Costs
Learning Objectives:
• Distinguish between explicit, implicit cost
and economic cost.
• Distinguish between short-run and longrun cost.
• Distinguish between fixed cost, variable
cost, total cost, marginal cost
• Explain the law of diminishing returns.
In Economics
• Because of the condition of scarcity, economic
cost (OC), which include all cost of production,
are opportunity cost of all resources used in
the production
Explicit Cost
• Payment made by a firm to outsiders to
acquire resources for use in production.
• Example:
– A firm hires labour and pays wages; it purchases
materials and pays suppliers; it uses elictricity and
pays the supplier and etc.
Implicit Cost:
• A sacrificed income arising from the use of
self-owned resources by firms.
• For example:
– In the case of office building owned and used by
the firm, the opportunity cost is the potential
income earned by renting the building. The hours
of work the owner of the firm puts into his/ her
business is equal to the potential income earned
working elsewhere.
Economic Cost:
• The sum of explicit and explicit costs, or total opportunity
cost incurred by a firm for its use of resources, whether
purchased or self-owned.
• When economists refer to ‘cost’ they mean economic cost.
• Example:
– Suppose I make $ 60000 a year as a teacher. I decide to open my
own coffee shop. The entrepreneurial effort I put in my business
is $45000 a year. I set up my office in the basement of my house
which I could rent for $4000 a year. I borrowed $30000 plus
$2000 in interest a year to pay for my resources. I pay $18000 a
year in wages.
– Implicit cost= 60000+45000+4000=109000
– Explicit cost=2000+30000+18000=50000
– Economic cost =109000+50000= 159000
• Distinguish between explicit, implicit cost
and economic cost.
• Why are economic costs greater than
explicit costs?
• Post your answer on edmodo.
SHORT-RUN
Remember
• In the short-run at least one factor input is
fixed.
• In the long-run all inputs are variable.
Costs
• In buying factor inputs, the firm
will incur costs
• Costs are classified as:
– Fixed costs – costs that are not related directly to
production – rent, rates, insurance costs, admin
costs. They can change but not in relation to
output
– Variable Costs – costs directly related
to variations in output. Raw materials primarily
Costs
• Total Cost - the sum of all costs incurred in
production
• TC = FC + VC
• Average Cost – the cost per unit
of output
• AC = TC/Output
• Marginal Cost – the additional cost of producing
one more unit of output
• MC = ΔTC/ΔQ or ΔTVC/ΔQ
• (In the LR there are no fixed costs so all
FC=VC)
•
•
•
•
•
AFC=TFC/Q
AVC=TVC/Q
ATC=TC/Q
TC=TFC+TAC
ATC=AFC+AVC
• Distinguish between TC, MC and AC.
• Post your answer on edmodo
Cost Curves & Product Curves
• Complete the provided handout (Calculating
cost) on cost
Cost Curves & Product Curves
Relating the cost and product
curve: Law of diminishing returns
Relating the cost and product curve:
Law of diminishing returns
• The law of diminishing returns is very important
in determining the shape of the cost curves.
• Increasing marginal returns:
– Extra output produced by an extra unit of labour rises
– This means the the additional cost of producing n
additional unit (MC) falls
• Decreasing marginal returns
– And additional output of each unit of labour is falling
– Therefore the additional cost of each unit (MC)
increases
remember
• The U-shape of the AVC,ATC and MC is due to
the laws of diminishing marginal returns. This
also explains the why the AVC and MC curves
are mirror images of the AP and MP curves
Test your knowledge
• Explain the relationship between the product
curves and the cost curves with reference to
the laws of diminishing marginal returns.
• Complete the provided handout on “Theory of
Cost” and “Short-run”
LONG-RUN
• You must be able to distinguish between
increasing, decreasing and constant return to
scale.
Remember
• In the long-run, all inputs are variable
• Increasing returns to scale:
– It means that output increases more than in proportion to
the increase in all inputs
• Constant returns to scale:
– It means that output increases at the same proportion as
all inputs
• Decreasing returns to scale:
– Output increases less in proportion to the increase in all
inputs.
Test your knowledge: edmodo
• Post your answer on edmodo
• distinguish between increasing, decreasing
and constant returns to scale.
Long-run Average Total Cost Curve:
• Curve shows the lowest possible AC that can
be attained by a firm for any level of output
when all firm’s input are variable.
• It is the curve that touches each of many
short-run ATC.
• It is known as the planning curve
• Outline the relationship between the SRAC
and LRAC
• Economies of Scale = if making cost savings
from the increase in scale of production
• Diseconomies of scale = if average cost of
production rises as the produce more
Types of internal economies of scale
Financial Economies
• Cost savings by the way firms raise money
– Selling shares
– Borrowing money to buy machinery
– Lower interest (for loans)
Market Economies
• Cost savings by the way they sell their
product
– Buy in bulk
– Employ purchasing specialists and sales people
Technical Economies
• Cost savings by method of production
– Specialized workers and machinery
– Research a faster method of production
– Types of transport
Risk-bearing Economies
• Cost savings by reducing the risk of fall in
demand
– Using many different suppliers
– Diversification of goods
Diseconomies of Scale
Management diseconomies
• Too many departments and managers=
disagreements
Labour Diseconomies
• Disengagement of the workers
• Strikes and disruptions
• Read the Cost section of the micro packet or
your text book and answer the following
question
• Describe factors giving rise to the economies
of scale, including specialization, efficiency
and marketing.
• Describe the factors giving rise to the
diseconomies of scale
Remember:
• Short run – Diminishing marginal returns
results from adding successive quantities
of variable factors to a fixed factor
• Long run – Increases in capacity can lead
to increasing, decreasing or constant
returns to scale