COST OF

PRODUCTION
Graphing Cost Curves

Total Cost Curves: The total variable cost curve has the same
shape as the total cost curve—increasing output increases
variable cost

2
The Short Run Cost Function

3
The Short Run Cost Function

 ATC = AFC + AVC

4
Total Cost Curves
TC
$400 VC
350
300
TC = (VC + FC)
Total cost

250
200 L
150
100 O
M
50 FC
0
2 4 6 8 10 20 30
Quantity of earrings

5
Average and Marginal Cost
Curves
 The marginal cost curve goes through the minimum point of
the average total cost curve and average variable cost
curve.
 Each of these curves is U-shaped.
 The average fixed cost curve slopes down continuously.

6
Downward-Sloping Shape of the
Average Fixed Cost Curve
 The average fixed cost curve looks like a child’s slide – it
starts out with a steep decline, then it becomes flatter and
flatter.
 It tells us that as output increases, the same fixed cost can
be spread out over a wider range of output.

7
The U Shape of the Average
and Marginal Cost Curves

 When output is increased in the short-run, it can only be

done by increasing the variable input.

8
The U Shape of the Average
and Marginal Cost Curves
 The law of diminishing marginal productivity sets in as
more and more of a variable input is added to a fixed input.

• Marginal and average productivities fall and

marginal costs rise.

9
The U Shape of the Average
and Marginal Cost Curves
 And when average productivity of the variable input falls,
average variable cost rise.

10
The U Shape of the Average
and Marginal Cost Curves
 The average total cost curve is the vertical summation of
the average fixed cost curve and the average variable cost
curve.

11
The U Shape of the Average
and Marginal Cost Curves
 If the firm increased output enormously, the average
variable cost curve and the average total cost curve would
almost meet.

• The firm’s eye is focused on average total cost

—it wants to keep it low.

12
 Per Unit Output Cost Curves
$30
28
26
24
22
20
18 MC
16
14 ATC
Cost

12 AVC
10
8
6
4 AFC
2
0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30 32
Quantity of earrings
13
The Short Run Cost Function

14
The Short Run Cost Function
 A change in input prices will
shift the cost curves.
 If fixed input costs are
reduced then ATC will shift
downward. AVC and MC will
remain unaffected.

15
 The Short Run Cost Function
 A change in input prices
will shift the cost curves.
 If variable input costs are
reduced then MC, AVC,
and AC will all shift
downward.

16
The Short Run Cost Function

17
A Firm’s Short Run Costs

18
Cost Curves for a Firm
TC
Cost 400
($ per Total cost
year) VC
is the vertical
sum of FC
and VC.
300
Variable cost
increases with
production and
the rate varies with
increasing &
200
decreasing returns.

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output

19
 Costs that are fixed in the short run may not be fixed in
the long run

Typically in the long run, most if not all costs are variable

20
The Short Run Cost Function
 Average total cost (ATC) is the average per-unit cost of
using all of the firm’s inputs (TC/Q)
 Average variable cost (AVC) is the average per-unit cost of
using the firm’s variable inputs (TVC/Q)
 Average fixed cost (AFC) is the average per-unit cost of
using the firm’s fixed inputs (TFC/Q)

21
Per-Unit, or Average, Costs

Average Total cost – firm’s total cost divided by its level of

output (average cost per unit of output)
ATC=AC=TC/Q

Average Fixed cost – fixed cost divided by level of output (fixed

cost per unit of output)
AFC=FC/Q

Average variable cost – variable cost divided by the level of

output.
AVC=VC/Q
22
Marginal Cost
– change (increase) in cost resulting from the production of one
extra unit of output
Denote “∆” - change. For example ∆TC - change in total cost
MC=∆TC/∆Q
Example: when 4 units of output are produced, the cost is 80,
when 5 units are produced, the cost is 90. MC=(90-80)/1=10

MC=∆VC/∆Q

since TC=(FC+VC) and FC does not change with Q

23
Cost Curves

120

100
MC
Cost ($/unit)

80

60
40
20
ATC
0
0 12
AVC
Output (units/yr)

AFC

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Short-Run Cost Functions

Q TFC TVC TC AFC AVC ATC MC

0 $60 $0 $60 - - - -
1 60 20 80 $60 $20 $80 $20
2 60 30 90 30 15 45 10
3 60 45 105 20 15 35 15
4 60 80 140 15 20 35 35
5 60 135 195 12 27 39 55

25
26
The Relationship Between
Productivity and Costs
 The shapes of the cost curves are mirror-image reflections
of the shapes of the corresponding productivity curves.

27
The Relationship Between
Productivity and Costs
 When one is increasing, the other is decreasing.

• When one is at a maximum, the other is at a

minimum.

28
The Relationship Between Productivity and Costs

Productivity of workers at this output

$18 9
16 MC 8
14 7
Costs per unit

12 AVC 6 A
10 5
8 4 AP of
6 3 workers
4 2
2 1 MP of workers
0 4 8 12 16 20 24 Output 0 4 8 12 16 20 24 Output

29
Relationship Between
Marginal and Average Costs
 The marginal cost and average cost curves are related.
 When marginal cost exceeds average cost, average cost must
be rising.
 When marginal cost is less than average cost, average cost
must be falling.

30
Relationship Between
Marginal and Average Costs

 Marginal cost curves always intersect average cost curves

at the minimum of the average cost curve.

31
Relationship Between
Marginal and Average Costs
 The position of the marginal cost relative to average total
cost tells us whether average total cost is rising or falling.

32
Relationship Between
Marginal and Average Costs
 To summarize:

If MC > ATC, then ATC is rising.

If MC = ATC, then ATC is at its low point.
If MC < ATC, then ATC is falling.

33
Relationship Between
Marginal and Average Costs
 Marginal and average total cost reflect a general
relationship that also holds for marginal cost and average
variable cost.
If MC > AVC, then AVC is rising.
If MC = AVC, then AVC is at its low point.
If MC < AVC, then AVC is falling.

34
Relationship Between
Marginal and Average Costs
 As long as average variable cost does not rise by more than
average fixed cost falls, average total cost will fall when
marginal cost is above average variable cost,

35
Relationship Between Marginal and Average Costs

$90
ATC MC
80
70 Area A Area C
60 AVC Area B
Costs per unit

50 ATC
40 AVC
30 B
20
MC A
10 Q0 Q1
0
1 2 3 4 5 6 7 8 9 Quantity
36
Long-Run Cost Curves

Long-Run Total Cost = LTC = f(Q)

Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q

37
 Relationship Between Long-Run and Short-Run Average Cost Curves

38
The LR Relationship Between Production and Cost
 In the long run, all inputs are variable.
 What makes up LRAC?

39
The Long-Run Cost Function

 LRAC is made up for SRACs

 SRAC curves
represent various
plant sizes
 Once a plant size is
chosen, per-unit
production costs are
found by moving
along that particular
SRAC curve

40
The Long-Run Cost Function

 The LRAC is the lower envelope of all of the SRAC curves.

 Minimum efficient scale is the lowest output level for which
LRAC is minimized

Is LRAC a function of market size?

What are implications?

41
The Long-Run Cost Function
 Reasons for Economies of Scale…
 Increasing returns to scale
 Specialization in the use of labor and capital
 Economies in maintaining inventory
 Discounts from bulk purchases
 Lower cost of raising capital funds
 Spreading promotional and R&D costs
 Management efficiencies

42
The Long-Run Cost Function

 Reasons for Diseconomies of Scale…

 Decreasing returns to scale

 Input market imperfections
 Management coordination and control
problems

43