Chapter 7 Costs of Production

© Edco 2012. Positive Economics

Chapter 7

Costs of Production


An Overview of Costs

Explicit costs are costs incurred by a firm when it pays an amount of money for something.

Implicit costs, on the other hand, do not involve the paying out of money.

Opportunity cost is the cost of anything in terms of the alternatives foregone (or simply the cost of foregone alternatives).

Fixed costs don’t change as output changes.

Variable costs vary as output changes.


The Short Run Average Cost (SAC) Curve

The SAC slopes downwards because of specialisation/division of labour and greater spread of fixed costs.

The SAC slopes upwards because of the law of diminishing marginal returns.

The minimum point of each SAC curve when joined together gives us the long run average cost curve.


The maxim for all companies in the short run is to cover their variable costs and contribute to the reduction of their fixed costs.

As more and more of a variable factor is added to a fixed factor, at some stage the increase in output caused by the last unit of the variable factor will begin to decline.

Average cost is calculated by dividing total cost by quantity (TC/Q or AFC + AVC).

Average Cost


Average Cost (Continued)Average cost also includes normal profit.

Normal profit is the return that sufficiently rewards the risk-taking of an entrepreneur and it be must earned to stay in business.


The Long Run Average Cost Curve (LRAC)

In the long run, all factors of production (land, labour, capital and enterprise) are variable and the company may use the exact amount of each factor to achieve maximum efficiency.

The long run average cost (LRAC) curve is made up of the minimum point of many SAC curves.

The minimum point of each SAC will give us the quantity that a company can produce at the lowest possible cost.


The LRAC curve is generally shown as saucer-shaped. As the firm grows in size, it experiences cost savings (otherwise called economies of scale). These savings cause the LRAC to slope downwards and average costs decrease. The upward part of the LRAC is due to diseconomies of scale and average costs begin to increase.

What Determines the Shape of the LRAC Curve?


What Determines the Shape of the LRAC Curve? (Continued)

Both economies and diseconomies of scale are present at all levels of output.

When economies are dominant, the curve slopes downwards. When diseconomies are more prevalent, the curve slopes back upwards.

The minimum point shown on the LRAC is referred to as the optimum level of output.


Internal economies of scale are forces within a firm that cause the average/unit cost of that firm to decline as it grows in size. Internal economies of scale include:

Increased use of machinerySpecialisation/division of labourConstruction savingsPurchasing economies

Internal Economies of Scale


Internal Economies of Scale (Continued)

Economies in distributionFinancial economiesMarketing economiesManagement economiesProblem of indivisibility reduced


External economies of scale are forces outside a firm that cause the average/unit cost of that firm to decline as the industry grows in size. External economies of scale include:

Better infrastructure

Specialist firms established

Development of separate research and development units

External Economies of Scale


External Economies of Scale (Continued)

Subsidiary trades may set up

Availability of training courses

Supports from public bodies


Internal diseconomies of scale are forces within a firm that cause the average/unit cost of that firm to increase as it grows in size. Internal diseconomies of scale include:

Poor decision-makingFall in staff moraleCommunication problemsControl problemsIncrease in administrative overheads

Internal Diseconomies of Scale


External diseconomies of scale are forces outside a firm that cause the average/unit cost of that firm to increase as the industry grows in size. External diseconomies of scale include:

Shortages of factors of productionRaw material shortageInfrastructural problems

External Diseconomies of Scale


What Effect Do Returns to Scale Have on Costs?

Increasing returns to scale refers to doubling inputs with output more than doubling. This would cause the LRAC to slope downwards. Decreasing returns to scale refers to doubling inputs with output less than doubling and it would cause the LRAC to slope upwards. Constant returns to scale refers to output changing at exactly the same rate as factors and this results in the LRAC being horizontal.


Why do small firms survive in the Irish market even though they don’t benefit

from economies of scale?

Small size of the market Consumer loyalty Personal services Traditional markets Nature of the good Membership of voluntary groups


Benefits of Small-scale Enterprises

Quick response time

Decision-making

High output per head

Fewer HR problems

Lower overheads


Social Costs and BenefitsSocial cost is a price that society has to

pay for the existence of a particular product or as a result of the production/consumption of a community.

External diseconomies of production occur when a producer carries out an activity and imposes a cost on third parties for which they are not compensated.

External economies of production happen when actions taken by producers result in benefits to third parties for which the producer is not compensated.


Social Costs and Benefits (Continued)

External diseconomies of consumption refer to where an action is taken by a consumer and this imposes a cost on third parties for which they are not compensated.

External economies of consumption refer to when a consumer undertakes an action and it benefits third parties, for which the consumer is not compensated.


Externalities are unintended costs or benefits to third parties.

The private cost of a good or service is the cost to the firm of making the good or providing the service.

Social Costs and Benefits (Continued)


Revenue = P x QAverage revenue (AR) is calculated by dividing

total revenue by quantity (AR = TR/Q = P). Marginal revenue is the change in total

revenue. A company should produce where MC = MR.MC cuts MR from below/MC is increasing at a

faster rate than MR.If a firm is to continue trading in the long run,

AR must be at least equal to AC.

Revenue


Short run Long run

MC = MR MC = MR

MC cuts MR from below MC cuts MR from below

AVC covered AC covered

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Chapter 7 Costs of Production