SCHOOL OF ECONOMICS

UNIVERSITY OF DAR ER SALAAM

Lecture Note Three -3-

The Production Costs Curves

By

Semboja Haji Hatibu Haji

Unedited Lecture Notes

To Be Presented at the EC377 Production and Industry Economics

Date Wednesday, June 01, 2022

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2.0. Introduction

2.0.1. The Cost Functions

We noted that cost functions can be summarized as follow;

1. The cost function, measures the minimum costs of producing a given

level of output at given factor prices.

2. Cost-minimizing behavior imposes observable restrictions on choices that firms make. In

particular, conditional factor demand functions will be negatively sloped.

3. There is an intimate relationship between the returns to scale exhibited by the technology and
the behavior of the cost function.

 Increasing returns to scale implies decreasing average cost,

 Decreasing returns to scale implies increasing average cost, and
 Constant returns to scale implies constant average cost.

2.0.2. Difficulties in Cost Analysis

 Unforeseen inflation
 Unpredictable changes in technology
 Unpredictable changes in input and output market prices and conditions
 Difference between accounting and economic cost measures
o Economic worth is measured by profit-generating capability
o Economic cost includes opportunity cost, which requires that we not only
understand actions taken, but also understand actions not taken
 Historical cost indicates market conditions at time of purchase, and is used in tax
analysis, while current cost, which reflects current market conditions, is more relevant in
valuation and cost analysis at the managerial level. Current costs can be represented by
replacement cost, which is the cost of replacing the productive capability of the capital
item at current market prices.

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2.0.3. Opportunity Costs

The opportunity cost of an asset (or, more generally, of a choice) is the highest valued
opportunity that must be passed up to allow current use. Thus the monthly opportunity cost of a
Mama Nitile may be, for example, the monthly income she/he could have generated if employed
as secretary for someone else to use.

Explicit costs are expenses for which one must pay with cash or equivalent. Because a cash
transaction is involved, they are relatively easily accounted for in analysis.

Implicit costs do not involve a cash transaction, and so we use the opportunity cost concept to
measure them. This analysis requires detailed knowledge of alternatives that were not selected at
various decision points. Relevant here are the opportunity cost of the firm's assets and cash, and
of the owner's time invested in the firm.

2.0.4. Incremental and Sunk Costs in Decision Analysis

Incremental cost is the change in cost caused by a particular managerial decision. Thus the
increment is at the decision level, and may involve multiple units of change in output or input.
Incremental costs may be involved when considering a product or service modification or a
change in production process.

Sunk costs are those parts of the purchase cost that cannot later be salvaged or modified through
resale or other changes in operations. Image advertising for a new product is a classic example of
a sunk cost, as is an option or investment in assets whose value is specific to a particular
situation. Sunk costs reflect commitment, or irreversibility, and so are not a part of incremental
analysis.

2.0.5. Short-Run and Long-Run Analysis

In microeconomics and managerial economics, the short run is the decision-making period
during which at least one input is considered fixed. The fixed input is commonly considered to
be some aspect of capital, such the production facility, but may also be a normally variable input
that is fixed because of production technology requirements, or a contractual commitment (e.g., a
facility lease) related to production. So when one refers to short-run analysis, the analysis is
focused on a planning period in which some input is fixed and others are variable, and the
manager is selecting levels of variable input and production output to optimize given the
constraint of the fixed input.

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The actual time period that makes up the economic short run depends on how long the fixed
input remains fixed. A grocery shop whose primary fixed input in the short run is their lease on
their facility has a short-run planning horizon equal to the period of time remaining in their lease,
which may be 6 months or 2 years.

A utility such as IPTL faces an economic short run planning period for that plant that may span
20 years or more. At SIDO business incubator, which offers leased commercial workshop
facilities for startups, entrepreneurs typically install use-specific modifications to the space for
their particular needs, and so the lease commitment (and so the short-run planning horizon) may
be 1-3 years or more.

In contrast, the economic long run is a planning horizon that looks beyond current commitments
to a future period in which all inputs can be varied. A typical long-run analytical problem is the
decision of whether to adjust capacity, seek a larger (or smaller) facility, to change product lines,
or to adopt a new technology.

At any given time managers must be concerned with both short-run and long-run analysis. Firms
must be concerned with both the problem of optimizing in the current (short-run) situation as
well positioning the firm for optimizing in the future (long-run).

2.1. The cost curve

This lecture continues investigation properties of the cost function through the use of an
important geometric construction of cost curves. The cost curves can be used to depict
graphically the cost function of a firm and are important managerial decision making tools.

2.1.1. The Cost function

Consider the cost function that gives the minimum cost of producing
output level y when factor prices are (w1, w2). In the rest of this lecture we will take the factor
prices to be fixed so that we can write cost as a function of y alone, c(y).

2.1.2. Fixed costs

By definition, fixed costs do not vary with the volume of goods or services produced as output.
Fixed costs are the costs associated with the fixed inputs that define the economic short run.
Thus fixed costs are only relevant in the economic short run. Even if the firm temporarily shuts
down, it still continues to incur the fixed cost expense. This is typical of capital loans or facility
lease agreements.

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2.1.3. Variable costs

Other costs vary change when output changes due to variation of some factors of production.
These are the variable costs.

2.1.4. The total costs

The total costs of the firm can always be written as the sum of the variable costs, c(y), and the
fixed costs, FC:

2.2. The average costs

The average cost function measures the cost per unit of output. The average variable cost
function measures the variable costs per unit of output, and the average fixed cost function
measures the fixed costs per unit output. By the above equation:

where AVC(y) stands for average variable costs and AFC(V) stands for average fixed costs.
What do these functions look like? The easiest one is certainly the average fixed cost function:
when y = 0 it is infinite, and as y increases the average fixed cost decreases toward zero. This is
depicted in the following Figure 1

Figure 1

Let us examine the variable cost function. Start at a zero level of output and consider producing
one unit. Then the average variable costs at y = 1 is just the variable cost of producing this one
unit. Now increase the level of production to 2 units. We would expect that, at worst, variable
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costs would double, so that average variable costs would remain constant. If we can organize
production in a more efficient way as the scale of output is increased, the average variable costs
might even decrease initially. But eventually we would expect the average variable costs to rise.
Why? If fixed factors are present, they will eventually constrain the production process.

For example, suppose that the fixed costs are due to the rent or mortgage payments on a building
of fixed size. Then as production increases, average variable costs-the per-unit production
costs-may remain constant for a while. But as the capacity of the building is reached, these costs
will rise sharply, producing an average variable cost curve of the form depicted in above Figure
3B1.2.

The average cost curve is the sum of these two curves; thus it will have the U-shape. The initial
decline in average costs is due to the decline in average fixed costs; the eventual increase in
average costs is due to the increase in average variable costs. The combination of these two
effects yields the U-shape depicted in the diagram.

2.3. Marginal Costs

The marginal cost curve measures the change in costs for a given change in output. That is, at
any given level of output y, we can ask how costs will change if we change output by some
amount Δy:

Where we wrote the definition of marginal costs in terms of the variable cost function: This is
equivalent to the first definition, since c(y) = c(y) + F and the fixed costs, F, don't change as y
changes.

Often we think of y as being one unit of output, so that marginal cost indicates the change in
our costs if we consider producing one more discrete unit of output. If we are thinking of the
production of a discrete good, then marginal cost of producing y units of output is just c(y) -c(y -
1). This is often a convenient way to think about marginal cost, but is sometimes misleading.
Remember, marginal cost measures a rate of change: the change in costs divided by a change in
output. If the change in output is a single unit, then marginal cost looks like a simple change in
costs, but it is really a rate of change as we increase the output by one unit.

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How can we put this marginal cost curve on the diagram presented above? First we note the
following. The variable costs are zero when zero units of output are produced, by definition.
Thus the marginal cost for the first small unit of amount equals the average variable cost for a
single unit of output.

Now suppose that we are producing in a range of output where average variable costs are
decreasing. Then it must be that the marginal costs are less than the average variable costs in this
range. For the way that you push an average down is to add in numbers that are less than the
average.

Think about a sequence of numbers representing average costs at different levels of output. If the
average is decreasing, it must be that the cost of each additional unit produced is less than
average up to that point. To make the average go down, you have to be adding additional units
that are less than the average.

Similarly, if we are in a region where average variable costs are rising, then it must be the case
that the marginal costs are greater than the average variable costs-it is the higher marginal costs
that are pushing the average up.

Thus we know that the marginal cost curve must lie below the average variable cost curve to the
left of its minimum point and above it to the right. This implies that the marginal cost curve must
intersect the average variable cost curve at its minimum point.

Exactly the same kind of argument applies for the average cost curve. If average costs are falling,
then marginal costs must be less than the average costs and if average costs are rising the
marginal costs must be larger than the average costs.

To review the important points:

 The average variable cost curve may initially slope down but need not. However, it will
eventually rise, as long as there are fixed factors that constrain production.

 The average cost curve will initially fall due to declining fixed costs but then rise due to
the increasing average variable costs.

 The marginal cost and average variable cost are the same at the first unit of output

 The marginal cost curve passes through the minimum point of both the average variable
cost and the average cost curves.

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It is important to notice that marginal cost crosses the average costs at their minimum point. The
story here is that marginal pulls average down when marginal is less than average, and pulls
average up when marginal is above average. Thus if marginal drops below average, but then
rises faster than average, it must cross the average curves at their minimum points.

Figure . Cost curves. The average cost curve (AC), the average variable cost curve (AVG"),
and the marginal cost curve (MC)

2.4. Examples of Specific Cost Curves

Let's consider the cost function c(y) derived cost curves:

 variable costs:

 faced costs:

 average variable costs:

 average fixed costs:

 average costs:

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 marginal costs:

Figure 3 Cost curves. The cost curves for c(y)=y2+1

2.5. Long-Run Costs

We have so far regarded the firm’s fixed costs being the costs that involve payments to factors of
product that is unable to vary/adjust in the short run. In the long-run a firm can choose the level
of its fixed factors and thus no longer fixed.

In practice, at any particular point in time there may still be quasi-fixed factors. That is, it may be
a feature of the technology that some factors and costs have to be paid to produce any positive
level of output. But in the long run there are no fixed costs, in sense that is always possible to
produce zero units of output at zero costs-, that is it is possible to go out of business.

Of course what constitutes the long run depends on the managerial problem we are analyzing. If
we are considering the fixed factor to be the size of the plant, then the long run will be how long
it would take the firm to change the size of its plant.

We may now proceed to think of the fixed factor as being the plant size and denote it by k; and
that the short-run cost function is denoted as c(y, k).

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For an given level of output there will be some plant size that is the optimal size to produce that
level of output. Let us denote that plant size as k(y). This is the firms conditional factor demand
for the plant size as a function of the output. Then the long run cost function of the firm will be
defined as c(y, k(y

This is the total cost of producing an output level y, given that the firm is allowed to adjust its
plant size optimally. That is the long0run cost of the firm is just the short-run cost function
evaluated at the optimal choice of the fixed factors of production.

An important implication is that the short-run cost to produce output y must be at least as large as
the long-run cost to produce y. That is in the short-run, the firm has a fixed plant size, while in
the long-run the firm is free to adjust its plant size. Since one of its long-run choice is always to
choice the plant size k., its optimal choice to produce y units of output must have cost at least as
small as c(y, k*) This means that the firm must be able to do at least as well by adjusting plant
size by having it fixed.

c( y )  cs ( y, k *)

For all levels of y. In fact, at one particular point level y, namely y*, we know that

At this point y* the optimal choice of plant size is k*, and that the long-run costs and short-run
costs are the same.

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Figure 4

If the short-run cost is always greater than the long-run cost and they are equal at one level of
output, then this means the short-run and the long-run cots have the same property

This implies that the short-run costs curve lies above the long-run cost average cost curve and
they touch as one point y*.

We can repeat the same construction of levels of output other than output y*. Let us assume in
the long-run output may increase with changes of technology. New technologies introduces new
ways of doing business in cost effectiveness. The other short-run cost curves will be low and lie
on the right hand side of the initial short-run cost curves. Based on these series of short-run cost
curves, we are able to pick series of corresponding plant sizes and outputs. Then the long-run
cost curve is the lower envelope of the short-run average cost curves

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Figure 5 Short-Run and Long-Run Average Cost Curves

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2.6. Long-Run Marginal Costs

When there are discrete levels of the fixed factor, the firm will choose the amount of the fixed
factor that minimize average costs. Thus the long-run marginal costs will consists of the various
segments of the short-run marginal costs curves associated with each different level of fixed
factor.

Figure 6 Long-Run Marginal Cost Curves

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2.7. Returns to scale (production) to economies of scale (costs).

Let us briefly discuss issues relating returns to scale (production) to economies of scale (costs).
We saw that the long-run average cost curve (LRAC) as the lower envelope of the set of all
possible short-run average cost (SRAC) curves. These points will now derive the concept of
minimum efficient scale. A key long-run issue addressed here is planning associated with
changes in scale of operation.

We have to understand that returns to scale relates to productivity of inputs. Thus increasing
returns to scale occurs when the output elasticity is greater than 1 -- when, for example, a 10%
increase in input usage results in more than a 10% increase in output. Increasing returns to scale
occur when the economies of specialization outweigh the diseconomies of congestion in a given
production facility.

Decreasing returns to scale occur, on the other hand, when a 10% increase in input usage results
in less than a 10% increase in output. Decreasing returns to scale occur when the diseconomies
of congestion outweigh the economies of specialization.

Increasing returns to scale means that the total product (TP) curve is rising at an increasing rate,
and that marginal product (MP) is rising. Decreasing returns to scale occur when TP is rising at a
decreasing rate (or is actually declining), and MP is declining.

It turns out that there is a linkage between returns to scale on the production side, and economies
of scale on the cost side. Economies of scale occur when average cost (AC) is declining as Y
rises, while diseconomies of scale occur when AC is rising as Y rises.

Take a moment and try to figure out the story for why increasing returns to scale imply
economies of scale, and why decreasing returns to scale imply diseconomies of scale. Hint: Its
easiest to see when marginal factor cost (e.g., hourly labor cost) is fixed, and so marginal cost is
inversely related to marginal product.

To see this duality between production and cost, lets compare the two diagrams below. We can
then see that marginal cost (MC) rises when marginal product (MP) falls, and MC falls when MP
rises:

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Thus when there are economies of scale there is an incentive for firms to grow larger because
increasing Y results in lower unit cost (AC), and thus allows the firm to be more price
competitive with its rivals. That's why we rarely see firms operating when there are returns to
scale in production -- there is an incentive to exploit them and grow larger.

Next, lets examine properties of the long-run average cost curve (LRAC). The LRAC is the
lower envelope of the efficient short-run average cost curves for all different scales of operation
for a firm. The term 'lower envelope' simply means that at any given production level, in the long
run the firm can select the technology appropriate for that production level, and thus placing it on
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the minimum point on the most efficient short-run average cost curve. Thus the LRAC is made
up of the minimum points on all the short-run average cost curves that would be efficient for
various possible output levels.

2.8. Minimum Efficient Scale Firm Size and Plant Size

Minimum efficient scale occurs at the first point where a firm encounters the minimum point on
its long-run average cost curve.

Firm Size and Plant Size

In most consumer products markets there is multi-plant production by a particular firm. For
example, a TBL (brewer) facing relatively high transportation costs may find it advantageous to
have regional breweries (e.g., one in Dar and another in Mwanza). This is an example of a
situation featuring multi-plant economies of scale, meaning that it is more economical to increase
output by increasing the number of production plants than to increase the scale of existing
facilities. In addition to transportation costs, most production facilities will eventually experience
diseconomies of scale -- they just get too big to be efficiently managed. Either way, what
happens is that the average cost curve for a single production plant grows steeply, creating an
incentive to shift output growth to a new facility.

This can be seen easily in the following illustration:

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You can see that average unit cost of production (including distribution costs) is actually lower at
8000 units (per day) when two smaller plants are used than when one big plant is used.

Another problem confronting a multi-plant operation producing the same good or service is to
correctly set output across the multiple plants. The solution to this problem calls for the
application of a microeconomic concept called the equimarginal principle. This principle calls
for each plant to produce at the same marginal cost level, which, if the plants have different cost
structures, will generally call for them to produce at different output levels.

To see this, consider the following example:

If this firm is producing a good for sale in a highly competitive market where price is currently
Tshs 12, for example, then each plant should be operated at an output level at which MR = MC.
Since MR = P in a competitive market, the equimarginal principle would call for each plant to
operate where P = MC = Tshs12. To prove this to yourself, suppose (for simplicity) that each
plant has a fixed cost of 100. Add up the marginal costs to get TVC, add that to TFC = 100 to get
TC. Calculate profit (PxQ) at the indicated output level when price =Tshs 12, and determine
whether it is possible to re-allocate production and raise profit.

Learning Curves

Average costs may decline with cumulative production because of managerial and other learning
effects. Simply speaking, experience with a particular set of suppliers, production process,
facility, workforce, distribution network, and managerial team can result in improvements in
technical efficiency.

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Economies of Scope

Economies of scope refer to a situation in which average costs (unit costs) are lower when two
complementary products are produced by a single enterprise ( the same facility, the same
management team, the same firm or trademark owner, or the same proximate location) than
when they are produced separately. This economy to joint production is fairly common.

Universities are conglomerations of different colleges, each of which produce different forms of
educational experience. In this case the economy to joint production has to do with the concept
of a liberal education, in which students are advantaged by having contact with classes from
outside their major area. Moreover, each college benefits from the umbrella brand of the
university name.

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