Chapter 6

Cost of Production

Cost of Production Definition

• Production refers to the transformation of inputs into outputs (or products).

• In production, there are direct costs and indirect costs: • Direct costs are those that are traceable to the creation

of a product and include costs for materials and labor.• Indirect costs refer to those costs that cannot be traced

to the product such as overhead.• For example, direct costs for manufacturing an

automobile are raw material (plastic, metal) or labor incurred to produce such an item. Indirect costs include overhead such as rent, salaries or utility expense.

Economic Cost vs Accounting Cost

• Accounting costs are actual costs, also known as explicit costs, are costs that involve money being spent such as rent, utility bills, interest payments.

• The economic cost of a decision depends on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost differs from accounting cost because it includes opportunity cost.

What you should remember!

• Explicit Costs = easily identified and accounted for cash outflows

• Implicit Costs = opportunity cost of forgoing an alternative, hard to measure

• Accounting Profit = TR – Explicit costs• Economic Profit = TR – Explicit - Implicit costs

= TR - Opportunity Cost

Example of Economic Profit and accounting profit

• Suppose a farmer spends 3 days working 8 hours a day farming his land to produce corn that he can sell for $100. and let’s suppose the cost to produce the corn is $40.

• Accounting Profit= Total Revenue – Explicit Cost• Accounting Profit= 100 – 40 = $60• (The accountant tells the farmer that he made $60 and the farmer is happy!!!)• (Here comes the economics who tells the farmer that he forgot to include his opportunity cost!!!)

• Suppose the farmer could work at the local McDonald at $5 per hour, so for every hour he spent farming he sacrifices $5 an hour working elsewhere.

• Implicit cost = 3 days * 8 hr * $5 = $120• Economic Profit= Total Revenue – Explicit cost – Implicit cost• Economic Profit= 100 – 40 – 120 = $-60• From an economic stand point, the farmer is better off working at the

local McDonald!!!

Opportunity Cost• Opportunity cost is the cost associated with

opportunities that are forgone by not putting the firm's resources to their best alternative use.

• Example: consider a firm that owns a building and therefore pays no rent for office space. Does this mean that the cost of office space is zero?

• While the firm's accountant might say yes, an economist would note that the firm could have earned rent on the office space by leasing it to another company. This forgone rent is the opportunity cost of utilizing the office space and should be included as part of the economic cost of doing business.

Question?

• A good definition for opportunity cost is:

a. The cost of resources that are forgone when a decision made.b. How much it cost to purchase raw suppliesc. The cost of goods soldd. The cost of wages

Answer

• The correct answer is A • The opportunity cost is defined as the cost of

explicit and implicit resources that are forgone when a decision is made.

Sunk Costs

• Money already spent and permanently lost. Sunk costs are costs that are already incurred and cannot be recovered regardless of future events.

• Example of a Sunk cost is insurance on machines of a factory, this insurance cost paid for those machines cannot be recovered.

• Cost of R&D of a pharmaceutical company.• Cost of marketing.

Fixed Cost and Variable cost

• Fixed cost (FC): A cost that does not vary with the level of output and that can be eliminated only by going out of business.

• Fixed cost does not vary with the level of output-it must be paid even if there is no output the only 'way that a firm can eliminate its fixed costs is

by shutting down. • Variable cost (VC): A cost that varies as output

varies.

Marginal Cost and Average Total Cost

• Marginal Cost (MC) sometimes called incremental cost-is the increase in cost that results from producing one extra unit of output. Because fixed cost does not change as the firm's level of output changes, marginal cost is equal to the increase in variable cost or the increase in total cost that results from an extra unit of output. We can write marginal cost as:

• MC = TC/q or MC = VC/q (for short term cost)

• Average Total Cost (ATC) or unit cost is equal to Total Cost (TC) divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of Average Variable Costs (AVC) (Total Variable Costs (TVC) divided by Q) plus Average Fixed Costs (AFC) (Total Fixed Costs (TFC) divided by Q).

• ATC = TC / Q or ATC = AFC + AVC• AVC = TVC / Q or AFC = TFC / Q• TC = TFC + TVC

Problem 1Output Fixed cost Variable

costTotal cost Marginal

costAverage

Fixed costAverage

Variable costAverage

Total Cost

0 50 0

1 50 50

2 50 78

3 50 98

4 50 112

5 50 130

6 50 150

7 50 175

8 50 204

9 50 242

10 50 300

11 50 385

Solution to Problem1

Problem 2• ABC company has a Fixed Cost of $16 and a

Variable cost as follows:

Calculate the TVC, AFC, TC, MC, and ATC?

Quantity Average Variable Cost

1 1

2 2

3 3

4 4

5 5

6 6

Solution to Problem 2Quantity AVC TFC TVC TC MC ATC AFC

1 1 16 1 17 1 17 16

2 2 16 4 20 3 10 8

3 3 16 9 25 5 8.3 5.3

4 4 16 16 32 7 8 4

5 5 16 25 41 9 8.2 3.2

6 6 16 36 52 11 8.7 2.7

Short-run vs. Long-run Cost of Production

• Short run is a period of time over which at least one factor must remain fixed. For most of the firms, the fixed resource or factors which cannot be increased to meet the rising demand of the good is capital i.e., plant and machinery.

• Short run, then, is a period of time over which output can be changed by adjusting the quantities of resources such as labor, raw material, fuel but the size or scale of the firm remains fixed.

• In the long run there is no fixed resource. All the factors of production are variable. The length of the long run differs from industry to industry depending upon the nature of production.

Problem 3• Which column provide long-run TC and short-run TC and why?• Calculate the TFC, TVC, AFC, AVC, and MC for the short run TC.• Calculate the long-run average total cost?

Quantity TC1 TC2

0 0 350

1 300 400

2 400 435

3 465 465

4 495 505

5 540 560

6 600 635

7 700 735

Solution to Problem 3Quantity TC1 TC2 TFC1 TVC1 AFC1 AVC1 MC1 LRATC

0 0 350 350 0 - - - -

1 300 400 350 50 350 50 50 300

2 400 435 350 85 175 42.5 35 200

3 465 465 350 115 117 38 30 155

4 495 505 350 155 87.5 38.75 40 123.75

5 540 560 350 210 70 42 55 108

6 600 635 350 285 58 47.5 75 100

7 700 735 350 385 50 55 100 100

Multiple Choice Questions• 1) A young boy decided to sell lemonade. He made $45.00 in revenue. He spent $12.00 on

supplies and he could have made $27.00 mowing lawns. What is his accounting profit?a. $18b. $33c. $45d. $39

2) Using the same numbers as above does the little boy have:a. Economic lossb. Zero economic profitc. Economic profit

3) A man owns a small building in down town Indianapolis that he runs a coffee shop out of. At the end of the year he realizes costs of $20,000, revenues of $80,000. His accounting profit is $60,000. What is an implicit cost for this man?a. Money earned from renting the building.b. The costs of $20,000.c. Cost of wages paid to employees.d. Cost of maintenance on the building.

Answers

1. The answer is b. Accounting profit only considers revenue and explicit costs. In this case it would be $45-$12=$33.

2. The answer is c. The little boy has economic profit. Taking into consideration all costs including opportunity costs the answer looks like this: $45-$12-$27=$6 of economic profit.

3. The answer is a. Implicit costs are the cost of giving up the next best alternative. Instead of running a coffee shop the man could have rented the building.