Chapter 7
The Cost of
Production
Chapter 7 Slide 2
Topics to be Discussed

Measuring Cost: Which Costs Matter?

Cost in the Short Run

Cost in the Long Run

Long-Run Versus Short-Run Cost
Curves

Production with Two Outputs
Economies of Scope
Chapter 7 Slide 3
Introduction

The production technology measures
the relationship between input and
output.

Given the production technology,
managers must choose how to
produce.
Chapter 7 Slide 4
Introduction

To determine the optimal level of

Chapter 7 Slide 7

An Example

A firm owns its own building and pays no
rent for office space

Does this mean the cost of office space
is zero?
Measuring Cost:
Which Costs Matter?
Chapter 7 Slide 8

Total output is a function of variable
inputs and fixed inputs.

Therefore, the total cost of production
equals the fixed cost (the cost of the
fixed inputs) plus the variable cost
(the cost of the variable inputs), or…
VC FC TC
+=
Measuring Cost:
Which Costs Matter?
Fixed and Variable Costs
Fixed and Variable Costs
Chapter 7 Slide 9

Fixed Cost


cost, it can be written as:
Q
TC
Q
VC
MC
∆
∆
=
∆
∆
=
Chapter 7 Slide
12
Cost in the Short Run

Average Total Cost (ATC) is the cost
per unit of output, or average fixed
cost (AFC) plus average variable cost
(AVC). This can be written:
Q
TVC
Q
TFC
ATC
+=
Chapter 7 Slide
13
Cost in the Short Run


Decreasing returns and cost

With decreasing returns, output is
decreasing relative to input and variable cost
and total cost will rise relative to output.
Chapter 7 Slide
16
Cost in the Short Run

For Example: Assume the wage rate
(w) is fixed relative to the number of
workers hired. Then:
Q
VC
MC
∆
∆
=
L VC w
=
Chapter 7 Slide
17
Cost in the Short Run

Continuing:
L VC
∆=∆
w
Q
L

Cost in the Short Run

In conclusion:

…and a low marginal product (MP)
leads to a high marginal cost (MC)
and vise versa.
L
MP
MC
w
=
A Firm’s Short-Run Costs ($)
0 50 0 50
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7
49.3
4 50 112 162 14 12.5 28
40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25
33.3
7 50 175 225 25 7.1 25
32.1
8 50 204 254 29 6.3 25.5
31.8
9 50 242 292 38 5.6 26.9
32.4
10 50 300 350 58 5 30 35

300
400
0 1 2 3 4 5 6 7 8 9 10 11 12 13
VC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.
TC
Total cost
is the vertical
sum of FC
and VC.
FC
50
Fixed cost does not
vary with output
Chapter 7 Slide
23
Cost Curves for a Firm
Output (units/yr.)
Cost
($ per
unit)
25
50
75
100

100
0
1
2 3 4 5 6 7 8 9 10
11
MC
ATC
AVC
AFC
Chapter 7 Slide
25
Cost Curves for a Firm

Unit Costs

MC = AVC and ATC
at minimum AVC and
ATC

Minimum AVC
occurs at a lower
output than minimum
ATC due to FC
Output (units/yr.)
Cost
($ per
unit)
25
50
75