Chapter 6

CHAPTER-6
THE COST OF PRODUCTION

MANAGERIAL ECONOMICS (BUS-525)
COURSE CONVENER:
DR. TAMGID AHMED CHOWDHURY
CHAPTER OUTLINE
Measuring Cost: Which Costs Matter?
Cost in the Short Run
Cost in the Long Run
Long-Run versus Short-Run Cost Curves
Production with Two OutputsEconomies of
Scope
Managerial Economics
MEASURING COST: WHICH ONE

MATTERS
Economic Cost versus Accounting Cost
accounting cost: Actual expenses plus
depreciation charges for capital equipment.
economic cost: Cost to a firm of utilizing
economic resources in production, including
opportunity cost.
Opportunity Cost
Cost associated with opportunities that are
forgone when a firms resources are not put to
their best alternative use. It is the next best
alternative:

MATTERS
Sunk cost: Expenditure that has been made
and cannot be recovered. Such as R&D costs.
Because a sunk cost cannot be recovered, it should
not influence the firms decisions.
fixed cost (FC): Cost that does not vary with
the level of output and that can be eliminated
only by shutting down. Such as, machinery cost,
rent, fixed utility bills etc.
variable cost (VC): Cost that varies as output
varies. Example, labor wages, input costs
Total cost (TC): Its the summation of fixed and
variable cost.

MATTERS
marginal cost (MC): Increase in cost resulting

from the production of one extra unit of output.
average total cost (ATC): Firms total cost

divided by its level of output.
average fixed cost (AFC): Fixed cost divided by
the level of output.
average variable cost (AVC): Variable cost
divided by the level of output.
TYPES OF COSTS: A NUMERICAL

EXAMPLE
COST CURVES
MATHEMATICAL EXAMPLE
3. A firm has a fixed production cost of $5,000

and a constant marginal cost of production
of $500 per unit produced.
What is the firms total cost function?
Average cost?
The short-run cost function of a company is given by the

equation TC = 200 + 55q, where TC is the total cost and q
is the total quantity of output, both measured in
thousands.
What is the companys fixed cost?
If the company produced 100,000 units of goods, what
would be its average variable cost?
What would be its marginal cost of production?
What would be its average fixed cost?
Suppose the company borrows money and expands its
factory. Its fixed cost rises by $50,000, but its variable
cost falls to $45,000 per 1000 units. The cost of interest
(i) also enters into the equation. Each 1-point increase in
the interest rate raises costs by $3,000. Write the new
cost equation.
FINDING COST MINIMIZING BUNDLE OF

INPUT
Iso-cost line is similar

to budget line with
equation of:
C = wL + rK
10
SHORT RUN VS LONG RUN

COST
In the short-run one

input or factor of
production (usually
capital) is constant. And
thus in the short run we
cant make choice
between different
combinations of labor
and capital to produce a
specific quantity. When
Labor become costly we
can chose capital and
thus move to point B. In
the long run, thats
possible.
11
INFLEXIBILITY OF SHORT-RUN
Output is initially at
level q1. In the short
run, output q2 can be
produced only by
increasing labor from
L1 to L3 because capital
is fixed at K1. In the
long run, the same
output can be produced
more cheaply by
increasing labor from
L1 to L2 and capital
from K1 to K2.
12
LONG RUN VS SHORT RUN COST

CURVES
The long-run average
cost curve LAC is the
envelope of the shortrun average cost curves
SAC1, SAC2, and SAC3.
With economies and
diseconomies of scale,
the minimum points of
the shortrun average
cost curves do not lie on
the long-run average
cost curve.
13
ECONOMIES OF SCALE
economies of scale Situation in which output
can be doubled for less than a doubling of cost.
diseconomies of scale Situation in which a
doubling of output requires more than a doubling
of cost.
14
LEARNING CURVE
learning curve Graph
relating amount of
inputs needed by a firm
to produce each unit of
output to its cumulative
output.
Firms production cost
may fall over time as
managers and workers
become more
experienced and more
effective at using the
available plant and
equipment.
15
APPLICATION OF LEARNING
CURVE
A firms average cost of
production can decline
over time because of
growth of sales when
increasing returns are
present (a move from A
to B on curve AC1),
or it can decline
because there is a
learning curve (a move
from A on curve AC1 to
C on curve AC2).
16
FEW MATHEMATICAL WORKS

The total cost function of a good is given by
TC = Q2 + 3Q + 36.
Calculate the level of output that minimizes
average cost. Find AC and MC at this value of
Q.
2. A firms short run production function is given
by Q = 30L2 0.5 L3
Find the value of L which maximizes APL and
verify that MPL = APL at this point.
1.
17
ANOTHER EXAMPLE
b.
a.
Suppose that a firms production function is q =

10L1/2K1/2. The cost of a unit of labor is $20 and the
cost of a unit of capital is $80.
The firm is currently producing 100 units of
output and has determined that the costminimizing quantities of labor and capital are 20
and 5, respectively. Graphically illustrate this
using isoquants and isocost lines.
The firm now wants to increase output to 140
units. If capital is fixed in the short run, how
much labor will the firm require? Illustrate this
point graphically and find the firms new total
cost.
18
CONTINUES......
c. Graphically identify the cost-minimizing level of

capital and labor in the long run if the firm
wants to produce 140 units.
d. If the marginal rate of technical substitution is
K/L , find the optimal level of capital and labor
required to produce the 140 units of output.
19

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CHAPTER-6

THE COST OF PRODUCTION

MEASURING COST: WHICH ONE

MEASURING COST: WHICH ONE

MEASURING COST: WHICH ONE

marginal cost (MC): Increase in cost resulting

average total cost (ATC): Firms total cost

TYPES OF COSTS: A NUMERICAL

3. A firm has a fixed production cost of $5,000

The short-run cost function of a company is given by the

FINDING COST MINIMIZING BUNDLE OF

Iso-cost line is similar

SHORT RUN VS LONG RUN

In the short-run one

LONG RUN VS SHORT RUN COST

FEW MATHEMATICAL WORKS

Suppose that a firms production function is q =

c. Graphically identify the cost-minimizing level of

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