1. The Cost of Production
Each firm uses various inputs (resources) in its production activity.
Commonly used inputs: labor and capital
Prices of inputs (wages, rents)  Cost of Production

2. Measuring Cost: Which Costs Matter?
It is clear that if a firm has to rent equipment or buildings, the rent
they pay is a cost.
What if a firm owns its own equipment or building?
How are costs calculated here?

3. Measuring cost:
Opportunity cost – the value of a highest forgone alternative;
– cost associated with opportunities that are forgone when a firm’s
resources are not put to their highest-value use.

4. Economic cost.
Some costs vary with output, while some remain the same ,no matter
amount of output.
Fixed Cost (FC) – cost that does not vary with the level of output.
- have to be paid as long as the firm stays in business (even if output is
zero)
Variable Cost (VC) – cost that varies as the level of output varies.
Total Cost (TC or C) – total economic cost of production, consisting of
fixed and variable costs.
TC=FC+VC

5. Which costs are variable and which are fixed depends on the time
horizon
Short time horizon – most costs are fixed
Long time horizon – many costs become variable
In determining how changes in production will affect costs, we
must consider if it affects fixed or variable costs

7. A Firm’s Short Run Costs
Cost in the Short run

8. Cost Curves for a Firm
Output
Cost
($ per
year)
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
TVC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.
TC
Total cost
is the vertical
sum of FC
and VC.
TFC50
Fixed cost does not
vary with output

9.  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.

10. 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

11. 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= TVC/ Q∆ ∆
since TC=(TFC+TVC) and TFC does not change with Q

12. A Firm’s Short Run Costs

13. Cost Curves
0
20
40
60
80
100
120
0 12
Output (units/yr)
Cost($/unit)
MC
ATC
AVC
AFC

14. Marginal Product and Costs
Suppose a firm pays each worker $50 a day.
Units of
Labor
Total
Product
MP VC MC
0 0 0 0
1 10 10 50 5
2 25 15 100 3.33
3 45 20 150 2.5
4 60 15 200 3.33
5 70 10 250 5
6 75 5 300 10

15. Short-run Costs and Marginal Product
 production with one input L – labor; (capital is fixed)
 Assume the wage rate (w) is fixed
 Variable costs is the per unit cost of extra labor times the amount of extra labor:
VC=wL
D Denote “∆” - change. For example ∆VC is change in variable cost.
MC=∆VC/∆Q ; MC =w/MPL,
where MPL=∆Q/∆L
With diminishing marginal returns: marginal cost increases as output
increases.

16. Shifts of the Cost Curves
Changes in resource prices or technology will cause costs to
change
⇒ Cost curves shift
FC increases by 100

17. Shift of FC curve
Output
Cost
($ per
year)
100
200
300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
VC
TC
FC50
FC’150
TC’

18. Summary
In the short run, the total cost of any level of output is the sum
of fixed and variable costs: TC=FC+VC
Average fixed (AFC), average variable (AVC), and average total
costs,(ATC) are fixed, variable, and total costs per unit of output;
marginal
cost is the extra cost of producing 1 more unit of output.
A FC is decreasing
AVC and ATC are U-shaped, reflecting increasing and then
diminishing return
Marginal cost curve (MC) falls and then rises, intersecting
both AVC and ATC at their minimum points.

19. Closing Questions:
Q1: Those things that must be forgone to
acquire a good are called
 a. substitutes.
 b. opportunity costs.
 c. explicit costs.
 d. competitors.

20.  Q2: Explicit costs
 a. require an outlay of money by the firm.
 b. include all of the firm's opportunity costs.
 c. include income that is forgone by the
firm's owners.
 d. Both b and c are correct.

21.  Q4: An example of an explicit cost of
production would be
 a. the cost of forgone labour earnings for an
entrepreneur.
 b. the lost opportunity to invest in capital
markets when the money is invested in one's
business.
 c. lease payments for the land on which a
firm’s factory stands.
 d. Both a and c are correct.

22. Q5: The amount of money that a wheat farmer
could have earned if he had planted barley
instead of wheat is
 a. an explicit cost.
 b. an accounting cost
 c. an implicit cost.
 d. forgone accounting profit.