PB 102 MICROECONOMICS CHAPTER 5 COST OF PRODUCTION

PB 102 MICROECONOMICS 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 �Cost of Production �Total Production (TP) �Fixed cost �Marginal Production (MP) �Variable cost �Average Production (AP) �Total cost (TC) �Law of Diminishing �Average fixed cost (AFC) Returns �Short run �Long run �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 Averag e fixed cost Average variable cost Averag e total cost Marginal cost 0 $3. 00 $0. 00 - - - 1 3. 30 3. 00 0. 30 $3. 00 $0. 30 $3. 30 $0. 30 2 3. 80 3. 00 0. 80 1. 50 0. 40 1. 90 0. 50 3 4. 50 3. 00 1. 50 1. 00 0. 50 1. 50 0. 70 4 5. 40 3. 00 2. 40 0. 75 0. 60 1. 35 0. 90 5 6. 50 3. 00 3. 50 0. 60 0. 70 1. 30 1. 10 6 7. 80 3. 00 4. 80 0. 50 0. 80 1. 30 7 9. 30 3. 00 6. 30 0. 43 0. 90 1. 33 1. 50 8 11. 00 3. 00 8. 00 0. 38 1. 00 1. 38 1. 70 9 12. 90 3. 00 9. 90 0. 33 1. 10 1. 43 1. 90

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

Total Cost Total-cost curve $15. 00 14. 00 13. 00 12. 00 11. 00 10. 00 9. 00 8. 00 7. 00 6. 00 5. 00 4. 00 3. 00 2. 00 1. 00 0 1 2 3 4 5 6 7 8 9 Quantity of coffee (cups per hour) Total Cost 0 1 2 3 4 5 6 7 8 9 10 $3. 00 3. 30 3. 80 4. 50 5. 40 6. 50 7. 80 9. 30 11. 00 12. 90 15. 00 Quantity of Output (cups of coffee per hour) 10

Fixed cost �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 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

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

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

Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs AFC = FC/Q. As FC is constant, FC/Q decreases as Q increases. Therefore, AFC decreases as Q increases $3. 50 3. 25 3. 00 2. 75 2. 50 2. 25 2. 00 1. 75 1. 50 1. 25 1. 00 0. 75 0. 50 AFC 0. 25 0 1 2 3 4 5 6 7 8 9 Quantity of Output (cups of coffee per hour) 10

Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs $3. 50 1. AFC decreases as Q increases, 3. 25 2. AVC increases as Q increases, because of diminishing returns. 3. As ATC = AFC + AVC, ATC is Ushaped: as Q increases, it decreases initially and then begins to increase. 3. 00 2. 75 2. 50 2. 25 2. 00 1. 75 1. 50 ATC 1. 25 AVC 1. 00 0. 75 0. 50 AFC 0. 25 0 1 2 3 4 5 6 7 8 9 Quantity of Output (cups of coffee per hour) 10

Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves. Costs $3. 50 The quantity at which ATC is lowest is called the efficient scale output. 3. 25 3. 00 2. 75 2. 50 2. 25 2. 00 1. 75 ATC 1. 50 1. 25 For Conrad’s Coffee Shop, the efficient scale is 5 or 6 cups of coffee per hour 1. 00 0. 75 0. 50 0. 25 0 1 2 3 4 5 6 7 8 9 Quantity of Output (cups of coffee per hour) 10

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 Averag e fixed cost Average Averag Variable e total cost Marginal cost 0 $3. 00 $0. 00 - - - 1 3. 30 3. 00 0. 30 $3. 00 $0. 30 $3. 30 $0. 30 2 3. 80 3. 00 0. 80 1. 50 0. 40 1. 90 0. 50 3 4. 50 3. 00 1. 50 1. 00 0. 50 1. 50 0. 70 4 5. 40 3. 00 2. 40 0. 75 0. 60 1. 35 0. 90 5 6. 50 3. 00 3. 50 0. 60 0. 70 1. 30 1. 10 6 7. 80 3. 00 4. 80 0. 50 0. 80 1. 30 7 9. 30 3. 00 6. 30 0. 43 0. 90 1. 33 1. 50 8 11. 00 3. 00 8. 00 0. 38 1. 00 1. 38 1. 70 9 12. 90 3. 00 9. 90 0. 33 1. 10 1. 43 1. 90 10 15. 00 3. 00 12. 00 0. 30 1. 20 1. 50 2. 10

Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs $3. 50 3. 25 3. 00 2. 75 2. 50 2. 25 MC 2. 00 Marginal cost rises with the amount of output produced. This reflects the assumption of diminishing marginal product 1. 75 1. 50 1. 25 1. 00 0. 75 0. 50 0. 25 0 1 2 3 4 5 6 7 8 9 Quantity of Output (cups of coffee per hour) 10

Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs $3. 50 3. 25 3. 00 2. 75 2. 50 2. 25 MC 2. 00 1. 75 1. 50 ATC 1. 25 AVC 1. 00 0. 75 0. 50 AFC 0. 25 0 1 2 3 4 5 6 7 8 9 Quantity of Output (cups of coffee per hour) 10

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

Figure 4 Conrad’s Coffee Shop Average-Cost and Marginal-Cost Curves Costs $3. 50 3. 25 3. 00 2. 75 2. 50 2. 25 MC 2. 00 1. 75 ATC 1. 50 1. 25 1. 00 0. 75 0. 50 0. 25 0 1 2 3 4 5 6 7 8 9 Quantity of Output (cups of coffee per hour) 10

Example of Typical Firm

Figure 5 Cost Curves of a Typical Firm Total Cost (a) Total-Cost Curve $18. 00 TC 16. 00 14. 00 12. 00 10. 00 8. 00 6. 00 4. 00 2. 00 0 2 4 6 8 10 12 14

Figure 5 Cost Curves of a Typical Firm Costs (b) Marginal- and Average-Cost Curves $3. 00 2. 50 MC 2. 00 1. 50 ATC AVC 1. 00 0. 50 AFC 0 2 4 6 8 10 12 14 Quantity of Output

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.

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

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.

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

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

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 Capital Land Labor Output Scale A 5 3 4 100 Scale B 10 6 8 300 TC • Assume each unit of capital = RM 5, Land = RM 8 and Labour = RM 22 • Calculate TC and then AC for the two different ‘scales’ (‘sizes’) of production facility • What happens and why? AC

Economies of Scale Capital Land Labor Output TC AC Scale A 5 3 4 100 57 0. 57 Scale B 10 6 8 300 164 0. 54 • 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