PRODUCTION AND COSTS

Explicit Cost
 Cost that a producer actually pays

Implicit Cost
 opportunity costs, associated with non
purchased factors or inputs
 not involve a direct money payment
ACCOUNTING PROFIT
 Difference between the total revenue and the

total explicit cost

ECONOMIC PROFIT
 Difference between the accounting profit and

the total implicit costs

Exhibit 1 Accounting and Economic Profit

Arnold Economics, 5e / Ch.

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ITEM RM RM
Total Revenue 150,000
Explicit Costs
Cost of production 20,000
Wages 22,000
Interest 3,000
Total Explicit Costs 45,000
Accounting Profit 105,000
Implicit Costs
Producer’s foregone salary 40,000
Producer’s forgone 8,000
interest
Depreciation of Capital 7,000
Total Implicit Cost 55,000

Economic Profit 50,000

Two types of inputs

1. Fixed Input (FI)

 input which the quantity does not vary
according to the amount of output
 fixed input is one which is permanent and
stays in the production by the same quantity
regardless of whether there is output or not.
 Examples of fixed inputs are a machine, a
building, office/restaurants space and tools.

2. Variable Input (VI)

 input which the quantity varies according to
the amount of output
 zero output requires zero variable input
 Examples of variable inputs are labor, raw
materials, electricity, water
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Production periods

 Short run = the time period is short that some

inputs remain unchanged (at least 1 input is fixed
input)

 Long run = the time period is long enough that

all inputs can change (all inputs are variable
inputs, no fixed input)

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Exhibit 2 Periods of Production, Inputs, and Costs

Arnold Economics, 5e / Ch.

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Short run production

Production function = relationship

between quantities of inputs and the
maximum output level (refer reference for diagram)

Total Product (TP) = total output produce

Average Product (AP) = qty of output per worker

(TP/QL)

Marginal Product (MP) = additional output

produce when adding an additional unit of VI
(ΔTP/ Δ QL)
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 TOTAL PRODUCT(TP)
 MARGINAL PRODUCT(MP)
 AVERAGE PRODUCT(AP)

 LAW OF DIMINISHING MARGINAL RETURNS

As the firm employs more and more variable
inputs to given fixed inputs, MP initially rises
until it reaches a certain maximum level after
which the MP will fall or diminish.
 TP max

MP max

AP max

MP =0
Stages of production

Stage I
 Starts from origin (0) to MP intersect AP
(AP=MP)
 TP increasing, MP and AP reach maximum
 Output level is still low as compared to
plant capacity (MP>AP)
 Production is inefficient
(refer production curves)

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Stage II
 Starts from MP = AP to MP = 0 or TP =
max output
 MP and AP starts falling (AP>MP)
 Most efficient stage since all inputs (FI and
VI are efficiently used)

Stage III
 Inefficient stage
 Additional labor will cause TP falling or MP
negative and AP reaching qty axis
 Output too big - machine, plant size
cannot cope with increasing VI (QL)
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 FIXED COSTS (FC)
 VARIABLE COSTS (VC)
 TOTAL COST (TC) = FC + VC
 AVERAGE FIXED COST (AFC) = FC/Q
 AVERAGE VARIABLE COSTS (AVC) = VC/Q
 AVERAGE TOTAL COSTS (ATC) = TC/Q
 MARGINAL COST (MC) = TC/ Q
 COST THEORY
1. Fixed Costs (FC)

◦ Fixed cost is the firm’s expenditure on fixed

inputs per period of time.
◦ Fixed costs are incurred before any
production or business takes place
◦ no relationship between total fixed cost and
the level of output i.e. fixed cost will remain
constant even though output changes.
◦ Examples of fixed costs are payments for
factory, machinery, tools, insurance premium,
rent.
◦ Formula: FC = TC - TVC
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2. Variable Costs (VC)

◦ Variable cost is the firm’s total expenditure

on variable inputs per period of time.
◦ Since more output requires greater utilization
of variable inputs such as raw material, labor
and utilities, variable cost varies directly with
the level of output.
◦ When there is no output, there is no variable
cost.
◦ Formula: VC = TC – TFC
◦ TC = FC + VC

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3. Total Costs (TC)

◦ Total cost can be defined as the total cost

incurred by the firm in the process of
producing goods and services.
◦ It is sum of total fixed cost and total variable
cost.
◦ Formula: TC = VC + FC

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 TC
Cost
VC

FC

200 FC

Q Qty

TC, FC, VC
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Short Run Average Cost Curves

1. Average Fixed Cost (AFC)

◦ Average fixed cost is total fixed cost per unit

of output.
◦ AFC will fall as output increases because of
spreading of fixed cost.
◦ Formula: AFC = TFC / Quantity

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2. Average Variable Cost

◦ AVC can be defined as the total variable cost

per unit of output.
◦ The AVC is U-shaped.
At first, as output increases, AVC falls because
of spreading of cost. As output increases
further, average variable cost is at the minimum
(optimum level because it is the best
combination between fixed and variable
factors). After the optimum level, as output
increases further, AVC will start increasing
because the law of diminishing returns is in
operation. As more and more of the variable
inputs are utilized, the extra output they
produce declines beyond some point, so the
amount spent on variable input per unit of
output increases.
◦ Formula: AVC = TVC / Quantity
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3. Average Total Cost (ATC)
Average total cost tells us how much a
product costs per unit.
◦ The ATC curve is also U-shaped
◦ Formula: ATC = TC / Quantity
= AVC + AFC
= (TVC/Q) + (TFC/Q)

4. MARGINAL COST
Additional cost incurred when you want to
produce another unit of output
◦ Formula: MC = Δ TC / Δ Qty

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 AC, AVC, AFC, MC
Cost

AC
MC
AVC

min AC

min AVC

AFC
QTY

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Exhibit 3a Total, Average, and Marginal Costs

Arnold Economics, 5e / Ch.

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Exhibit 3b Total, Average, and Marginal Costs (Continued)

Arnold Economics, 5e / Ch.

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Production Costs in the Long Run
Production Costs in the Long Run
Cost

SRAC7
SRAC1
SRAC6 LRAC
SRAC2
SRAC5
SRAC3

SRAC4

0 Q5 Qty

Economies of scale Diseconomies of scale

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Exhibit 8 Long-Run Average Total Cost Curve (LRATC)

Arnold Economics, 5e / Ch.

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©2001 South-Western
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 The long run average cost (LRAC) curve is
u-shaped because of the economies and
diseconomies of scale.

Economies of scale
 are the advantages and benefits the firm

enjoys as it becomes larger and larger

 As output increase, the long run average

cost will fall because of the economies of

scale, which will bring about increasing
returns to scale (decreasing costs).

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Diseconomies of scale
 are the problems and disadvantages the
firm will face when it becomes too large.
 As output increases further, long run
average cost will increase because of the
diseconomies of scale which will bring
about decreasing returns to scale and
increasing costs.
Factors leading to economies of scale:
1. Economies of specialization.
◦ Workers will specialize in jobs - increase the
efficiency, the skill of the worker and time
saving - output will increase without an
increase in wages - AC will fall
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2. Financial economies
◦ Large firms can easily get loans, lower rate than
that offered to small firms, issue new shares and
sell to the public in order to raise fund for
investment

3. Technical economies
◦ Large scale firms can use machines which are
modern and sophisticated
◦ sophisticated machines can increase the quantity
of output produced

4. Administrative / managerial economies

◦ Departmentalization and employment of
professionals will ensure higher productivity and
greater efficiency 31
5. Marketing economies
◦ Large scale firms are able to buy raw materials
in bulks
◦ market is not limited to local markets

Problems causing diseconomies of scale

1. Labor diseconomies
2. Managerial problems
3. Technological problems

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