CHAPTER 6

DPB10013
CHAPTER 6
PRODUCTION COST

SAZALIANA BINTI HJ SHAIRALI

End of this chapter, student should be able to:

Illustrate the short run production cost in
microeconomics

Describe the formula, apply and sketch the curves

Illustrate long-run production cost
Compare economy of scale and diseconomy of scale

Cost of Production

• The expenses incurred by the producer in
producing a particular quantity of output.

• Production costs can be divide into two main
categories:

• Explicit cost
• Implicit cost

Total Economic Cost The sum of cost of all
Explicit costs inputs: fixed and variable
Implicit costs inputs used to produce

goods and services

the value of resources
purchased for production

The value of input
services that are used in
production which are not
purchased in the market

Short run costs

Total Cost Fixed Variable

(TC) Cost (FC) Cost (VC)

Sum of cost of all Cost of input that Cost of input that
inputs: fixed and are independent of change with output
variable inputs
used to produce output
goods and services

TC = FC + VC FC = TC - VC VC = TC - FC

Types of Costs in the Short Run

Total costs Average costs

Quantity FC VC TC AFC AVC AC MC

0 0 20
1 35
2 45
3 50
4 55
5 65
6 85
7 110

Relationship between TC, FC and VC

Cost

FC curve: horizontal and parallel TC
to the X-axis VC

VC curve: start from the origin 0 FC
showing that is zero when there Output
is no production and increases
when output increasing

TC curve: will not start from zero
because fixed cost has been
incurred.

Activity 1

• The diagram shows cost TC
the variable cost curve, 100 VC
fixed cost curve and
total cost of a firm 40 FC
0
• Calculate total cost at Q1 Q2 Output
output 0Q1

• Calculate fixed cost and
variable cost at output
0Q2

Short run Cost

Average Fixed Average Average Cost Marginal Cost
Cost (AFC) Variable Cost (AC) (MC)

Fixed cost (AVC) Change in
per unit total cost
output Variable Total cost that results
cost per per unit of
AFC = unit output from
FC/Q output producing

AVC = AC = another
VC/Q TC/Q unit of
output

MC =
TC/ Q

Cost

MC

AC
AVC

AFC

Output

The Relationship via Graphs Between AC, AVC, AFC and MC

MC, AC, AFV and AFC Curve

AFC curve: has AVC curve: Summary of relationship
negative slope, U-shaped
• MC > AVC ; AVC increase
curve slope • MC < AVC ; AVC decrease
downwards • MC = AVC ; when AVC min
throughout the
Summary of relationship
quantity
• MC > AC ; AC increase
AC curve: U- MC curve: will • MC < AC ; AC decrease
shaped initially fall, • MC = AC ; when AC min
reach a

minimum and
finally increase

again

LONG RUN PRODUCTION COSTS

• In long run, all inputs become variable inputs, and all cost
become variable costs

• Long-Run Average Cost Curves (LRAC)

• The curve that shows the minimum cost or producing any given
output when all the inputs are variable

• Firms plan how to minimize the average cost, the firm will select the
plants which give the lowest average cost at given output levels

• LRAC is derived from a series of SAC curves
• LRAC curve also is often called as firm’s planning curve

Long Run Average Cost

reflects the plant size that allows the
minimum possible short run average costs
to produce each possible level of output.

Only a plant in SAC 4 are used to produce
Q output minimum long run average cost of
production. At this point, curve is tangent to
the minimum point of the SAC curve.

To the left of this point all short run cost
curves are tangent to the LRAC curve on
the left side of their respective minimums.

To the right of point C , tangencies with the
LRAC curve are at the right sides of the
short run curves.

Economy and diseconomy of scale

LRAC

• Economy of scale • Diseconomy of scale

• Benefits and advantages • Problems and disadvantages
of a firm as it grows larger faced by a firm as it grows
larger

Internal External Internal External

Economic of Scale

Internal External

• Labour economies • Economies of government
• Managerial economies action
• Marketing economies
• Technical economies • Economies of
• Financial economies concentration
• Transport and storage
• Economies of information
economies

Diseconomies of Scale

Internal External

• Labour diseconomies • Scarcity of raw materials
• Management problems • Wage differentials
• Technical difficulties • Concentration problems

Activity 2

• The following are costs incurred by a chocolate factory in
the short run. Indicate whether each one is a fixed cost or
variable cost.

• Salary of top management
• Assessment rates on the building
• The cost of electricity for running the machines
• Interest on a loan
• Wages for unskilled workers

Activity 3

TP AVC AC TC AFC MC • Complete in the table

0 500 - above (9M)

1 700 200 • Is the firm operating in
the short run or long
2 800 100 run? Why? (2M)

3 1050 250

4 1450 400 • Determine the fixed

5 1960 510 cost incurred by the
firm. (1M)

Activity 4

• Identify whether each following cost is an explicit or
implicit cost.

• The cost of electricity for running the machines
• Interest saved because the capital is one’s own
• Worker’s salary
• Rent income forgone by the entrepreneur of a company by

operating his own building

• List 2 types of internal economic of scale and 2 external
economic of scale

Activity 5 • Complete the table:

• Define the concepts Qty VC TC AC AFC AVC MC
below: 0 40
1 48
• Cost of production 2 17
• Fixed cost 3 27
• Variable cost 4 78
• Economies of scale 5 50
• Diseconomies of scale
• Identify the fixed cost
(10M) faced by the firm