Cost of Production

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In economics, the cost-of-production has the following components:

Key Terms

  1. Explicit Costs
    • Costs that requires direct monetary expenses by the firm
  2. Implicit Costs
    • Costs that does not require direct monetary expenses by the firm
  3. Fixed Costs
    • Costs that does not vary with the quantity of output
  4. Variable Costs
    • Costs that varies with the quantity of output
  5. Total Costs
    • The market value of all the inputs that a firm uses during production
  6. Average fixed Cost
    • Fixed cost divided by the quantity of output
  7. Average Variable Cost
    • Variable cost divided by the quantity of output
  8. Average Total Cost
    • Total cost divided by the quantity of output
  9. Marginal Cost
    • The increase in total cost that comes up from producing an extra unit of output

Shape of Cost Curves

Marginal Cost Curve (MC)

  • Has a positive slope demonstrating the property of diminishing marginal product. In other words, when small quantities of a product are being produced, adding one more worker will increase marginal productivity therefore making the marginal cost small. However, when large quantities are being produced, labour may be crowed and equipments fully utilized. In this case, the marginal product will be small and therefore the marginal cost of an extra unit of the good is large.

Average Total Cost (ATC)

  • U-Shaped to illustrate the combined effects of average fixed cost and average variable cost. When a small quantity is produced, ATC is high because average fixed cost is spread over a few units. However, as more quantity are produced, ATC begin to decrease because average fixed cost is spread over more units. However, after reaching the lowest point, called the efficient scale, average variable cost starts to rise due to diminishing returns to scale. The rising AVC eventually overtakes the AFC and causes ATC to increase.

Relationship between ATC and MC

  • Whenever MC is less than ATC, ATC is falling. Whenever MC is greater than ATC, ATC is rising.

Profit Equations

  • Profit = Total Revenue - Total Cost
  • Accounting profit = Total Revenue - Explicit Cost
  • Economic Profit = Total Revenue - Explicit Cost - Implicit Cost
  • Normal Profit = Accounting Profit - Economic Profit


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