“ Don’t try just do it”

Chapter 4:
The Costs of
Production

Instructor:
Dr. NGUYỄN THỊ THANH THÚY

Chapter 4: The Costs of Production

Objectives

- Understanding definitions of different costs

- How to measure various costs

- Distinguish accounting profit and economic profit

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 1. WHAT ARE COST

1.1 Total revenue, total cost, and profit

• Total revenue is the amount a

firm receives for the sale of its
output
• Total cost is the market value
of the inputs a firm uses in
production
• Profit is total revenue minus
total cost

1. WHAT ARE COST

1.2 Opportunity cost

Explicit costs
input costs that require
an outlay of money by
Total cost
the firm
= explicit costs +
Implicit costs implicit costs.
input costs that do not
require an outlay of
money by the firm

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 1. WHAT ARE COST

1.3 Economic profit versus accounting profit

Economic Accounting
profit profit

Revenue Revenue
Implicit costs

Explicit costs Explicit costs

How an Economist How an Accountant

Views a Firm Views a Firm

2. PRODUCTION AND COSTS

2.1 Production function
Ex: A moon-cake firm requires some inputs for its
production as below table:
1milVND
Number Output Marginal Cost of Cost of Total cost (cost
of product of factory worker of factory + cost
workers labor of worker
0 0 - 30 - 30
1 50 50 30 5 35
2 90 40 30 10 40
3 120 30 30 15 45
4 140 20 30 20 50
5 150 10 30 25 55

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 2. PRODUCTION AND COSTS

2.1 Production function

 A production function is purely technical
relation which connects factor inputs &
outputs. It describes the transformation of
factor inputs into outputs at any particular time
period. Q = f( L,K,R,L ,T,t) d
where
Q = output R= Raw Material
L= Labour Ld = Land
K= Capital T = Technology
t = time

For our current analysis, let’s reduce the inputs to two,

capital (K) and labor (L):
Q = f(L, K)

2. PRODUCTION AND COSTS

2.1 Production function
 In the short run some inputs are fixed and some
variable
e.g. the firm may be able to vary the amount
of labor, but cannot change the amount of
capital
 In the long run all inputs become variable
e.g. the long run is the period in which a firm
can adjust all inputs to changed conditions
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 2. PRODUCTION AND COSTS
2.2 Average product and marginal product
 Average product (AP) is the output that is produced, on average,
by each unit of the variable factor.

Q
APL  (Holding K instant)
L APL : Average product of L
APK : Average product of K
Q : output (total product)
L : Labour
K : Capital
Q
APK  (Holding L instant)
K

2. PRODUCTION AND COSTS

2.2 Average product and marginal product
 Marginal product (MP) is the extra output that is produced by
using an extra unit of the variable factor.

Q dQ
MPL   (Holding K instant)
L dL
MPL : Marginal product of L
MPK : Marginal product of K
Q dQ
MPK   (Holding L instant)
K dK

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 2. PRODUCTION AND COSTS

2.2 Average product and marginal product

Ex: Analyze average product and marginal product of the
moon-cake firm

Number Output Marginal product of L Average product of L

of labor (MPL ) (APL )
0 0 - -
1 50 50 50
2 90 40 45
3 120 30 40
4 140 20 35
5 150 10 30

2. PRODUCTION AND COSTS

2.2 Average product and marginal product

The diminishing marginal product

 Diminishing marginal product is the property

whereby the marginal product of an input declines as
the quantity of the input Increases.

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 2. PRODUCTION AND COSTS

2.2 Average product and marginal product

K L Q APL MPL
10 0 0 - -
10 1 10
10 2 30
10 3 60
10 4 80
10 5 95
10 6 105
10 7 110
10 8 110
10 9 107
10 10 100

2. PRODUCTION AND COSTS

2.2 Average product and marginal product

120.00

100.00

80.00

60.00 AP(L)
Q
40.00 MP(L)
20.00

0.00
0 2 4 6 8 10 12
-20.00

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 3. THE VARIOUS MEASURES OF COSTS
3.1 Costs in short run
a. Total cost, fixed cost, and variable cost
Ex: A moon-cake firm requires some inputs for its production as
below table:
milVND
Number Output Marginal Cost of Cost of Total cost (cost
of product of factory worker of factory + cost
workers labor of worker
0 0 - 30 - 30
1 50 50 30 5 35
2 90 40 30 10 40
3 120 30 30 15 45
4 140 20 30 20 50
5 150 10 30 25 55

3. THE VARIOUS MEASURES OF COSTS

3.1 Costs in short run
a. Total cost, fixed cost, and variable cost

The amount that

the firm pays to
TC = FC Total cost
(constant) + VC
buy inputs
(TC)

Fixed costs (FC):

costs that do not Variable costs (VC):
vary with the Costs that vary with
quantity of the quantity of output
output produced produced

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3. THE VARIOUS MEASURES OF COSTS
3.1 Costs in short run
a. Total cost, fixed cost, and variable cost
C
TC

VC

FC

Q
0 Total cost

3. THE VARIOUS MEASURES OF COSTS

3.1 Costs in short run
b. Average costs
Is fixed cost
Average Fixed Cost (AFC) divided by
FC the quantity
AFC  of output AFC always
Q falls as
output
increases

Average Variable Cost (AVC)

Is variable
VC cost divided
AVC  by the
Q
quantity of
output

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 3. THE VARIOUS MEASURES OF COSTS
3.1 Costs in short run
b. Average costs
Average Total Cost(ATC)

TC
ATC 
Q
FC VC
ATC    AFC  AVC
Q Q Is total cost
divided by
the quantity
of output

3. THE VARIOUS MEASURES OF COSTS

3.1 Costs in short run
b. Marginal costs

TC
MC  Is the increase
Q in total cost
that arises
dTC dVC from an extra
MC   unit of
dQ dQ production

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 3. THE VARIOUS MEASURES OF COSTS
 Ex: A lemon-juice company has various costs as below table:
1.000VND
Lemon- Total Fixed Variable Average Average Average Marginal
juice can cost cost cost fixed cost variable cost total cost cost
(Q) (TC) (FC) (VC) (AFC) (AVC) (AC) (MC)

0 3 3 0- - - -
1 3.3 3
2 3.8 3
3 4.5 3
4 5.4 3
5 6.5 3
6 7.8 3
7 9.3 3
8 11 3
9 12.9 3
10 15 3

3. THE VARIOUS MEASURES OF COSTS

 Ex: A lemon-juice company has various costs as below picture

TC
FC
VC
AFC
AVC
AC
MC

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 3. THE VARIOUS MEASURES OF COSTS
 Ex: A lemon-juice company has various costs as below picture

MC
AFC
AVC
AC
AC
AVC MC

AFC

3. THE VARIOUS MEASURES OF COSTS

 Relationships:
 AC and MC:
 If MC > ATC then ATC is rising
 If MC < ATC then ATC is falling
 If MC = ATC then ATC is minimized.

The marginal-cost curve

crosses the average-total-
cost curve at its minimum

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 3. THE VARIOUS MEASURES OF COSTS
3.2 Costs in long run

The LRAC curve and short run average cost curves

3. THE VARIOUS MEASURES OF COSTS

3.2 Costs in long run

Increasing, constant, and decreasing returns to scale

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 3. THE VARIOUS MEASURES OF COSTS
3.2 Costs in long run

• the property whereby long-run

Economies of scale average total cost falls as the
quantity of output increases

• the property whereby long-run

Diseconomies of scale average total cost rises as the
quantity of output increases

Constant returns • the property whereby long-run

average total cost stays the same
to scale as the quantity of output changes

“ Don’t try just do it”

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