Cost Of Production

PART I Basic Idea of cost of production Opportunity cost Explicit & Implicit cost Accounting & economic profit D/B Short & Long Run

• It refers to the transformation of inputs or resources into outputs of goods and services. • & Cost exist because resources are scarce, productive & have alternative use

• COP is a cost which a firm have to bear while involved in production process i.e. Cost of raw material, rent, wages etc

• It is observed that peoples normally forgoes all alternative opportunities to use their resources

• Therefore for measuring cost economist always uses the concept of Cost measured in terms of next best alternative forgone

•

To apply the concept of opportunity cost over a particular firm we divide its factors in two Categories

•

Economic (Opportunity) costs include explicit and implicit costs

(Factors/Resources not owned by a Firm) Explicit Cost are the monetary payment (or expenditure) made by a firm for the use of resources owned by others i.e. transportation services, Labor services etc (Factors/Resources owned by a firm) – Opportunity cost of resource firm owns Implicit Cost are the money payments that a self employed resources could have earned in their best alternative use. e.g., owner could earn $15 as teacher, implicitly foregone to run firm.

In Accounting Profits Implicit cost is not included, It can be calculate by Subtracting explicit cost & depreciation form revenue Accounting Profit = Revenue - Explicit Costs Economic profit can be calculated by subtracting Economic (Opportunity) costs include explicit and implicit costs from Revenue Economic Profit = Revenue – Opportunity (Explicit + Implicit) Costs . Economic profit is smaller than accounting profit.

Economic (opportunity) Costs

Profits to an Economist Economic Profit Implicit costs

Explicit Costs

Profits to an Accountant T O T A L R E V E N U E

Accounting Profit

Accounting costs (explicit costs only)

•Suppose you are sales representative for a T-short • fdf manufacturer •Earning 22000$ per year •You decided to open a retail store of your own •You invest 20000$ from savings & made a sacrifice of 1000$ interest • this shop is renting out for 5000$ •You also hire clerk & paying 18000$ annually •A year after you open the store, you total up your Accounts & find the following

Total sales Revenue

120000$

Cost of T-Shirt

40000$

Clerk salary

18000$

Utilities

5000$

Total (explicit) cost

(63000$)

Accounting Profit

57000$

•But this 57000 ignores your implicit cost •22000$ salary you are getting before opening store •1000$ interest you are getting annually •5000$ rent you may get when you rented out your shop annually •And lets take your entrepreneurial talent is worth say 5000$ annually

Accounting Profit Forgone Interest Forgone rent Forgone wages Forgone entrepreneurial income

Total implicit cost Economic Profit

57000 1000 5000 22000 5000 (33000) 24000

• Difference between short & long Run for production point of view

•The period of time in which one (or more) of the resources employed in a production process is fixed or incapable of being varied. •For example, for a production plant of fixed size and capacity, the firm can increase output only by employing more labor, such as by paying workers overtime or by scheduling additional shifts.

Variable Plant •The period of time in which all the resources employed in a production process can be varied. •For e.g: That is, they can change the amount of all inputs used. The firm can alter its plant capacity, it can build a larger plant or revert to a smaller plant

INPUT: A resource or factor of production, such as a raw material, labor

skill, or piece of equipment, that is employed in a production process

PART II

PART II

Short Run Production Relationship

Law of diminishing Returns

Short Run Production Cost

• The period of time in which one (or more) of the resources employed in a production process is fixed or incapable of being varied. • For example, for a production plant of fixed size and capacity, the firm can increase output only by employing more labor, such as by paying workers overtime or by scheduling additional shifts.

It is the total amount of the output produced in physical units, such as, bushels of wheat or a number of sneakers etc. MP of an input is the extra output produced by 1 additional units of that input while other inputs are held constant. Marginal Product = Change in Total Product Change in Labor Input

Also called labor productivity, is the output per unit of labor input. It equals total output divided by total units of input. Average Product = Total Product Unit of Labor

minishing Marginal Produ Diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases. Example: As more and more workers are hired at a firm, each additional worker contributes less and less to production because the firm has a limited amount of equipment.

Law of Diminishing Returns (1) Units of the Variable Resource (Labor)

(2) Total Product

(3) Marginal Product Change in (2) Change in (1)

(4) Average Product (2) / (1)

0

0

___

1

10

10

10.00

2

25

15

12.50

3

45

20

15.00

4

60

15

15.00

5

70

10

14.00

6

75

5

12.50

7

75

0

10.71

8

70

-5

8.75

75

Total Product, TP

Total Product

Quantity of Labor Average Product, AP, and Marginal Product, MP

Increasing Marginal Returns

Diminishing Marginal Returns

Negative Marginal Returns

Average Product Quantity of Labor

Marginal Product

Returns to scale In economics, returns to scale and economies of scale are related terms that describe what happens as the scale of production increases There are 3 types of returns to scale: constant, increasing, and decreasing.

Example If the quantity of all inputs used in the production is increased by a given proportion, •We have Constant returns to scale if output increases in the same proportion; •Increasing returns to scale if output increases by a greater proportion; and •Decreasing returns to scale if output increases by a smaller proportion.

Constant Returns to Scale

6

B 200Q A

3

100Q 3

6

Increasing returns to scale

6

C 300Q

3

A 100Q 3

6

Labor

Decreasing Returns to Scale capital

6

D 150Q

3

A 100Q 3

6

labor

• Short Run Costs are either fixed or Variable

Cost that in total do not vary with changes.

Cost that change with the change in level of output.

TC

Costs (dollars)

TVC Fixed Cost

Total Cost

Variable Cost

TFC

Quantity

Average cost is the total cost divided by the total number of units produced. OR Average cost is the sum of average variable costs plus average fixed costs.

Average cost = Total cost / output

Three types of Avg. Costs: Average Fixed Cost (AVF)

= Total FC Quantity

Average Variable Cost (AVC) = Total VC Quantity Average Total Cost (ATC) ATC = AFC + AVC

= Total Cost Quantity

It is the extra or additional cost of producing one more unit of Output MC = Change in TC Change in Q

HORT RUN SCHEDULE FOR VARIOUS COST

0.94

(b) Marginal- and Average-Cost Curves Costs $3.00 2.50 MC 2.00 1.50

ATC AVC

1.00 0.50

AFC 0

2 4 6 8 10 12 Quantity of Output (bagels per hour)

14

Suppose a baseball pitcher has allowed his opponents an average of 3 runs per game in the first three games. Now, Whether his average falls or rises as a result of pitching a 4th(marginal) game will depend on whether the additional runs he allowed in the extra game are fewer or more than his current (3) run avg. If the 4th game he allows fewer than (3) run, for e.g., 1 run, his total runs will rise from 9 to 10 and his Avg. will fall from (3) to (2.5). Conversely, if in the 4th game he allows more than 3 runs say, (7), his total will increase from (9) to (16) and his avg. will rise from 3 to 4 (=16/4). Reference: Mcconell Page number 425

Cost Curves Relations MC relationship to AVC and AC MC below AVC and AC, AVC and AC will falling MC above AVC and AC, AVC and AC will rising MC equals AVC, AVC at minimum MC equals AC, AC at minimum Shapes of cost curves related to shapes of product curves

Costs (dollars)

Average product and marginal product

AP MP

Quantity of labor

MC

Quantity of output

AVC

PART III

PART III LONG-RUN LONG RUN PRODUCTION COST LONG-RUN COST CURVES ECOMOMIES O& DISECONOMIES OF SCALE

• In long run all factor of production are variable, an industry and the individual firms it comprises can undertake all desired resource adjustments. That is, they can change the amount of all inputs used. The firm can alter its plant capacity, it can build a larger plant or revert to a smaller plant. http://www.pdfcoke.com/doc/6607244/Cost-of-Production

ATC

ATC 4 ATC 1

ATC 2

ATC 3

ATC 5

Output

•

The long run ATC curves shows the lowest average total cost at which any out put level can be produces after the firm has had the time to make all appropriate adjustments in its plant size.

Average total cost

Long run ATC

Out put

•

refer to the property whereby long-run average total cost falls as the quantity of output increases.

•

refer to the property whereby long-run average total cost rises as the quantity of output increases.

•

refers to the property whereby long-run average total cost stays the same as the quantity of output increases

Average total cost

Economies Constant returnsDiseconomies to scale of scale of scale

long-run ATC

Out put

Average total cost

long-run ATC

Out put

Average total cost

long-run ATC

Out put