Lecture 6 – Cost of Production

Given a firm’s production technology, managers have to decide how to produce. As we could
see, inputs can be combined in different ways to yield the same level of output. Therefore,
the important thing is to determine the optimal – cost minimising – combination of
inputs. To do so, we also have to define different categories of costs and the ways to measure
them.

Accounting cost, opportunity cost, and economic cost

Financial accountants are usually concerned with reporting past performance of the firm for
external use – in the firm’s annual reports. As a result, accounting cost includes actual
expenses of the firm and depreciation charges for capital equipment. Economists should
also be concerned with the allocation of scarce resources. Therefore, besides accounting cost,
they have to take into account a so-called opportunity cost. Opportunity cost is associated
with opportunities that are forgone when a firm’s resources are not put to their highest
value use. For example, consider a firm that owns a building and therefore pays no rent for
the office space. Does this mean that the cost of office space is zero? An accountant would say
: yes, but an economist would say that the firm could lease the office space to another
company and earn a rent on it. This forgone rent is the opportunity cost of utilizing the
office space and should be included as a part of economic cost of doing business. So, the
economic cost is a cost of use the economic resources in a firm, including opportunity
cost.

Fixed and variable costs

Some of the firm’s costs vary with output, while others remain unchanged. We therefore
divide total cost (TC) – the total economic cost of production – into two components:
fixed cost (FC) and variable cost (VC). Fixed cost does not vary with the level of output –
it must be paid even if there is no output. It can be eliminated only by going out of
business. It includes expenditures for plant maintenance, insurance, interest payments,
depreciation expenses, and the salaries of top management and key personnel. Variable cost

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varies with output and includes expenditures for wages, salaries, energy, and raw
materials.

Which costs are variable and which are fixed depends on the time horizon. Over a short time
most costs are fixed, because a firm is obliged to pay for contracted raw materials and cannot
easily lay off workers. In the long run many costs become variable as the firm can easily
reduce its workforce, buy less raw materials or even sell off some of its capital.

We begin our analysis with costs in the short run – when there exist both categories of
costs. The data in Table 1 describes a firm with fixed cost of 10. Variable cost increases with
output, as does total cost, which is the sum of fixed cost in column 1 and variable cost in
column 2. Marginal cost is the increase in cost resulting from producing one extra unit of
output. Because fixed cost does not change with output, marginal cost is equal to the
increase in variable or total cost that results from an extra unit of output (MC = ∆VC/∆Q
= ∆TC/∆Q).

Table 1. Short run costs

Average costs
Q FC VC TC MC
AFC AVC ATC
0 10 0 10.0 - - - 0
1 10 8.0 18.0 8.0 10.0 8.0 18.0
2 10 9.4 19.4 1.4 5.0 4.7 9.7
3 10 11.4 21.4 2.0 3.3 3.8 7.1
4 10 15.2 25.2 3.8 2.5 3.8 6.3
5 10 21.5 31.5 6.3 2.0 4.3 6.3
6 10 38.0 48,0 16.5 1.7 6.3 8.0

Marginal cost tells us how much it will cost to expand the firm’s output by one unit. In
Table 1, it is calculated form either the variable cost (column 3) or the total cost (column 4).
For example, the marginal cost of increasing output from 2 to 3 units is 2, because the
variable cost of the firm increases from 9.4 to 11.4.

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Average total cost (ATC) is the firm’s total cost divided by the level of output (TC/Q). It
tells us what is the average cost of production of one unit of output. ATC has two
components. Average fixed cost is the fixed cost divided by the level of output (FC/Q).
Because fixed cost is constant, AFC declines as output increases. Average variable cost is
the variable cost divided by the level of output (VC/Q).

The determinants of short run costs

Table 1 shows that total and variable costs increase with output. The rate at which these costs
increase depends on the nature of the production process, particularly on the extent to which
production involves diminishing returns to variable factors. Recall from previous lecture that
diminishing returns to labour occur when the marginal product of labour decreases. If we
assume that labour is the only variable input, the firm has to increase labour input to increase
output. Then, if the marginal product of labour decreases as the amount of labour
increases (due to diminishing returns), greater expenditures must be made to produce
output at the higher rate. As a result, variable and total cost increase as the rate of
output is increased.

Let’s analyse the relationship between production and cost in more detail. Assume that the
firm hires more labour at the fixed wage w for each worker. Recall that MC is the change in
variable cost for one unit change in output (∆VC/∆Q). But the change in variable cost is the
cost of extra worker (w) times the amount of labour needed to produce the extra output (∆L).
Since ∆VC = w∆L, it follows that:

MC = ∆VC/∆Q = w∆L/∆Q

Recall from previous lecture that marginal product of labour MPL is the change in output
resulting from one unit change in labour input (∆Q/∆L). Therefore, the extra labour needed to
obtain the extra unit of output is ∆L/∆Q = 1/ MPL. As a result:

MC = w/ MPL

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The above equation states that the marginal cost is equal to the price of the input
divided by its marginal product. A low marginal product of labour means that a large
amount of labour is needed to produce more output that in turn leads to a high marginal cost.
Generally, when the marginal product of labour decreases, the marginal cost of
production increases, and vice versa.

The shapes of the cost curves

Figure 1 shows three categories of costs: total, fixed and variable costs. Fixed cost FC does
not vary with output – it is shown as horizontal line at 10. Variable cost VC is zero as
output is zero and then increases continuously as output increases. The total cost curve
TC is determined by vertically adding the FC and VC curves. Because fixed cost is
constant, the vertical distance between the two curves is always 10.

Figure 1. Total, fixed and variable costs

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Figure 2 presents the corresponding set of marginal and average cost curves. Because total
fixed cost is 10, the average fixed cost curve AFC falls from 10 when output is 1, toward
zero for larger output. The shapes of the remaining costs are determined by the relationship
between the marginal and average cost curves. When marginal cost curve lies below
average cost, the average cost curve falls. When marginal cost curve lies above average
cost, the average cost curve rises. When average cost is at a minimum, marginal cost
equals average cost.

The ATC curve shows the average total cost of production. Because average total cost is the
sum of average variable cost and average fixed cost, and the AFC curve declines everywhere,
the vertical distance between the ATC and AVC curves decreases as output increases.
The AVC curve reaches its minimum at a lower output than the ATC curve. This follows
because MC = AVC at its minimum and MC = ATC at its minimum. Because ATC is always

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greater than AVC and the MC curve is rising, the minimum point on the ATC curve must lie
above and to the right of the minimum point of the AVC curve.

Figure 2. Average and marginal costs

Costs in the long run

In the long run, a firm can change all its inputs. We will show how the firm chooses the
combination of inputs that minimizes the cost of producing a given output. We begin by
looking at the cost of hiring factors of production (inputs), which can be presented by the
firm’s isocost lines. An isocost line shows all possible combinations of labour and capital
that can be purchased for a given total cost. Recall that the total cost of any particular
output is given by the sum of the firm’s labour cost (wL) and its capital cost (rC):

TC = wL + rC
where:
w –wage
L – amount of labour

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r- cost of capital
C – amount of capital

Figure 3. Isocost lines

For each different level of total cost, the above equation shows a different isocost line. If
we rearrange the total cost equation as an equation for a straight line, we get:

C = TC/r – (w/r)L

It follows that the isocost line has a slope of – (w/r), which is the ratio of wage to the cost of
capital.

Suppose we wish to produce at output level Q1. How can we do so at minimum cost? Look at
the firm’s production isoquant Q1 in Figure 4. The problem is to choose the point on this
isoquant that minimises total cost. Suppose the firm is going to spend Ic1 on inputs.
Unfortunately, no combination of inputs can be purchased for expenditure Ic1 that will allow
the firm to achieve output Q1. However, output Q1 can be achieved with the expenditure of Ic3.
But Ic3 is not the minimum cost. The same output Q1 can be produced more cheaply, at a cost
of Ic2. In fact, isocost line Ic2 is the lowest isocost line that allows output Q1 to be produced.

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The point of tangency of the isoquant Q1 and the isocost Ic2 shows us the cost minimizing
choice of inputs. At this point, the slopes of the isoquant and isocost line are equal.

Figure 4. Producing a given output at minimum cost.

Recall that in out analysis of production technology, we indicated that the marginal rate of
technical substitution (MRTS) is the slope of the isoquant and is equal to the ratio of marginal
products of labour and capital:

MRTS = ∆K/∆L = MPL/MPC

Above we noted that the isocost line has a slope of ∆K/∆L = w/r. It follows that when a firm
minimizes the cost of producing particular output, the following condition holds:

MPL/MPC = w/r

We can rewrite this condition as follows:

MPL/w = MPC/r

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Why must this condition hold for cost minimization? Suppose that w = 10 and r = 2. Suppose
also that adding a unit of capital will increase output by 20 units, while adding a worker to the
production process will increase output also by 20 units. In that case, the additional output per
zloty spent on capital will be 20/2 = 10, and , the additional output per zloty spent on labour
will equal 20/10 = 2. Because a zloty spent for capital is five times more productive than a
zloty spent for labour, the firm will want to use more capital and less labour. If the firm
reduces labour and increases capital, its marginal product of capital will decline and marginal
product of labour will grow. Eventually, the point will be reached where the production of
an additional unit of output costs the same regardless of which additional input is used.
At that point the firm is minimizing its cost.