The Cost of

Production

Dr. C S Shylajan
 Topics to be Discussed
 WHAT?
 Relationship between Production and
Costs
 Measuring Cost: Which Costs Matter?
 Cost in the Short Run
 Cost in the Long Run
 Topics to be Discussed
 Short-Run Cost Curves
 Long-Run Cost Curves
 Plant Size and Economies of Scale
 Plant Size and Diseconomies of Scale
 Economies of Scope
 Breakeven Analysis
 Estimating and Predicting Costs
 Why Cost Analysis is important?
 Costs play in determining the profitability of the
firm
 Conventional accounting statements do not
always present the information needed for
effective managerial decisions
 Understand various cost concepts
 Understand concepts of economies of scale and
scope and apply them to business strategy
Introduction

 The production technology measures

the relationship between input and
output. (Q =f (K, L, R) )
 Given the production technology,
managers must choose how to produce
a product with minimum cost
 Why outsourcing?
Introduction

 To determine the optimal level of

output and the input combinations,
we must know costs of production.
 We know Total cost C=w (L) + r (K)
 Various cost concepts
 Measuring Cost:
Which Costs Matter?
Economic
Economic Cost
Cost vs.
vs. Accounting
Accounting Cost
Cost
 Accounting Cost
 Eg.Actual expenses plus depreciation charges for capital
equipment
 These are explicit costs
 Economic Cost (explicit + implicit costs)
 Cost to a firm of utilizing economic resources in production,
including opportunity cost (implicit costs)
 So economic costs include both explicit and implicit costs
 Measuring Cost:
Which Costs Matter?
 Opportunity Cost
 Opportunity costs refer to the value of the inputs owned and used by
the firm in its own production activity.

 In measuring production costs, the firm must include the opportunity

costs of all inputs, whether purchased or owned by the firm.

 Profit = Total Revenue – Total Cost

 Accounting Profit Vs Economic Profit

 Accounting Profit = Total Revenue – Explicit costs

 Economic Profit = Total Revenue – (Explicit + implicit cost)

 Measuring Cost:
Which Costs Matter?
 An Example for opportunity cost
 A firm owns its own building and pays no rent for office space
 Does this mean the cost of office space is zero?
 NO!
 There is also Cost of Being “Your Own Boss”
 Private Costs and Social Costs
 Any example for social cost?
 How to estimate social costs?
 Measuring Cost:
Which Costs Matter?
Fixed,
Fixed, Variable
Variable Costs
Costs and
and Total
Total Costs
Costs
 Total output is a function of variable inputs
and fixed inputs. (Q=f (K, L,R,Land)
 Therefore, the total cost of production
equals the fixed cost (the cost of the fixed
inputs) plus the variable cost (the cost of
the variable inputs), or…

TC = FC + VC
 Measuring Cost:
Which Costs Matter?
Fixed
Fixed and
and Variable
Variable Costs
Costs
 Fixed Cost
 Does not vary with the level of output
 Cost paid by a firm that is in business regardless of
the level of output
 Fixed cost must be paid even if output is zero

 Variable Cost
 Cost that varies as output varies
 Example?
 A Firm’s Short-Run Costs
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (AC)

050 0 50--- ------ ---

150 50 10050 5050 100
250 78 12828 2539 64
350 98 14820 16.732.7 49.3
450 112 16214 12.528 40.5
550 130 18018 1026 36
650 150 20020 8.325 33.3
750 175 22525 7.125 32.1
850 204 25429 6.325.5 31.8
950 242 29238 5.626.9 32.4
1050 300 35058 530 35
1150 385 43585 4.535 39.5
Cost in the Short Run

 MarginalCost (MC) is the cost

of expanding output by one
unit. Since fixed cost have no
impact on marginal cost, it can
be written as:
∆VC ∆TC
MC = =
∆Q ∆Q
Cost in the Short-Run
 Average Fixed Cost is Total Fixed cost divided
by the quantity of output produced

AFC= TFC/Q
 Average Variable Cost is Total Variable Cost
divided by the quantity of output produced

AVC= TVC/Q
Cost in the Short Run

 Average Total Cost (ATC) is the

cost per unit of output, or
average fixed cost (AFC) plus
average variable cost (AVC).

TFC TVC
ATC = +
Q Q
Cost in the Short Run

 That is,

TC
ATC = AFC + AVC or
Q
Cost in the Short Run

 The Determinants of Short-Run Cost

 The relationship between the

production function and cost can be
exemplified by either increasing
marginal returns and decreasing cost
or decreasing marginal returns and
increasing cost.
 Cost in the Short Run
 The Determinants of Short-Run Cost
 Increasing marginal returns and decreasing cost
With increasing marginal returns, output is
increasing relative to input and variable cost and
total cost will fall relative to output.

 Diminishing marginal returns and increasing cost

With decreasing marginal returns, output is
decreasing relative to input and variable cost and
total cost will rise relative to output.
Cost in the Short Run

 Consequently (see the table):

 MC decreases initially with increasing
marginal returns
 0 through 4 units of output
 MC increases with decreasing
marginal returns (due to law of
diminishing marginal returns)
 5 through 11 units of output
 A Firm’s Short-Run Costs (Rs)
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)

050 0 50--- ------ ---

150 50 10050 5050 100
250 78 12828 2539 64
350 98 14820 16.732.7 49.3
450 112 16214 12.528 40.5
550 130 18018 1026 36
650 150 20020 8.325 33.3
750 175 22525 7.125 32.1
850 204 25429 6.325.5 31.8
950 242 29238 5.626.9 32.4
1050 300 35058 530 35
1150 385 43585 4.535 39.5
Cost Curves for a Firm
Total cost
is the vertical TC
Cost 400 sum of FC
(Rs.per and VC.
year) VC
Variable cost
300 increases with
production and
the rate varies with
increasing &
200 decreasing returns.

100 Fixed cost does n

50 vary with output
FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output
Cost Curves for a Firm
Cost
(Rs per
100
unit)
MC

75

50 AC
AVC

25

AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)
Cost in the Long Run

A firm’s expansion path

shows the minimum cost
combinations of labor (L) and
capital (K) at each level of
output.
A Firm’s Expansion Path
Capital
per The expansion path illustrates
year the least-cost combinations of
labor and capital that can be
used to produce each level of
150 Rs3000 Isocost Line output in the long-run.

Rs2000 Expansion Path

Isocost Line
100
C
75
B
50
300 Unit Isoquant
A
25
200 Unit
Isoquant
Labor per year
50 100 150 200 300
A Firm’s Long-Run Total Cost Curve
Cost
per
Year
Expansion Path
F
3000

E
2000

D
1000

Output, Units/yr
100 200 300
Long-Run Cost Curves and Returns to
Scale

 Long-Run Average Cost (LAC)

 Constant Returns to Scale

 If input is doubled, output will

double and average cost is
constant at all levels of output.
Long-Run Cost Curves
and Returns to Scale

 Long-Run Average Cost (LAC)

 Increasing Returns to Scale

 If input is doubled, output will more

than double and average cost
decreases at all levels of output.
Long-Run Cost Curves
and Returns to Scale

 Long-Run Average Cost (LAC)

 Decreasing Returns to Scale

 If input is doubled, the increase in

output is less than twice as large
and average cost increases with
output.
Long-Run Cost Curves
and Returns to Scale

 Long-Run Average Cost (LAC)

 In the long-run:

 Firms experience increasing and

decreasing returns to scale and
therefore long-run average cost is
“U” shaped.
Long-Run Average
and Marginal Cost

Cost
(Rs per unit
of output LMC

LAC

Output
Economies of Scale

 Economies of Scale are technological

or organisational advantages that
accrue to the firm as it increases
output in the long run.
 Economies of scale reduces long run
average costs.(Declining portion of
LAC curve)
 Economies of Scale
 Economies of Scale
Economies of Scale occur when increase
in output is greater than the increase in
inputs.
Due to advancing technological devt and
mass production, there will be reduction in
the production costs and prices
 Eg: Computer, other consumer electronics etc.
Economies of Scale

 At higher scales of operation, more

specialised and productive machinery
can be used.
 There are financial reasons for
economies of scale
 Bulk purchase advantage, bank loans
at lower interest rates, decreasing
costs in advertisement and
promotional activities
 Economies of Scale
 Economies of scale due to International
trade in inputs
 Outsourcing accounts for more than one
third of total manufacturing costs by
Japanses firms, saving them more than 20 %
of production costs.
 Opening of production facilities abroad
 Globalisation and new economies of scale
Diseconomies of Scale
 Diseconomies of Scale
 Increase in output is less than the increase
in inputs.
 Diseconomies of scale are organisational
disadvantage that the firm encounters as it
increases output in the long run.
 Diseconomies of scale increase long run
average costs (Increasing portion of LAC
Curve)
Measuring Economies of Scale

 Measuring Economies of Scale by

estimating Cost-Output Elasticity

Ec = Cost − output elasticity

= %Δ in cost from a 1% increase
in output
Cost –Output Elasticity

 Cost Output Elasticity is the

percentage change in long run
total cost from a 1 per cent
change in output
Measuring Economies of Scale

 Measuring Economies of Scale

 The cost elasticity reflects the
presence of either economies of
scale or diseconomies of scale
 Ec= percentage change in LTC

Percentage change in Q
 Measuring Economies of Scale

 Ec= ∆ LTC . (Q2 +Q1)

∆ Q (LTC2 + LTC1)

Where LTC is Long run Total Cost

Q is output. Here we have used Arc method of estimating elasticity.

Measuring Economies of Scale
Q1 is initial output and Q2 is New level of output

LTC1 is long run total cost in the initial period

LTC2 is long run total cost for new level of output

Measuring Economies of Scale
 Ec <1 means LTC increases by a
smaller percentage than the
percentage increase in output (E of S)
 Ec =1 means LTC changes by the
same percentage as the percentage
change in output (CRS)
 Ec >1 means LTC increases by a larger
percentage than the percentage
increase in output (DES)
Measuring Economies of Scale

Ec < 1 means Economies of

Scale

Ec = 1 means constant returns to

scale

Ec > 1 means diseconomies of

scale
 Economies of Scope

 Economies of scope occur when the

average cost of undertaking two or
more activities together is less than
the sum of the costs of each activity
separately.
Economies of Scope
 Examples:
 Automobile company--cars and trucks
 What are the advantages of joint production?
 Consider an automobile company producing
cars and tractors
Economies of Scope
 Advantages
1) Both use capital and labor.
2) The firms share management resources.
3) Both use the same labor skills and type of
machinery.
Then joint cost of production may come down.
Economies of Scope

 Observations
 There
is no direct relationship
between economies of scope and
economies of scale.
 May experience economies of
scope and diseconomies of scale
 May have economies of scale and
not have economies of scope
Economies of Scope

 Degree of Economies of Scope measures

the savings in cost due to Economies of
Scope and can be written:
C(Q1) + C (Q 2) − C (Q1, Q 2)
SC =
C (Q1, Q 2)
 C(Q1) is the cost of producing Q1
 C(Q2) is the cost of producing Q2
 C(Q1Q2)is the joint cost of producing both
products
Example

 CQ1 =$2000
 CQ2 =$3000
 C (Q1, Q2) = $4000
 SC= ($2000+$3000 ) – ($4000)
$4000
=$1000/$4000 =0.25
Approx..25 % saving in cost due to joint
production.
Economies of Scope

 Interpretation:

 IfSavings in Cost > 0 -- Economies of

scope

 IfSavings in Cost < 0 -- Diseconomies

of scope
 Estimating and Predicting Cost
 Estimates of future costs can be obtained from
a cost function, which relates the cost of
production to the level of output and other
variables that the firm can control.
 Suppose we wanted to derive the total cost
curve for automobile production.
 Either using time series data or cross section
data on variables we can estimate cost
functions and predict for future.
 Estimating and Predicting Cost
 Difficulties in Measuring Cost
1) Output data may represent an
aggregate of different type of products.
2) Cost data may not include opportunity
cost.
3) Allocating cost to a particular product
may be difficult when there is joint
products.
Break-even Analysis
 Most useful for managerial decision making
 A firm is at break even when revenue of the
firm is equal to its cost
TR = TC
No profit, No loss
 How to calculate Breakeven point Quantity?
Break-even Analysis

 Qb = TFC/ (P-AVC)
 TFC = Total Fixed Cost
 P= Price of product
 AVC= Average Variable Cost
 Break-even Analysis
 Suppose a firm producing a product
which has total fixed cost per month
$100000, Average Variable Cost of
production is $20, Selling Price of
Product is $30. What is the breakeven
output ?
 BE output=TFC/ (P- AVC)
 100000/ (30–20)
 = 10,000 units. Why don’t you calculate
total sales revenue at breakeven point?
Summary

 Cost functions relate the cost of

production to the level of output of the
firm.
 Managers, investors, and economists
must take into account the opportunity
cost associated with the use of the
firm’s resources.
 Firms are faced with both fixed and
variable costs in the short-run.
 Summary
 When there is a single variable input, as
in the short run, the presence of
diminishing returns determines the
shape of the cost curves.
 In the long run, all inputs to the
production process are variable. The
shape of long run average cost curve is
determined by whether firm
experiences IRS, CRS or DRS
Summary

 The firm’s expansion path describes

how its cost-minimizing input choices
vary as the scale or output of its
operation increases.
 A firm enjoys economies of scale when
it can double its output at less than
twice the cost.
Summary

 Economies of scope exist when

the joint output of a single firm is
greater than the output that could
be achieved by two different firms
each producing a single output.
Thank you