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 fixed cost Average variable cost Average total cost Marginal cost 0$3.00 $ $3.00$0.30$3.30$

Total cost The Total Cost of production may be divided into fixed costs and variable costs. TC = FC + VC

Total Cost $ Quantity of Output Total-cost curve (cups of coffee per hour) Quantity of coffee (cups per hour) Total Cost $

Fixed cost Fixed costs 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 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

Quantity Costs (dollars) Total Cost Fixed Cost TVC Variable Cost TFC Combining TVC With TFC to get Total Cost

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

Costs $ Quantity of Output (cups of coffee per hour) AFC AFC = FC/Q. As FC is constant, FC/Q decreases as Q increases. Therefore, AFC decreases as Q increases Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves

Costs $ Quantity of Output ATC AVC AFC 1.AFC decreases as Q increases, 2.AVC increases as Q increases, because of diminishing returns. 3.As ATC = AFC + AVC, ATC is U- shaped: as Q increases, it decreases initially and then begins to increase. (cups of coffee per hour) Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves

Costs $ Quantity of Output ATC (cups of coffee per hour) For Conrad’s Coffee Shop, the efficient scale is 5 or 6 cups of coffee per hour The quantity at which ATC is lowest is called the efficient scale output.

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

The various measures of cost: Conrad’s Coffee Shop Quantity of coffee (cups per hour) Total cost Fixed cost Variable cost Average fixed cost Average Variable cost Average total cost Marginal cost 0$3.00 $ $3.00$0.30$3.30$

Costs $ Quantity of Output MC (cups of coffee per hour) Marginal cost rises with the amount of output produced. This reflects the assumption of diminishing marginal product Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves

Costs $ Quantity of Output MC ATC AVC AFC (cups of coffee per hour) Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves

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 efficient scale The marginal-cost curve crosses the average-total-cost curve at the efficient scale. Efficient scale is the quantity that minimizes average total cost.

Costs $ Quantity of Output ATC MC (cups of coffee per hour) Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves

Example of Typical Firm

$ TC Total Cost 0 (a) Total-Cost Curve Figure 5 Cost Curves of a Typical Firm

(b) Marginal- and Average-Cost Curves Quantity of Output Costs $ MC ATC AVC AFC

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: LRAC Each small U-shaped curve is a SAC curve. Each small U-shaped curve is a SAC curve. The LRAC curve. $/Q Q Average costs for a typical firm.

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.

LRAC $/Q Q Average costs for a typical pizza firm. LRAC shows economies of scale here. ECONOMIES OF SCALE: When output increases, long-run average costs decline.

LRAC $/Q Q Average costs for a typical pizza firm. LRAC shows diseconomies of scale here. DISECONOMIES OF SCALE: When output increases, long-run average costs increase.

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 ScaleCapitalLandLaborOutputTCAC Scale A Scale B 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?

Economies of Scale ScaleCapitalLandLaborOutputTCAC Scale A Scale B 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