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Cost of Production & Cost Curves

Cost of Production & Cost Curves. Mohammad S. A. Khan Mamun, PhD Department of Economics. Concepts of cost of production . Accounting cost & Economic cost Opportunity cost Total cost Average cost Marginal cost. Accounting cost Vs. Economic cost.

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Cost of Production & Cost Curves

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  1. Cost of Production & Cost Curves Mohammad S. A. Khan Mamun, PhD Department of Economics

  2. Concepts of cost of production • Accounting cost & Economic cost • Opportunity cost • Total cost • Average cost • Marginal cost IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  3. Accounting cost Vs. Economic cost • A account calculate cost of production taking into account all cash payment made by the firm to ensure production process. Examples: wage + interest+ payment for input etc. • But an economist calculate cost of production taking into account many implicit cost going beyond accounting cost. Implicit costs are alternative use of investment and labour. So, Economic cost = accounting cost + implicit cost. IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  4. What is opportunity cost? • The opportunity cost of any good is the next best alternative that is given up. Say, a deploying all resources can produce 100 gram cheese or 500 gram wool. AB is production possibility curve. Here 100 gram cheese = 500 gram cheese. Unit Wool A D B C Unit O Cheese So, the opportunity cost of producing OD amount of Wool is CB amount of Cheese, an amount that is given up. IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  5. Why we study opportunity cost? • Reason is, as a producer we also look for the best use of scare resources. A producer faces multiple choices of production possibilities. Out of all possibilities, a producer try to ensure efficient use of resources. Opportunity cost analysis helps a producer to come to a conclusion. IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  6. Total costs • Total cost is divided into two concepts: • Fixed costs – costs that do not vary with the level of output. Fixed costs are the same at all levels of output (even when output equals zero). • Variable costs – costs that vary with the level of output (= 0 when output is zero) IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  7. Example IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  8. Example (cont.) IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  9. Fixed costs IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  10. Variable costs IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  11. TC, TVC, and TFC IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  12. Average fixed cost • Average fixed cost (AFC) = TFC / Q IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  13. Average variable cost • Average variable cost (AVC) = TVC / Q IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  14. Average total cost • Average total cost (ATC) = TC / Q • ATC = AFC + AVC (since TFC + TVC = TC) IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  15. Marginal cost • Marginal cost (MC) = cost of an additional unit of output. Definition of Marginal Cost is the additional cost incurred in producing one extra unit of output. IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  16. IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  17. ATC IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  18. Relationship continue.. • When MC is less than AC, AC falls • When MC is greater than AC, AC rises. • That is MC, decide the position of a AC. • The MC curve lies above the AC curve, the AC is rising. At the point of intersection L where MC is equal to AC, AC is neither falling nor rising, that is, at point L, AC is just ceased to fall but has not yet begun to rise. At point L, where the MC curve crosses the AC curve to lie above the AC curve, is the minimum point on the AC curve. IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  19. The Link between Production and Cost • For each level of output, firms must choose the least costly combination of inputs. A profit –oriented firm will always strive to choose the bundle of inputs that produces output at lowest cost. • Say a firm’s engineers have calculated that the desired output level of nine (9) units could be produced with two possible options. In both cases, price of fuel costs Tk 2.00 and labour Tk. 5.00 per unit. OPTION 1 requires fuel 10 units and labour 2 units. OPTION 2 requires fuel 4 units and labour 5 units. Which option is preferred ? IUBAT-Int'l Uni. of Buss. Agric. & Tech.

  20. Economies and diseconomies of scale • Economies of scale – factors that lower average cost as the size of the firm rises in the long run • Sources: specialization and division of labor, indivisibilities of capital, etc. • Diseconomies of scale – factors that raise average cost as the size of the firm rises in the long run • Sources: increased cost of managing and coordination as firm size rises • Constant returns to scale – average costs do not change as firm size changes IUBAT-Int'l Uni. of Buss. Agric. & Tech.

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