantity
 Q
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Short-run Average Total Cost

Short-run average total cost (SRATC)
measures total cost per unit of output produced.
TFC TVC
SATC 

Q
Q
Short-run
Fixed
Average
= Cost per
Total Cost
Unit
Variable
+ Cost per
Unit
SATC  AFC  SAVC
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Short-run Marginal Cost

Short-run marginal cost (SRMC)
is the change in total cost resulting from
a 1-unit increase in the output of an
existing production facility.
 TC
MC 
Q
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The Relationship between Marginal &
Average Curves


The marginal cost of production is the
amount of money necessary to buy the
additional labor and materials
necessary to produce one more unit of
output.
The marginal cost of production
increases because output increases at
a decreasing rate with additional
labor hours.
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Short-run Average and Marginal
Costs: An Example
OUTPUT
FIXED
Cost
TOTAL
VARIABLE
COST
SR
TOTAL
COST
SR
MARGINAL
COST
AVERAGE
FIXED
COST
SR
AVERAGE
VARIABLE
COST
SR
AVERAGE
TOTAL
COST
Q
FC
TVC
STC
SMC
AFC
SAVC
SATC
0
$36
$0
36
$-
$-
$-
$-
1
36
8
44
8
362
$8
44
2
36
12
48
4
183
6
24
3
36
15
51
3
12
5
17
4*
36
20
56
5*
9
5*
14
5
36
27
63
7
7
5.4
12.6
6
36
36
72
9
6
6
12
7*
36
48
84
12*
5.14
6.86
12*
8
36
65
101
17
4.5
8.13
12.63
9
36
90
126
25
4
10
14
10
36
130
166
40
3.6
13
16.6
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Short-run Average and Marginal
Costs: An Example
Per-unit costs
SMC
40
35
C o s t in $
30
25
20
SATC
15
SAVC
10
5
AFC
0
0
1
2
3
4
5
6
7
8
9
10
11
Output: Rakes per minute
MC
ATC
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A Closer Look at SR Production Costs
 To
study the relationship
between the components of
short-run production costs,
consider the following
example concerning a
producer of computer chips
facing diminishing returns.
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Short-run Average Total Cost (SATC)
Short-run Average Total Cost
Quantity of
Chips
Material
Fixed Cost Labor 100
Labor
Labor
Cost
x $8
Cost per
per Chip
Hours Cost
per Chip
Chip
Average
Total
Cost
Small: 100
$72
100
$800
$8
$10
$90
Medium: 300
24
900
7,200
24
10
58
Large: 400
$7,200/100
18
$7,200+800
2,000 16,000
40
100
10$72+$8+$10
68
Assumptions: Total fixed cost: $7,200 Hourly wage: $8.00
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Short-run Average Total Cost (SATC
 Average Total Cost is the Sum of Average Variable
and Average Fixed Cost
Quantity
Produced
Average
Total
Cost ($)
Average
Fixed
Cost ($)
Average
Variable
Cost ($)
100
300
400
90
58
68
72
24
18
18
34
50


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The gap between SATC and SAVC
decreases as output increases.
AFC continuously decreases as
total fixed cost is spread over more
units of output produced.
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Short-run Average Total Cost (SATC)

© 2005 Prentice Hall Business Publishing
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The SATC curve is Ushaped because of the
behavior of its two
components as output
produced increases.

AFC decreases as
output increases.

SAVC increases as
output increases.
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Diminishing Returns and Increasing
Marginal Cost
Diminishing Returns and Increasing Marginal Cost
Quantity of Chips
Additional
Labor Hours
Additional Additional
Labor Cost Material Cost
Marginal
Cost
Small: 100
2
$16
$10
$26
Medium: 300
Large: 400
6
10
48
80
10
10
58
90
Initially, it takes 4 additional labor hours to increase the quantity of chips by
200, from 100 to 300. Then, it takes another 4 hours of labor to increase
output by only 100 more chips, from 300 to 400. Marginal cost increases
because output increases at a decreasing rate with additional labor hours.
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Relationship between Short-run MC
and AC Curves

As long as SATC is
declining, marginal
cost lies below it.

When SATC rises,
SMC is greater than
SATC.
At point m,
SATC=SMC.

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Relationship between Short-run MC
and AC Curves
Quantity
Produced
Marginal
Cost
($)
Average
Total Cost
($)
100
26
90
300
400
58
90
58
68

© 2005 Prentice Hall Business Publishing
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The marginal cost curve
(SMC) intersects the
average cost curve (SATC)
when average cost is
minimum.
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Production and Cost in the Long Run

The key difference between the short
run and the long run is that there are
no diminishing returns in the long run.
 Diminishing
returns occur because
workers share a fixed facility. In the
long run the firm can expand its
production facility as its workforce
grows.
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Long-run Average Cost


Long-run average cost (LAC) is total
cost divided by the quantity of output
when the firm can choose a production
facility of any size.
The LAC curve describes the behavior of
average cost as the plant size expands.
Initially, the curve is negatively sloped,
then beyond some point, it becomes
horizontal.
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Indivisible Inputs


Because of indivisible inputs, the long-run
average cost curve will be negatively
sloped.
 Indivisible input: an input that cannot
be scaled down to produce a small
quantity of output.
Most production processes have at least
one indivisible input.
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Examples of Indivisible Inputs






A computer factory uses sophisticated
machines and testing equipment.
A transatlantic shipper uses a large ship to
carry TV sets from Japan to the United
States.
A cable-TV firm uses a cable running
throughout its territory.
A steel mill uses a large furnace.
A freight hauler uses a freight truck.
A pizzeria uses a pizza oven.
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Long-run Average Cost
When long-run total cost is proportionate to
the quantity produced, long-run average cost
does not change as output increases.
A v e ra g e c o s t: $ p e r ra k e

Long-run Average Cost Curve
Output:
Rakes per
Minute
3.5
7
14
28
12

0
0
7
14
21
28
Output: Rakes per minute
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Long-run
Total Cost
Long-run
Average
Cost
$70
$84
$168
$336
LAC
$20.00
$12.00
$12.00
$12.00
The long-run average cost
curve is horizontal for 7
or more rakes per hour.
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Labor Specialization

In a large operation, each worker
specializes in fewer tasks thus is
more productive than his or her
counterpart in a small operation.

Higher productivity (more output
per worker) means lower labor costs
per unit of output, thus lower
production costs (ever-decreasing
average cost).
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Economies of Scale

Economies of scale: a situation in which
an increase in the quantity produced
decreases the long-run average cost of
production.

Economies of scale refer to cost savings
associated with spreading the cost of
indivisible inputs and input
specialization.
When economies of scale are present, the
LAC curve will be negatively sloped.

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Minimum Efficient Scale

The minimum efficient scale
describes the output at which scale
economies are exhausted;


The long-run average cost curve
becomes horizontal.
Once the minimum efficient scale
has been reached, an increase in
output no longer decreases the longrun average cost.
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Diseconomies of Scale

A firm experiences diseconomies
of scale when an increase in output
leads to an increase in long-run
average cost—the LAC curve
becomes positively sloped.

Diseconomies of scale may arise for
two reasons:
 Coordination
problems
 Increasing input costs
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Examples of Economies of Scale
LAC Curve for Electricity
Generation
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LAC Curve for
Aluminum Production
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Examples of Economies of Scale
LAC Curve for Truck
Freight
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LAC Curve for Hospital
Services
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