COST OF PRODUCTION

MICROECONOMICS
SUBMITTED TO: Miss FOUZIA AWAN SUBMITTED BY: BILAL AHMAD 12002001006, SAJID NADEEM 12002001004, MEHMAN ALI 12002001005 BS.AM

1/14/2013

COST OF PRODUCTION 2013

Table of Contents
Cost of Production ........................................................................................................................................ 2 Total Cost .................................................................................................................................................. 2 Total Revenue ........................................................................................................................................... 2 Profit ......................................................................................................................................................... 2 Opportunity Cost ....................................................................................................................................... 2 Explicit Costs ................................................................................................................................................ 3 Implicit Costs ................................................................................................................................................ 3 Economic Profit vs. Accounting Profit ......................................................................................................... 4 Economic Profit ............................................................................................................................................ 5 The Production Function............................................................................................................................... 5 Law of Diminishing marginal product .......................................................................................................... 6 Comparison of Total Cost Curve and Production Function .......................................................................... 7 Various Measures of Cost ............................................................................................................................. 7 Fixed Cost ................................................................................................................................................. 8 Variable Cost ............................................................................................................................................ 8 Total Cost .................................................................................................................................................. 8 Average Total Cost ................................................................................................................................... 8 Average Fixed Cost................................................................................................................................... 8 Average Variable Cost .............................................................................................................................. 8 Marginal Cost............................................................................................................................................ 8 Shapes of Cost Curves .................................................................................................................................. 9 Relationship between ATC and MC ........................................................................................................... 10 Relationship between ATC, AFC, and AVC. ............................................................................................. 10

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Cost of Production
In economics, the cost-of-production is the price of a good which is determined by the sum of the cost of the resources that went into making it. The cost can compose any of the factors of production (including labor, entrepreneur, capital, or land) and taxation.

Total Cost
Cost is the market value of inputs that a company uses in production of certain good.

Total Revenue
The amount a firm receives for the sale of its output.

Profit
Total revenue Total cost

Opportunity Cost
The value of most appealing alternative that is not chosen is called opportunity cost. It is the cost of something is what you give up to get it i.e. the cost of an item refers to all those things that must be forgone to acquire that item. Example Opportunity cost is the value of something you give up to obtain another thing. It can also be thought of as "the next best thing". Opportunity cost is not monetary but can be applied when money is involved. An example of opportunity cost would be if you have two choices: to work all day and make some money or to take the day off and go to a movie that you have been waiting to see for a long time. If you choose the movie, the opportunity cost is the money that you could've made working all day. If you choose the work, the opportunity cost is the joy you would receive from seeing the movie.i

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Opportunity cost = Explicit cost + Implicit cost The opportunity cost of a decision is based on what must be given up (the next best alternative) as a result of the decision. What must be given up can be either explicit cost or implicit cost. It is ii this combination of implicit and explicit costs that when combined; make up the total opportunity cost.iii

Explicit Costs
Input cost that requires an outlay of money by the firm is called explicit cost. Explicit costs are payments to non-owners of a firm for their resources. Explicit costs represent obvious cash outflows from businesses that reduce its bottom-line profitability. Some of the resources the firm needs must be purchased or hired from outside the firm and thus must be obtained on payment. Such resources include electricity, fuel, raw materials, labor, insurance, etc.; these are items for which payments are made.

Real Life Explicit Cost Example

Suppose you and five friends - six entrepreneurs - get together and open up a computer software firm that produces specialized computer software. Some of the payments that must be made for the production of the software are termed explicit costs. For example, these explicit costs might include computer hardware, utilities, supplies, property and other taxes, maintenance costs, payments to wholesalers for the materials needed to produce the software, and the salaries of office support staff.

Implicit Costs
An implicit cost is a cost that is represented by lost opportunity in the use of a company's own resources, excluding cash. Since these resources are not obtained by direct monetary payments (as were the resources for which explicit costs were paid), these costs are termed implicit costs. For example, the time and effort that an owner puts into the maintenance of the company rather than working on expansion is an implicit cost.

Real Life Implicit Cost Example

In the example above, if the entrepreneurs that started the computer software firm own the small building outright within which they operate, use their own funds (in equal amounts =$50,000 each) to finance the startup of the computer firm, and each put in 60 hours a week into the software business, then the implicit cost of such resources would include the lease payment or rent they would otherwise receive for the use of the building, the interest or dividends their
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money could earn if invested elsewhere, and the salaries they could earn if they were employed in another business.

Economic Profit vs. Accounting Profit Understanding Accounting Profit

An accounting profit is the excess of business income over the business expenses. The business earns money after selling their goods or services. If the money they earn is more than the money they spend for making/providing the goods/services, it is said that the business has made an accounting profit. So once all these costs are reduced from the total income earned by a business enterprise, if the remaining amount is positive, it is an accounting profit. If the remaining amount is negative, it is known as an accounting loss, which means that the business has spent beyond its earning capacity in the accounting period. Thus we can say that an accounting profit is the excess of accounting income over accounting expenses. Accounting Profit = Total Income - Total Expensesiv

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Economic Profit
Total revenue minus total cost including implicit and explicit costs is called economic profit. It is the difference between the revenue received from the sale of an output and the opportunity cost of the inputs used. Economic Profit = Total Income - Total Expenses - Opportunity Lost Cost Economic profit is always less than the accounting profit.

The Production Function

It is the relationship between quantity of input used to make good and the quantity of output. The production function describes the maximum output that can be produced from any combination of inputs available in a given time period.

Table shows an example of the quantity of cookies Helens factory produces per hour depends on the number of workers. No. workers/ quantity 0 1 2 3 4 5 6 of Output Marginal quantity of product cookies produced/hour 0 $50 50 40 90 30 120 20 140 150 5 155 30 60 90 10 30 30 40 50 70 80 30 30 60 30 20 50 30 10 40 Fixed cost/ Variable cost/ Total cost of cost of factory cost of inputs= workers F.C+V.C $30 $0 $30

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Production function and T.C curve is shown in graphs.

Law of Diminishing marginal product

The property where the marginal product of an input declines as the quantity of the input increases is called law of diminishing marginal product. The law of diminishing returns states that as one type of production input is added, with all other types of input remaining the same, at some point production will increase at a diminishing rate. There may be levels of input where increasing inputs causes production to go up at an increasing rate. However, according to the law of diminishing returns, at some point production will go up at a decreasing rate.

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Comparison of Total Cost Curve and Production Function
The total cost curve gets steeper as the amount produces rises, whereas the production function gets flatter as the production increases. This is due to the law of diminishing marginal product as the production increases the production area become more crowded due to increase in workers. Thus each additional worker adds less to the production. Therefore production function is relatively flat. When the production area is crowded then producing an additional unit requires a lot of additional workers and thus very costly. Therefore when the quantity produce is large, the total cost curve is relatively steep.

Various Measures of Cost

There are various types of costs which is described below with the help of table.

Marginal cost Average Average Average Fixed Variable Total Change in Quantity fixed variable total cost= cost cost cost=F.C+V.C total cost=FC/Q cost=VC/Q AFC+AVC cost/change in quantity 0 1 2 3 4 5 6 7 8 9 10 $3 3 3 3 3 3 3 3 3 3 3 $0.0 0.3 0.8 1.5 2.4 3.5 4.8 6.3 8.0 9.9 12 $3 3.3 3.8 4.5 5.4 6.5 7.8 9.3 11.0 12.9 15.0 --$3.0 1.5 1.0 0.75 0.6 0.5 0.43 0.38 0.33 0.30 --$0.30 0.40 0.50 0.6 0.7 0.8 0.9 1.0 1.10 1.20 --$3.3 1.9 1.5 1.35 1.30 1.30 1.33 1.38 1.43 1.50

$0.3 0.5 0.7 0.9 1.1 1.3 1.5 1.7 1.9 2.1

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Fixed Cost
Costs that do not vary with the quantity of output produced. In economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month.v

Variable Cost
Costs that do vary with the quantity of output produced. Variable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs. For example, a firm pays for raw materials. When activity is decreased, less raw material is used, and so the spending for raw materials falls. When activity is increased, more raw materials is used and spending therefore rises. Note that the changes in expenses happen with little or no need for managerial intervention. These costs are variable costs.vi

Total Cost
F.C+V.C

Average Total Cost

Total cost divided by the quantity of output. In economics, average cost or unit cost is equal to total cost divided by the number of goods produced (the output quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus average fixed costs (total fixed costs divided by Q).vii

Average Fixed Cost

Fixed cost divided by the quantity of output.

Average Variable Cost

Variable cost divided by the quantity of output.

Marginal Cost
The increase in total cost that arises from an extra unit of production. The increase or decrease in the total cost of a production run for making one additional unit of an item. It is computed in situations where the breakeven point has been reached: the fixed costs have already been absorbed by the already produced items and only the direct (variable) costs have to be accounted for. Marginal costs are variable costs consisting of labor and material costs, plus an estimated portion of fixed costs (such as administration overheads and selling expenses). In companies where average costs are fairly constant, marginal cost is usually equal to average cost. However, in industries that require heavy capital investment (automobile plants, airlines, mines) and have high average costs, it is comparatively very low. The concept of marginal cost is critically important in resource allocation because, for optimum results, management must concentrate its resources where the excess of marginal revenue over the marginal cost is maximum. Also called choice cost, differential cost, or incremental cost.viii
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Shapes of Cost Curves Cost Curves

The short-run marginal cost (MC) curve will at first decline and then will go up at some point, and will intersect the average total cost and average variable cost curves at their minimum points.

The average variable cost (AVC)

The average variable cost (AVC) curve will go down (but will not be as steep as the marginal cost), and then go up. This will not go up as fast as the marginal cost curve.

The average fixed cost (AFC)

The average fixed cost (AFC) curve will decline as additional units are produced, and continue to decline.

The average total cost (ATC)

The average total cost (ATC) curve initially will decline as fixed costs are spread over a larger number of units, but will go up as marginal costs increase due to the law of diminishing returns. The graph below illustrates the shapes of these curves.ix

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Relationship between ATC and MC
When MC is below ATC, ATC must be declining. When MC is above ATC, ATC must be rising. Therefore, MC crosses ATC at the minimum of ATC.

Relationship between ATC, AFC, and AVC.

AFC plus AVC equals ATC.

http://apecon3.wikispaces.com/Opportunity+Cost http://www.buzzle.com/articles/economic-profit-vs-accounting-profit.htm iii http://econ651spring2008.wikispaces.com/Opportunity+costs+including+implicit+costs+and+explicit+costs iv http://www.buzzle.com/articles/economic-profit-vs-accounting-profit.html v http://en.wikipedia.org/wiki/Fixed_cost vi http://en.wikipedia.org/wiki/Variable_cost vii http://en.wikipedia.org/wiki/Average_total_cost viii http://www.businessdictionary.com/definition/marginal-cost.html ix http://www.investopedia.com/exam-guide/cfa-level-1/microeconomics/marginal-average-total-costcurve.asp#axzz2HwxMSh8p
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