Thai Nguyen University

Thai Nguyen University of Technology

Faculty of International Training

(ECEN 4503)
Engineering Economics
Lecture #8:

The Cost of Production

June 05th 2015
Lecturer: Nguyen Minh Y, Ph.D.

Reviewing

Supply,
demand and
government
policies
- Controls of
price
- Taxes

Market and
welfare
- Consumer,
producer and
the efficiency of
markets
- Taxes
- International
Trading

Department of Electrical Engineering taught in English

Firm behavior
and the
organization
of industry
- Cost of
production

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Introduction
Law of supply
The supply curve slopes upward
Firms are willing to produce and sell a greater quantity of a good

when the price of the good is higher

Firm behavior
Some firms are large, thousands of workers, thousands of

stockholders
Some firms are small, e.g., local candy shop, few workers, and one
owner
What is behind the supply curve?
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1. What are costs?

Example: Carolines Cookie factory
The cost incurred when making the good and service.
To produce cookies
Ingredients: sugar, chocolate, other ingredients
Machine: mixer, ovens
Labor: hiring workers

To sell cookie to customers

Cookie shop

Goals of the firm?

Revenue?
Costs?
Profit?
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1. What are costs?

1.1 Total Revenue, Total Cost, and Profit
Economists normally assume that the goals of a firm are to

maximize profit.
Total revenue the amount a firm receive for the sale of its output.
Total cost the market value of the inputs a firm uses in production.
Profit total revenue minus total cost.

Profit = Total revenue Total cost

How to calculate total revenue, total cost?

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1. What are costs?

1.2 Costs as Opportunity Costs
Explicit cost and implicit cost.
Explicit cost inputs costs that require an outlay of money by the

firm
Example: Carolines cookie shop
$1,000 for buying flour
$10 per worker per hour

Implicit cost input costs that do not require an outlay of money

buy the firm

Example:
If Caroline is skilled at computer, she would $100 per hour working

as programmer
Difference between economists and accountants?
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1. What are costs?

1.3 Costs of Capital as Opportunity Costs
Costs of capital the opportunity cost of the financial capital that

has been invested in the business.

Example: Carolines cookie shop
Caroline used $300,000 of her saving to buy the factory
If the money in the bank account, she get 5% interest rate per year
Opportunity cost is $15,000 per year

Implicit cost or explicit cost?

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1. What are costs?

1.4 Economic Profit versus Accounting Profit
The economists and accountants measure the cost differently, then

the profits are different.

Economic profit the total revenue minus total cost, including both

explicit and implicit cost

Accounting profit the total revenue minus total explicit cost
Example: Carolines cookie shop making decision
Economist profit?
Accounting profit?

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2. Production and Costs

The cost incurred when firms buy inputs to produce the goods and

services that they plan to sell.

Assumption:
The size of factory is fixed
The quantity of goods and services can only changed by changing the

number of workers
Is the assumption realistic?
Short-run?
Long-run?

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2. Production and Costs

2.1 The Production Function
Production function the relationship between the quantities of

inputs used to make a good and the quantity of output of that

good.
Example: Carolines cookie factory
The quantity of cookie produced per hour depends on the number of

workers.
Cost of worker per hour is $10

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2. Production and Costs

2.1 The Production Function
Example: Carolines cookie factory
Number of
worker
0
1
2
3
4
5
6

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Output
(quantity of
cookies)
0
50
90
120
140
150
155

Cost of
factory

Cost of
workers

Total cost of
inputs

$30
30
30
30
30
30
30

$0
10
20
30
40
50
60

$30
40
50
60
70
80
90

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2. Production and Costs

2.1 The Production Function
Example: Carolines cookie factory

The production function gets flatter as the number of workers increases.

The total cost curve gets steeper as the quantity of output increases.
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2. Production and Costs

2.1 The Production Function
Marginal product the increase in output that arises from an

additional unit of input.

The number of worker increases, the marginal product declines,

called diminishing marginal product.

Diminishing marginal product the property whereby the

marginal product of an input declines as the quantity of the input

increases.
Example: Carolines cookie factory
Few workers hired, easy access to the kitchen equipment: mixer,

oven, etc.
More workers hired, the kitchen becomes crowded, need to share the
machines
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2. Production and Costs

2.1 The Production Function
Example: Carolines cookie factory
Number of
worker
0
1
2
3
4
5
6

Output
(quantity of
cookies)
0
50
90
120
140
150
155

Marginal
production
of labor
50
40
30
20
10
5

Cost of
factory

Cost of
workers

Total cost of
inputs

$30
30
30
30
30
30
30

$0
10
20
30
40
50
60

$30
40
50
60
70
80
90

The number of worker increases, the marginal product declines, called

diminishing marginal product
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2. Production and Costs

2.2 From the Production Function to the Total-cost Curve
Total-cost curve the relationship between the quantity of output and the total

cost of production.

The total-cost curve gets steeper as the amount produced rises?

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Diminishing marginal product

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Practice
Ex1. A commercial fisherman notices the following relationship

between hours spent fishing and the quantity of finishing caught:

a)
b)
c)

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What is the marginal product of each hour spent fishing?

Use these data to graph the fishermans production function.
The fisherman has a fixed cost of $10. The opportunity cost of his
time is $5 per hour. Graph the fishermans total cost curve.
Hours

Quantity of fish
(in pound)

0 hour
1
2
3
4
5

0 lb
10
18
24
28
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3. The Various Measures of Cost

Example: Conrads Coffee Shop.

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Quantity
of coffee
0

Total
cost
$3.00

Fixed
cost
$3.00

Variable
cost
$0.00

3.30

3.00

0.30

3.80

3.00

0.80

4.50

3.00

1.50

5.40

3.00

2.40

6.50

3.00

3.50

7.80

3.00

4.80

9.30

3.00

6.30

11.00

3.00

8.00

12.90

3.00

9.90

10

15.00

3.00

12.00

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The slope of the

total cost curve is?

Why the starting

point is here?

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3. The Various Measures of Cost

3.1 Fixed Cost and Variable Cost
Fixed cost costs that do not vary with the quantity of output

produced.
Variable cost costs that vary with the quantity of output produced.
Example: Conrads Coffee Shop
Fixed costs:
Rent
Bookkeeper to pay bills, etc.

Variable costs:
Cost of coffee bean
Milk, sugar, paper cups, worker salary, etc.
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The firms total cost is the sum of fixed costs and variation costs.
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3. The Various Measures of Cost

3.2 Average and Marginal Costs
Conrad has to decide how much to produce
How much does it cost to make the typical cup of coffee?
How much does it cost to increase production of coffee by a cup?

To address the first question:

Average total cost total cost divided by the quantity of output
ATC = TC / Q
Average fixed cost fixed cost divided by the quantity of output.
AFC = FC / Q
Average variable cost variable cost divided by the quantity of
output.
AVC = VC / Q
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3. The Various Measures of Cost

3.2 Average and Marginal Costs
Conrad has to decide how much to produce
How much does it cost to make the typical cup of coffee?
How much does it cost to increase production of coffee by a cup?

To address the second question:

Marginal cost the increase in total cost that arises from an extra
unit production.
MC = TC / Q

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3. The Various Measures of Cost

The costs associated with Conrads decision.

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Quantity
of coffee
0

Total
cost
$3.00

Fixed
cost
$3.00

Variable
cost
$0.00

Average
fixed cost
-

3.30

3.00

0.30

$3.00

$0.30

$3.30

$0.30

3.80

3.00

0.80

1.50

0.40

1.90

0.50

4.50

3.00

1.50

1.00

0.50

1.50

0.70

5.40

3.00

2.40

0.75

0.60

1.35

0.90

6.50

3.00

3.50

0.60

0.70

1.30

1.10

7.80

3.00

4.80

0.50

0.80

1.30

1.30

9.30

3.00

6.30

0.43

0.90

1.33

1.50

11.00

3.00

8.00

0.38

1.00

1.38

1.70

12.90

3.00

9.90

0.33

1.10

1.43

1.90

10

15.00

3.00

12.00

0.30

1.20

1.50

2.10

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Average
Average
variable cost total cost
-

Marginal
cost
-

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3. The Various Measures of Cost

3.3 Cost curve and their shapes
Average total cost, average fixed cost, average variable cost and

marginal cost

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3. The Various Measures of Cost

3.3 Cost curve and their shapes
Property of cost curve
Rising marginal cost
Conrads marginal cost rises with the quantity of output produced.
Caused by diminishing marginal product

U-shaped average total cost

Conrads average total cost curve is U-shaped.
Sum of average fixed cost and average variable cost
When the quantity of output increases
Average

fixed cost?
Average variable cost?
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3. The Various Measures of Cost

3.3 Cost curve and their shapes
Property of cost curve
Efficient scale the quantity of output that minimizes average total

cost.
The marginal cost curve crosses the

average cost curve at its minimum.

When marginal cost is less than
average total cost, average total cost
is falling.
When marginal cost is greater than
average cost, average cost is rising.
Proof.
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Practice
Ex2. Consider the following cost information for a pizzeria:
What is the pizzerias fixed cost?
Construct a table in which you can calculate the marginal cost per

dozen pizzas using the information on total cost. Also, calculate

the marginal cost per dozen pizzas using the information on
variable cost. What is the relationship between these sets of
number?
Quantity
0 dozen pizza
1
2
3
4
5
6

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Total cost
$300
350
390
420
450
490
540

Variable cost
$0
50
90
120
150
190
240

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4. Cost in the Short-run and Long-run

4.1 The relationship between short-run and long-run average
total cost
The division of total costs depends on the time horizon
Fixed cost
Variable cost

Example:
Ford Motor Company: The number and size of the factories
Short term:
Fixed

or variable?
How to change the production?
Long term:
Fixed or variable?
How the long-term average total cost looks like?
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4. Cost in the Short-run and Long-run

Short-run and Long-run total

average costs
The short-run curve lies on or

above the long-run curve because

the firm has flexibility in the longrun.
In long-run, the firm can choose
which short-run curve to use.
In short-run, the firm has to use
the short-run curve it has chosen
in the past.

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4. Cost in the Short-run and Long-run

Economies of scale the property

whereby long-run average total cost

falls as the quantity output increase.
Diseconomies of scale the property

whereby long-run average total cost

rises as the quantity of output increase.
Constant returns to scale the property

whereby long-run average total cost

stays the same as the quantity of output
changes.

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Practice
Ex6. Consider the following table of long-run: Total cost for

three different firms.

Quantity 1

Firm A

$60

$70

$80

$90

$100

$110

$120

Firm B

11

24

39

56

75

96

119

Firm C

21

34

49

66

85

106

129

Does each of these firms experience economies of scale or

diseconomies of scale?

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Conclusion
Total revenue
Total cost
Profit
Cost as opportunity cost
Fixed cost
Variable cost

Average fixed cost

Average variable cost
Average total cost
Marginal cost
Relationship of ATC, MC
Short-run and long-run

Total average cost

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