Production and cost theory

(Business behaviour: The cost of production)

Van Rensburg et al., chapter 4

Professor Corné van Walbeek

April 2025
 Learning outcomes

• Why economic costs include both explicit costs

and implicit costs
• How the law of diminishing returns relates to a
firm’s short-run production costs
• The distinction between fixed and variable costs
and total, average and marginal costs
• The link between a firm’s size and its average
costs in the long run
 Economic costs

• For a business, there are explicit costs and

implicit/economic/opportunity costs
• Explicit costs
• Monetary payments for inputs in the production
process, e.g. raw materials, labour, interest on loans
from the bank
• Implicit costs
• Opportunity cost of self-owned, self-employed
resources
• Opportunity costs
• The cost of the best alternative use of that resource
 Normal profit vs.
economic profit
• Normal profit
• The minimum amount of profit the entrepreneur
needs to get to compensate him for the risk, stress
and entrepreneurial talent to start/run the business

• Economic profit
• Total revenue less all explicit and implicit costs
• Economic profit is always less than accounting profit
 Calculate accounting
profit and economic profit
• You give up your salaried job where you were
earning R400 000 a year to become an entrepreneur.
• You evict your tenant who was paying you R60 000
each year in rent, and use the room as your office
• You use R100 000 of your savings, on which you were
earning 10% income to start the business
• You want to earn at least R150 000 per year for being
an entrepreneur
• You incur explicit costs as follows:
• Labour costs of R700 000
• Cost of inputs: R600 000
• Other explicit costs: R200 000
• Your total revenue is R2 400 000
 Calculate accounting
profit and economic profit
• Accounting profit:
Revenue less explicit costs
= R2 400 000 – R1 500 000
= R900 000
• Implicit costs
• Forgone salary R400 000
• Forgone rent R60 000
• Forgone interest R10 000
• (Forgone) entrepreneurial income R150 000
• Total implicit costs = R620 000
• Economic profit
• R900 000 – R620 000 = R280 000
• OR R2 400 000 – R2 120 000 = R280 000
Accounting profit vs.
economic profit
 Short run vs. long run

• Short run:
• Firm is unable to change the plant (factory) size
• But it can change the degree to which the fixed plant
size is used
• Long run:
• Everything is variable
• Firm can change the plant size, and the degree to
which the plant is used
• Firms can leave the industry or other firms can enter
the industry
 Short-run production
relationships
• Important terms
• Total product (TP): relationship between total output
(quantity produced) and labour inputs

• Marginal product (MP): change in total output if one

additional labourer joins the production process

• Average product (AP): Total product divided by total

labour inputs

Previous texts have used the term “total physical product”; it is the same as total product
 The law of diminishing
returns
• If more units of a variable input are added to a
fixed resource, the output will increase by
diminishing amounts
• Usually capital is the fixed resource and labour is
the variable resource
• It does not say that total output will decrease,
just that the additional (marginal) output will
increase
Short-run production
relationships
Key graph 4.2

Note the very

substantial error in
the text (print and
electronic)
 Short-run production
relationships
• Important points
• MP is at its maximum at the inflection point of the TP
curve
• AP is at its maximum when the slope of a ray onto the
TP curve is at its maximum
• The MP curve cuts the AP curve at the AP curve’s
maximum
• MP is zero when TP is at its maximum

• Where does the law of diminishing returns come

into operation?
Short-run production
costs
 Fixed and variable costs

• Fixed costs (TFC)

• Costs that in total do not vary with changes in output.
They are associated with the firm’s existence and
have to be paid even if its output is zero

• Variable costs (TVC)

• Costs that change with the level of output. They are
associated with payments for inputs to the
production process

• Total costs (TC)

• Sum of fixed cost and variable cost at each level of
output: TC = TFC + TVC
 Average and marginal
costs
• Average fixed costs (ATC)
• AFC = TFC/Q
• Graphically: hyperbolic
• Average variable costs (AVC)
• AVC = TVC/Q
• U-shaped
• Average total costs (ATC)
• ATC = AFC + AVC
• ATC = TC/Q
• Marginal cost (MC)
• MC = ΔTC/ΔQ or MC = ΔTVC/ΔQ
Short-run production costs

Total cost data Average & Marginal cost data

(1) (2) (3) (4) (5) (6) (7) (8)

TP TFC TVC TC AFC AVC ATC MC
(2+3) (2/1) (3/1) (4/1) (4/1)

0 R100 R0 R100 R-- R-- R--

R90
1 100 90 190 100.00 90.00 190.00
80
2 100 170 270 50.00 85.00 135.00
70
3 100 240 340 33.33 80.00 113.33
60
4 100 300 400 25.00 75.00 100.00
70
5 100 370 470 20.00 74.00 94.00
80
6 100 450 550 16.67 75.00 91.67
90
7 100 540 640 14.29 77.14 91.43
110
8 100 650 750 12.50 81.25 93.75
130
9 100 780 880 11.11 86.67 97.78
150
10 100 930 1030 10.00 93.00 103.00
Short-run total production costs
R1100
1000 TC
900
TVC
800
700

600
Costs

Fixed
500 cost
400
300 Total Variable
cost cost
200
100
TFC
0 1 2 3 4 5 6 7 8 9 10 Q
Short-run average production costs
R200

MC
150

AFC
ATC
Costs

100
AVC

50
AVC

AFC
0 1 2 3 4 5 6 7 8 9 10 Q
 Important points

• The MC curve cuts the AVC curve at the AVC’s

minimum
• The MC curve cuts the ATC curve at the ATC’s
minimum
• The ATC curve converges onto the AVC curve as Q
increases
• AFC determines the distance between ATC and
AVC but is not related to MC
• (Often the AFC is not shown in graphs)
 Linking production and
cost theory
Labourers TP AP MP TVC AVC MC
0 0 - -
10 R100.00
1 10 10 R1000 R100.00
14 R71.43
2 24 12 R2000 R83.33
12 R83.33
3 36 12 R3000 R83.33
10 R100.00
4 46 11.5 R4000 R86.96
8 R125.00
5 54 10.8 R5000 R92.59
Production curves and cost curves
Production curves

Average product and

Marginal product

AP
MP
Quantity of labour
Cost curves
MC
AVC
Cost (Rand)

Quantity of output
 Shifts of the cost curves

• If fixed costs increase, the AFC and ATC curves will

shift upwards
• MC is unaffected by changes in the fixed costs

• If variable costs (like labour) increase, the AVC

and ATC curves will shift upwards
• MC will also move upwards
Long-run production
costs
 What is the long run?

• A period where all costs are variable

• Distinction between fixed and variable costs falls
away
• The firm can adjust the plant size
• Firms can leave the industry and new firms can
enter the industry
 Plant size and costs

• A single-plant manufacturer may start on a

small scale and due to successful
operations, may expand to successively
larger plant sizes with larger output
capacities
• Larger plant sizes may be associated with
lower average costs, but still larger plant
sizes may result in higher average costs
Long-run production costs

ATC-1 ATC-5
Average total costs

ATC-4
ATC-2 ATC-3

Output
Long-run production costs

ATC-1
ATC-5
Average total costs

ATC-2
Long-run
ATC-3 ATC-4
ATC

Output

The long-run ATC curve just

‘envelopes’ the short-run ATCs
 Returns to scale

• What happens to quantity of output if all inputs

are increased by X%?
• Decreasing returns to scale
• Output increases by less than X%

• Increasing returns to scale

• Output increases by more than X%

• Constant returns to scale

• Output increases by exactly X%
 Economies of scale

• Returns to scale focuses on the physical

aspects of production,
• I.e. quantity of inputs and outputs
• Economies (and diseconomies) of scale
focus on the financial (cost) aspects
 Economies of scale

• Decrease in long-run average cost as output

increase
• Explanation
• Labour specialization
• Managerial specialization
• Costs are spread over a larger number of units,
e.g. start-up costs, advertising
 Diseconomies of scale

• Increase in long-run average cost as output

increase
• Explanation
• Coordination failures
• Many layers of management
• Bureaucratic red tape
• Worker alienation and worker shirking
 Presenting this graphically

Economies Constant returns Diseconomies

of scale to scale of scale
Average total costs

Long-run
Long-run ATC constant over wide ATC
range of output

q1 q2
Output
Long-run production costs
Alternative long-run ATC shapes
Economies Diseconomies
of scale of scale
Average total costs

Long-run
ATC

Output

Extensive economies of scale; diseconomies

of scale occur only at very large outputs.
Long-run production costs
Alternative long-run ATC shapes
Economies Diseconomies
of scale of scale

Long-run
Average total costs

ATC

Output

Economies of scale are exhausted quickly,

followed immediately by diseconomies of scale;
minimum ATC at relatively low output.
 Minimum efficient scale
and industry structure
• Minimum efficient scale
• The lowest level of output where a firm can minimize
long-run average costs
• If this happens at high levels of output, efficient
production will be achieved with a few large-scale
producers
• Small firms cannot realize MES and will not be able to
compete
• Economies of scale might extend beyond the market’s size
• Natural monopoly: a situation in which LACs are
minimised when only one firm produces the good or
service
• See previous graphs
 Minimum efficient scale
and industry structure
• Minimum efficient scale
• The lowest level of output where a firm can minimize
long-run average costs
• If this happens at high levels of output, efficient
production will be achieved with a few large-scale
producers.
• Small firms cannot realize MES and will not be able to
compete.
• Economies of scale might extend beyond the market’s
size.
• Natural monopoly: a situation in which LACs are
minimised when only one firm produces the good or
service.
 Applications
• Impact of rising fuel prices on cost structures
• Some industries are more affected by rising fuel
prices than others

• Aircraft manufacturers and manufacturers of raw

cement
• Location is the key

• Successful start-up firms

• Spreading the costs of product development
• Reaping economies of scale
 Production and cost
theory

END OF THIS SECTION