NORTH SOUTH UNIVERSITY

Group Assignment: Cost of Production

COURSE NAME: Managerial Economics
BUS 525
SECTION: 04
SUBMITTED TO:
Professor Dr. K.M. Zahidul Islam
School of Business and Economics
MBA Program
SUBMITTED BY:
1. Nusrat Sorwar – 2016127060
2. Ahsanul Haque Kabi - 2115179660
3. Shabbir Haque Akash - 2115410660
4. Farzana Akter – 2125062660
5. Md. Arhamer Mahdin - 2125087660

Date of Submission: 02/01/2021

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 Learning Objectives
The entrepreneur combines other resources in production. When there are only a fixed
number of tools, or capital goods, to work with the amount of output that can be made is
somewhat limited. Within this time frame, the costs of production depend on the ability to
produce items. This hands-on lesson will help students understand what an entrepreneur must
grapple with in terms of controlling costs of production as well as developing an
understanding of the concept of diminishing returns. Also, it will eventually lead us to:
 Distinguish between fixed and variable costs of production
 Understand how the law of diminishing returns affects the shape of a firm’s short-run
total costs and short-run average costs.
 Understand the relationships between marginal cost and the average costs faced by a
firm
 Distinguish between the short-run and the long-run and understand how economies of
scale determines the shape of a firm’s long-run ATC curve.
 Evaluate the importance to a business firm of understanding its short-run and long-run
costs of production.
Table of Contents

Topics Pages

Introduction 1-6

Different Types of Cost 6-11

Relationship between Marginal Cost 12

and Average Total Cost

Short Run, Long Run, Economics of 12-16

Scale, Diseconomics of Scale, Constant
returns to scale

Learning Curve, Cost Minimization 17-20

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 Introduction
Cost of production refers to a company’s overall cost of manufacturing a given quantity of a
commodity or of delivering a service. The costs of manufacturing products at a factory can be
divided into the costs of recruiting inputs also called production factors. Costs of production
may involve items like labor, raw materials, or consumable products. Typically the two main
inputs are divided into labor, such as salaries, wages, contractor fees, distribution fees, and
resources, either purchasing or renting machinery, equipment. Producers who desire to earn
profits must be concerned about both the revenue (the demand side of the economic problem)
and the costs of production. Profits (Π) are defined as the difference between the total
revenue (TR) and the total cost (TC).
In Economics, cost of production has a special meaning. It is all of the payments or
expenditures necessary to obtain the factors of production of land, labor, capital and
management required to produce a commodity. It represents money costs which we want to
incur in order to acquire the factors of production.
Cost of production is the concern to managers as it is a critical factor in understanding the
cost mechanisms of the business, and the knowledge of economics helps in leveraging the
tools that can be utilized to effectively get an overview of the cost of production, and provide
a ground, as to how they could be related to the economic theories and principles. Therefore,
such an understanding of the content is of the utmost imperative to present-day managers.
Cost of production denotes the total cost acquire in a business to generate a fixed sum of a
product or give a service. Production costs may consist of things such as labor, raw materials,
or consumable supplies.
For instance, the production costs for an automobile tire may consist of costs such as rubber,
labor required to make the product, and several manufacturing materials. In the service
industry, the costs of production may involve the material costs of transporting the service,
along with the labor costs waged to employees assigned with giving the service.
Cost:
Cost comes from factor price and how many units are used. In a basic economic sense, the
cost is the measure of the substitute chances foregone in the option of one good or activity
over others. This essential cost is usually denoted as opportunity cost. For a customer with a
fixed salary, the opportunity cost of buying a new local appliance may be, for instance, the
worth of a trip not taken.
In general, the cost has to do with the connection between the price of production inputs and
the level of output. The total cost denotes the total expense incurred in attaining a particular
level of output; if such total cost is divided by the quantity produced, average or unit cost is
found. A fraction of the total cost identified as fixed cost—e.g., the costs of house rent or
heavy equipment does not differ with the quantity produced and, in the short run, does not
adjust with changes in the amount produced. Variable costs, like the costs of labor or raw
materials, change with the level of output.

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Cost Function:
Let w be the cost per unit of labor and r be the cost per unit of capital. With the input Labor
(L) and Capital (K), the production cost is
w × L + r × K.
A cost function C(q) is a function of q, which tells us what the minimum cost is for producing
q units of output. We can also split total cost into fixed cost and variable cost as follows:
C(q) = FC + V C(q).
Fixed cost is independent of quantity, while variable cost is dependent on quantity. The sum
of fixed cost and the product of the variable cost per unit times quantity of units produced,
also termed as total cost.
For example, the coffee bar enterprise has two components: the fixed cost component of
$30,000 that remains the same regardless of the volume of units and the variable cost
component of $0.40 times the number of items. The calculation for the cost function is C =
$30,000 + $0.4 Q, where C is the total cost. Here, we are calculating economic cost, not
accounting cost.
Types of costs of Production: There are different types of costs of production that companies
may incur when producing a product or delivering a service. They include the following:
Accounting Cost: Actual expenses plus depreciation charges for capital equipment.
Accounting cost, related to accounting profit, peruses the key values of accounting. In easier
terms, accounting cost is the total cost of anything in one’s business paid for.
Economic cost: Cost to a firm of using economic resources in production including
opportunity cost.The most valuable forgone alternative. The economic goal of any firm is
maximizing profit.
Economic cost is a step further than typical accounting and is often used by economists to
analyze two distinct methodologies. To compare the prudence of one course of action with
that of another.It also inspects the effect each methodology would have on one’s business.
The economic cost is computed by taking one’s accounting cost, which has previously been
computed and also subtracting any implicit costs. Implicit costs are estimated by evaluating
one’s recent resources and assessing the cost of those resources, along with their effect on
one’s business, should he or she choose to use them in an alternative way. Cost to a firm of
utilizing economic resources in production, including opportunity cost.
Opportunity Cost: Cost associated with opportunities that are forgone when a firm’s
resources are not put to their best alternative use. It is the next best alternative. It is the value
sacrificed when a choice is made.
Formula and Calculation of Opportunity Cost
Opportunity Cost =FO-CO ;( where FO= Return on best foregone option, CO= Return on
chosen option)

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The formula for calculating an opportunity cost is simply the difference between the expected
returns of each option. For example: A person who opens their own business and decides not
to pay himself or herself any wages must realize that there is a "cost" associated with their
labor, they sacrifice a wage that they could have earned in some other use. A worker earns a
wage based on their opportunity cost. An employer must pay a worker a wage that is equal to
or greater than an alternative employer would pay (opportunity cost) or the worker would
have an incentive to change jobs. Capital has a greater mobility than labor. If a capital owner
can earn a higher return in some other use, they will move their resources. The opportunity
cost for any use of land is its next highest valued use as well. It is also crucial to note that the
entrepreneur also has an opportunity cost. If the entrepreneur is not earning a "normal profit"
is some activity they will seek other opportunities. The normal profit is determined by the
market and is considered a cost.
Explicit and Implicit Cost: Explicit costs are normal business costs that appear in the general
ledger and directly affect a company's profitability. Explicit costs have clearly defined
monetary amounts, which flow through to the income statement. Examples of explicit costs
include wages, lease payments, utilities, raw materials, and other direct costs.

Explicit costs also known as accounting costs are easy to identify and link to a company's
business activities to which the expenses are attributed. They are recorded in a company's
general ledger and flow through to the expenses listed on the income statement.Explicit costs
are the only accounting costs that are necessary to calculate a profit, as they have a clear
impact on a company's bottom line. The explicit-cost metric is especially helpful for
companies' long-term strategic planning.

An implicit cost is any cost that has already occurred but not necessarily shown or reported as
a separate expense. It represents an opportunity cost that arises when a company uses internal
resources toward a project without any explicit compensation for the utilization of resources.
This means when a company allocates its resources, it always forgoes the ability to earn
money off the use of the resources elsewhere, so there's no exchange of cash. Put simply, an
implicit cost comes from the use of an asset, rather than renting or buying it.For example, a
company could earn income from renting out its building versus the revenue earned from
using the building for manufacturing and selling its products.
Implicit costs are also referred to as imputed, implied, or notional costs. These costs aren't
easy to quantify. That's because businesses don’t necessarily record implicit costs for
accounting purposes as money does not change hands.It is often the job of economists and
accountants to estimate implicit costs and express them in monetary terms. Capital is used in
the production process and it is "used" up, i.e. its value depreciates. Accountants assume the
expected life of the asset and a path (straight line, sum of year's digits, double declining, etc.)
to calculate a monetary value. In economics both implicit and explicit opportunity costs are
considered in decision making. A "normal profit" is an example of an implicit cost of
engaging in a business activity. An implied wage to an owner-operator is an implicit
opportunity cost that should be included in any economic analysis.
An explicit cost is a total cost that is financially definable. Explicit costs, involve tangible
assets and monetary transactions and result in real business opportunities. Explicit costs are

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easy to identify, record, and audit because of their paper trail. Expenses relating to
advertising, supplies, utilities, inventory, and purchased equipment are examples of explicit
costs. Although the depreciation of an asset is not an activity that can be tangibly traced,
depreciation expense is an explicit cost because it relates to the cost of the underlying asset
owned by the company. Companies use both explicit and implicit costs when calculating a
company's economic profit—defined as the total return a company receives based on all costs
incurred to attain that revenue. Specifically, economic profit is used extensively to determine
whether a business should enter or exit a market or industry.
For example, A firm has spent $x on Y. For instance, employees’ incomes, utility expenses,
and lease are all examples of explicit costs. In comparison, an implicit cost is the cost of
select one option over another. For example, deciding not to work overtime means $x as an
implicit cost as that salary is foregone.

Sunk cost: Expenditure has been made and cannot be recovered. A fixed cost which is also
independent of output, but whose cost is not incurred, because of no cash outlay and no
opportunity cost. Usually fixed costs are considered sunk costs because they happen before
production begins.
Sunk cost, in economics, is a cost that has previously been acquired and that cannot be
reclaimed. In economic decision-making, sunk costs are conducted as bygone and are not
reconsidered when determining whether to remain in an investment project. Sunk costs are
generally excluded from a sale. Costs which are occurred and cannot be recovered are called
sunk costs. For example (Two building choices) a firm has two building choices. For
Building 1, they have paid 500,000, and will pay 5,000,000 in the future; for Building 2, they
have not paid anything, and will pay 5,300,000 in the future. Although Building 2 is cheaper
than Building 1, the firm will choose Building 1 because the 500,000 is sunk.
Another example, supposes expenditure of $10 million on constructing a cloth industry that is
predicted to cost $15 million. The $10 million previously paid, the sunk cost should not be
reconsidered when determining whether the cloth industry should be done. What is fitting is
the matter instead is opportunities of future costs and future returns after the cloth industry is
functioning.
Fixed cost (FC): A fixed cost is a cost that remains same even if the production level
increases or decreases. It may vary in the long run but not because of the level of output, it
can be due to the change in the rate of the payment. So, it indicates that fixed cost does not
change in the short run no matter how much goods a company produces or sells and they
must pay this cost even if the output is zero. Thus, the company cannot neglect its fixed cost.
They can remove these costs only by shutting down their business.

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Some examples of fixed cost are: rents, salaries, insurance payments, utility & electricity
bills, property taxes, interest payments. All these costs are independent from the level of
output a company produces.

From these two graph we can see that, the horizontal

line is the fixed cost which is unaffected by the
production level. And the total fixed cost meets with
the y-axis because, the companies have to pay fixed
cost even when output is zero.

Fixed Cost = Total Cost of Production – (Variable Cost Per Unit * No. of Units Produced)

Suppose, XYZ is a Bakery shop. The total cost of a bakery shop is $70,000; the variable cost
per unit is $0.90 per cookies and the number of cookies made in this month is $50,000

So the Fixed cost of XYZ will be,

Fixed Cost=$70,000-(0.90*$50,000)

= $25,000

Therefore, XYZ bakery shop have to pay $25,000 as a monthly fixed cost and this fixed cost
may include the monthly rent of the shop, electricity bills, telephone bills, salaries of workers.
In the short run, XYZ must pay fixed cost of $25,000 in every month whether their business
is doing well or bad, they can’t avoid these costs.

Variable cost (VC): A variable cost is a cost that changes with the level of output a company
produces or sells. If the level of output increases, the variable cost also increases, and if the
level of output decreases, so does the variable cost. So it means that, variable cost varies in
respect to production level and it doesn’t remain stable like the fixed cost. Depending on the

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output level, variable cost fluctuates and if there is zero output level, then there won’t be any
variable cost.

Some examples of variable costs are: direct materials cost (materials used in the manufacture
of a product), packaging cost, production supplies, freight out cost, direct labor, sales
commission. All these costs vary with the production volume, so they are regarded as a
variable cost.

In this graph, the upward sloping line is the variable cost. From this graph we can see that, as
the production unit is increasing, the variable cost also increasing.

Variable cost = Raw material per unit + Labor cost per unit + Other direct costs per unit

Suppose, XYZ company produces mugs. They want to find out their variable cost and to do
so, they are using the per unit cost of their operations. Raw material per unit of mugs= $20,
Labor cost per unit of mugs = $15, Other direct costs per unit of mugs = $10

Variable cost = $20+ $15+ $10

=$45 per mug

So to produce one mug, XYZ company have to spend of variable cost $45 per mug.

Total cost (TC): A total cost is a cost that is occurred to produce a certain level of output. It
includes both fixed cost and variable cost. So it’s a summation of a fixed and variable cost.
Thus, the total cost considers all the costs that is acquired during producing a given level of
output.

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From this graph, we can easily interpret that Total cost is the sum of both fixed cost and
variable cost.

Total cost = Total Fixed cost + Total Variable cost

= Total fixed cost + (Average Variable Cost Per Unit * Quantity of Units
Produced)

Suppose, ABC Company’s total fixed cost of producing toys is $400,000; average variable
cost per unit is $70, and they produce 20000 units of toys

Fixed cost = $400,000 + ($70* 20,000)

= $1800000

Therefore, $1800000 is the fixed cost of ABC company for producing $20,000 unit of toys.

Marginal cost (MC): Marginal cost means an increase in production cost during producing
extra one unit of output. So it explains additional variable cost or total cost while making one
additional unit. It also explains how much a company have to spend for additional one unit.
Marginal cost helps a company to understand at what point they will be able to gain
economic of scales and optimize the production level. So it helps them to decide whether they
should continue the additional production level or not.

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A company can maximize their profit if marginal cost is equal to marginal revenue which
means, at this point the additional unit that the company produces will be equal to the
earnings they are getting from selling the product.

Suppose, ABC produces 20,000 units of cars, and the cost of manufacturing car is $500,000.
They are thinking to manufacture 30,000 units of car which will cost them $550,000

Marginal cost = ($550,000- $500,000) / (30,000-20,000)

= $5 per cars

Thus, to manufacture one additional car, ABC Company has to spend extra $5.

Average fixed cost (AFC): Average fixed cost is the fixed cost that doesn’t vary regardless
production level increases or decreases. So it is a fixed cost per unit and we calculate average
fixed cost by fixed cost divided by output unit.

Average fixed cost = Fixed cost / Output

Average fixed cost is for short period of time, it doesn’t sustain in the long run. Also, average
fixed cost decreases, when production level increases and average fixed cost increases, when
production level decreases.

For example, if a fixed cost of soap company is $10,000 and it manufactures 200 soaps. Then
the Average fixed cost (AFC)= $10000 / 200 = $50 per soap

Again, if soap company manufactures 500 soaps, then AFC = $10,000/500 = $20 per soap

From the example we can see that as the production rises from 200 soaps to 500 soaps, the
average fixed cost decreases. But the fixed cost $10000 is fixed, regardless the number of
soaps the company produces.

Total variable cost: Total variable cost is a cost that varies with respect to the total output
level of a company in a given period of time. It has a direct relation with a company’s level of
production and based on how much a company can manufacture, these cost increases or
decreases. So, total variable cost depends on the company’s production level and its capacity
to produce output.

Total Variable Cost Formula = (Number of Units Produced * Variable Cost per Unit)

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Suppose, a company manufactures 2000 units of mugs and its variable cost per unit is $10,
then the total variable cost is = (2000* $10) = $20,000. Again, if the company manufactures
1500 units of mugs; then TVC = (1500 * $10) = $15,000

Therefore, with the number of the production level, the total variable cost is also changing. If
production level increases, TVC also increases and when production level decreases, so does
the TVC.

Average Variable Cost (AVC): Average variable cost is a cost that includes all variable
costs while producing the output. In total variable cost, it explains all the variable costs for a
production run and in average variable cost, it helps the company to determine how much all
these variable cost aggregate for each produced output unit. Average variable cost is very
crucial for a company because it helps them to determine the profit of their company,
financial conditions and the ability to run their production in the short run. So, if average
variable cost is less than their goods price (marginal cost), that means they have the ability to
stay in the production. But if their AVC is higher than their goods price (marginal cost), then
company have to shut down the production to eliminate the cost.

For example, the total variable cost of ABC Company is $30,000 and they produced 1500
units. So the AVC would be= $30,000 / 1500 = 20 per unit

Average total cost (ATC): Average total cost is the summation of total variable cost and
total fixed cost and then divided by the total number of output unit. Average total cost is very
important for making pricing strategy. If the price of the goods is exceeding to the average
total cost, then the company will be able to make profit in the long run and vice versa.

Average total cost = (Total fixed costs + Total variable costs) / Number of units produced

Suppose, a company’s fixed cost is $80,000; its variable cost is $40,000 and the company
produced 30,000 units

Average total cost = ($80,000 + $40,000) / 30,000 = $4

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 Output Fixed Variable Total Marginal Average Average Average
Cost Cost Cost Cost Fixed Variable Total
cost Cost Cost
0 100 0 100 0 0 0 0
1 100 80 180 80 100 80 180
2 100 88 188 8 50 44 94
3 100 95 195 7 33.33 31.67 65
4 100 92 192 -3 25 23 48
5 100 96 196 4 20 19.2 39.2
6 100 100 200 4 16.67 16.67 33.34
7 100 105 205 5 14.29 15 29.29
8 100 110 210 5 12.5 13.75 26.25
9 100 112 212 2 11.11 12.44 23.55
10 100 115 215 5 10 11.5 21.5

Relationship between Marginal Cost and Average Total Cost:

1. When Average Variable Cost decreases, Marginal Cost also decreases and Marginal Cost
will be in the below position of Average Variable Cost.
2. When Average Variable Cost is equal to Marginal Cost then it can be considered that
Average Variable Cost is in the lowest position.
3. When Average Variable Cost increases then Marginal Cost also increases and it indicates
that Marginal Cost will be in the above portion of the Average Variable Cost and it also
indicates that this above portion is short run supply curve.

Short Run

The short-run is an economical word that refers to a future time in which one input is
constant while others are changeable. Because there is not enough time to modify all inputs,
some are fixed and others are modified, resulting in input variation. The term "short-run"
does not apply to a specific period; instead, it refers to the form or entity under consideration.
Short run is distinguished from the long-run by both fixed and variable inputs. Because there
is not enough time to modify all inputs, some are fixed while others are modified, resulting in
input variation.

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A business creates an output at which marginal cost equals perfect competition. If the price is
higher than the marginal cost, the business will benefit by increasing matching the price. A
company's variable costs must be covered in the short term. In the short run, a business's
marginal cost curve equals the supply curve of a perfectly competitive firm. A business will
not supply below its minimum average variable cost (SAVC).

The supply curve for the industry is shown in Figure, which corresponds to a business in this
Figure. The SMC curve is the firm's marginal cost curve and its short-run supply curve.
Because prices below OP0 correspond to the dotted region of the SMC, which is below the
minimum point of the SAVC (short-run average variable cost) curve, nothing will be offered
below that price. This industry comprises 100 similar businesses, such as the one seen in
Figure.

Long Run

The long run is defined as the time when the overall price level, contractual wage rates, and
expectations have fully adjusted to the current state of the economy. Firms can modify all
costs in the long run, but they can only impact pricing by adjusting output levels in the near
run. Long-run models may also deviate from short-run equilibrium, in which supply and
demand react more flexibly to price levels. For example, a company may implement change
by raising (or lowering) production size in response to profits (or losses) or industry
consolidation. The long-run is designed to be a long enough period to allow for changes in
the size of the plant and the number of enterprises in the industry. A company will look for
the production technique to deliver the target output level at the lowest cost in the long run. In
the short-run, a business generates the production at which its marginal cost equals the price
in the short term. This is because the price must be equal to both the marginal and average

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costs. The industry will be in equilibrium when all of its businesses are earning expected
profits.

In an increasing cost industry, production rises as current businesses expand or new firms
enter into fulfilling rising demand. External diseconomies outweigh external economies. The
increasing demand for productive resources necessary to generate more considerable output
to meet the rising demand for the product boosts its pricing, resulting in higher production
costs. In a decreasing cost industry, costs fall as production rises, either via current business
expansion or the addition of new enterprises. If any, the economies of scale outweigh the
diseconomies in this scenario. This occurs when a new industry emerges in an area where
productive resources are abundant. The cost curves will be pushed down by net external
economies, resulting in more production supplies at lower prices

The dotted LMC and LAC curves in the increasing cost industry demonstrate that they have
been forced higher, where each business finds a long-run equilibrium where the price OP,
=MC = AC. In Figure, which is related to the industry, at a price OPi, more ON1 is delivered
than at a price OP. This is because greater prices must be paid for limited productive
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resources to entice them away from other purposes and raise output in this industry. The new
curves meet at E1, indicating that the industry's businesses have reached long run
equilibrium.

Economics of Scale

Increased output leads to lower long-run average costs, resulting in economies of scale. It
simply implies that when a company grows in size, it becomes more efficient

Reduce long-run average expenses from P1 to P2 by increasing Q1 to Q2. Economies of scale

are significant because they allow businesses to become more efficient as they grow in size. It
is critical to have a massive corporation in sectors with considerable economies of scale, such
as aviation manufacturing; otherwise, they will be inefficient.

Diseconomies of Scale

Diseconomies of scale occur when long-run average costs rise parallel with growing output.
Firms may seek to solve scale inefficiencies by dividing the company into more controllable
pieces. A substantial multinational, for example, maybe divided into smaller geographic
regions, with local managers being rewarded for maximizing efficiency. If a company's input
costs remain constant, falling returns to scale mean higher long-run average costs and scale
diseconomies. However, if the business achieves buying economies, it is feasible that
increasing factor inputs by 50% will not result in a 50% rise in costs. As a result, falling
returns to scale are feasible but not necessarily diseconomies of scale. Even if we assume a
fixed input price, falling returns will result in scale diseconomies.

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Economies of scale occur up to Q1. After output Q1, long-run average costs start to rise.
Constant returns to scale
When an increase in inputs (capital and labor) leads to an increase in output that is
proportionate to the increase in inputs. We are more likely to have minimum economies or
diseconomies of scale if a corporation has consistent returns to scale. Even with constant
returns to scale, a company might still benefit from economies of scale (lower average costs
with increased output). This is related to bulk purchasing economies, which allow for reduced
average purchase costs (due to bulk purchasing economies) and marketing/financial
economies. When increasing inputs leads to a proportionally lesser rise in output, this is
known as decreasing returns to scale.

Constant returns to scale occur when increasing the number of inputs leads to an equivalent
increase in the output.

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Application of learning curve
 A firm’s average cost of production can decline over time because of makes more
sales due to increasing returns to scale. In the graph below we can observe this
phenomenon as a move from A to B on curve AC1.

A firm’s average cost of production can also decline over time due to the effects of the
learning curve. As seen in the graph below as a move from A on AC1 to C on curve AC2

Learning Curve Example

A computer company’s cost function, which relates its average cost of production AC to its
cumulative output in thousands of computers Q and its plant size in terms of thousands of
computers produced per year q, within the production range of 10,000 to 50,000 computers is
given by
AC = 10 - 0.1Q + 0.3q
a. Is there a learning-curve effect?
Answer:
The learning curve effect is the relationship between the cumulative output vs the inputs
required to produce a level of output. Average cost is measured by the input requirements per
unit of output. We can claim that the learning curve exists if the average cost falls with
increase in cumulative output. In the equation above -0.1Qindicates that for an increase of

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1000 unit in Q there will be a decrease in cost by $0.10. Therefore, we can conclude the
presence of learning curve effect.

b. Are there economies or diseconomies of scale?

Answer:
There are diseconomies of scale. Taking cumulative output, Q, constant, there are
diseconomies of scale if the average cost increases with increase in annual output q. In this
example, average cost increases by $0.30 for each additional 1000 computers produced, so
there are diseconomies of sale.

c. During its existence, the firm has produced a total of 40,000 computers and is producing
10,000 computers this year. Next year it plans to increase production to 12,000 computers.
Will its average cost of production increase or decrease? Explain.
Answer:
The firm has produced a total of 40,000 computers and it is producing 10,000 computers this
year. Next year it plans to increase production to 12,000 computers.
AC1 = 10-0.1Q+0.3q
= 10-0.1*40+0.3*10 = 9.00.
AC2 = 10 – 0.1*50 + 0.3*12 = 8.60
While cumulative output has increased from 40,000 to 50,000. The average cost will decrease
because of the learning effect. Annual output increases from 10 to 12 thousand computers, so
diseconomies of scale are present and also learning effect can be seen.

Cost Minimization
The theory of the firm relies on the assumption that firms choose inputs to theproduction
process that minimize the cost of producing output. If there are two inputs, capital K and
labor L, the production function F(K, L) describes the maximum output that can be produced
for every possible combination of inputs. We assume each factor in the production process
has positive but decreasing marginal products. Therefore, writing the marginal product of
capital and labors MPK(K, L) and MPL(K, L), respectively, it follows that
 Marginal product per dollar spent should be equal for all inputs:

MPL MPK

w r
 Expressed differently

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 w
MRTS KL 
r

Isocost curves describe the combination of inputs to production that cost the same amount to
the firm. Isocost curve C1 is tangent to isoquant q1 at A and shows that output q1 can be
produced at minimum cost with labor input L1 and capital input K1. Other input
combinations— L2, K2 and L3, K3—yield the same output but at higher cost.

Cost Minimization Example

You manage a plant that mass-produces engines by teams of workers using assembly
machines. The technology is summarized by the production function = 5 KL where q is the
number of engines per week, K is the number of assembly machines, and L is the number of
labor teams. Each assembly machine rents for = $10,000 per week, and each team costs w =
$5000per week. Engine costs are given by the cost of laborteams and machines, plus $2000
per engine for raw materials. Your plant has a fixed installation of 5assembly machines as
part of its design.

a. What is the cost function for your plant—namely, how much would it cost to produce
engines? What are average and marginal costs for producing engines? How do average costs
vary with output?
Answer:
The short-run production function is q = 5(5)L = 25L, because K is fixed at 5. Thus, for any
level
q
of output q, the number of labor teams hired will be L = . The total cost function is thus
25
given
By the sum of the costs of capital, labor, and raw materials:

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 q
TC (q) = rK + wL + 200q = (10, 0000) (5) + (5000) * + 2000q
25
TC (q) = 50000 + 2200q

The average cost function is then given by:

TC(q) 50000+2200 q
AC (q) = = q
= = q
And the marginal cost function is given by:

dTC
MC (q) = = dq = 2200.
Marginal costs are constant at $2200 per engine and average costs will decrease as quantity
increases because the average fixed cost of capital decreases.

b. How many teams are required to produce 250engines? What is the average cost per
engine?
Answer:
q
To produce q = 250 engines we need, so L = , so L = 10 labor teams. Average costs are $2400 as
25
shown below:
50000+2200(250)
AC (q = 250) =
250
= 2400.
c. You are asked to make recommendations for the design of a new production facility.
What capital/labor (K/L) ratio should the new plant accommodate if it wants to minimize
the total cost of producing at any level of output q?

We no longer assume that K is fixed at 5. We need to find the combination of K and L that
minimizes cost at any level of output q. The cost-minimization rule is given by

MPk MPl
r
= w

To find the marginal product of capital, observe that increasing K by 1 unit increases q by 5L,
so MPK = 5L. Similarly, observe that increasing L by 1 unit increases q by 5K, so MPL = 5K.
Mathematically,

dq dq
MPK = dK = 5L and MPL = dK = 5K.

Using these formulas in the cost-minimization rule, we obtain:

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 5L 5K K w 5000 1
= r == w => = L == r = = 10000 = 2

The new plant should accommodate a capital to labor ratio of 1 to 2, and this is the same
regardless of the number of units produced.

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