Cost Concepts in Economics

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Agenda
 Opportunity Cost
 Long Versus Short-Run
 Cost Concepts
 Revenue Concepts
 Production Rules in Short and Long-Run
 Size in Long-Run

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Opportunity Costs
 The value of the product not produced
because an input was used for another
purpose.
 The income that would have been
received if the input had been used in
its most profitable alternative use.
 It denotes the real cost of using an
input.

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Short Versus Long Run
 The short run is a period of time
sufficiently short that only some of the
variables can be changed.
 The long run is a period of time that all
variables can be changed.

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Types of Costs
 Variable Costs
 These costs exist only if production occurs.
 E.g., fuel for tractor, seed, etc.
 Fixed Costs
 These cost exist whether production occurs or not.
 In the long-run there are no fixed costs.
 Can be both cash and non-cash expenses.
 E.g., depreciation on tractors and buildings, etc.

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Types of Costs Cont.
 Sunk Costs
 Is an expenditure that cannot be
recovered.
 In essence, it becomes part of fixed costs.
 E.g., pre-harvest costs.

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Cost Concepts
 Total Fixed Costs (TFC)
 The summation of all fixed and sunk costs to
production.
 Total Variable Costs (TVC)
 The summation of all variable costs to production.
 Total Costs (TC)
 The summation of total fixed and total variable
costs.
 TC=TFC+TVC

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Cost Concepts Cont.
 Average Fixed Costs (AFC)
 The total fixed costs divided by output.
 Average Variable Costs (AVC)
 The total variable costs divided by output.
 Average Total Costs (ATC)
 The total costs divided by output.
 The summation of average fixed costs and
average variable costs, i.e., ATC=AFC+AVC.

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Cost Concepts Cont.
 Marginal Costs
 The change in total costs divided by the
change in output.
 TC/Y
 The change in total variable costs divided
by the change in output.
 TVC/Y

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Side Note on Marginal Cost
 How can marginal cost equal both the
change in total cost divided by the
change in output and the change in
total variable cost divided by the
change in output when variable costs
are not equal to total costs?
 Short answer: fixed costs do not change.

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Side Note on Marginal Cost
Cont.
 We want to show that MC = TVC/Y when TVC 
TC.
 We know that TC = TFC + TVC
 This implies that TC = (TFC + TVC)
 This implies that TC = TFC + TVC
 We know that TFC = 0
 Hence, TC = TVC
 Divide the previous by Y, we obtain
 TC/Y = TVC/Y
 MC = TVC/Y

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Graphical Representation of
Cost Concepts
$

TC

TVC

TFC

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Graphical Representation of
Cost Concepts Cont.
$
MC

ATC

AVC

AFC

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Notes on Costs
 MC will meet AVC and ATC from below
at the corresponding minimum point of
each.
 Why?
 As output increases AFC goes to zero.
 As output increases, AVC and ATC get
closer to each other.

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 Example of Cost Concepts

X Y TFC TVC TC AFC AVC ATC MC

10 10 1000 1000 2000 100 100 200

16 30 1000 1600 2600 33.33 53.33 86.67 30
20 48 1000 2000 3000 20.83 41.67 62.50 22.22
22 65 1000 2200 3200 15.38 33.85 49.23 11.76
26 81 1000 2600 3600 12.35 32.10 45.45 25
32 96 1000 3200 4200 10.42 33.33 43.75 40
40 108 1000 4000 5000 9.26 37.04 46.30 66.67
50 116 1000 5000 6000 8.62 43.10 51.72 125
62 120 1000 6200 7200 8.33 51.67 60.00 300
76 117 1000 7600 8600 8.55 64.96 73.51 -466.67
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Revenue Concepts
 Revenue (TR) is defined as the output
price (py) multiplied by the quantity (Y).
 Average revenue (AR) equals total
revenue divided by output (Y), i.e.,
TR/Y, which equals py.
 Marginal Revenue is the change in total
revenue divided by the change in
output, i.e., TR/Y.

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Short-Run Decision Making
 In the short-run, there are many ways
to choose how to produce.
 Maximize output.
 Utility maximization of the manager.
 Profit maximization.
 Profit () is defined as total revenue minus
total cost, i.e.,  = TR – TC.

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Short-Run Decision Making
Cont.
 When examining output, we want to set
our production level where MR = MC
when MR > AVC in the short-run.
 If MR  AVC, we would want to shut down.
 Why?
 If we can not set MR exactly equal to MC,
we want to produce at a level where MR is
as close as possible to MC, where MR >
MC.

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Intuition for Setting MR = MC
 Suppose MR < MC.
 This implies that by producing more
output, you have a greater addition of
cost than you do revenue.
 Hence you would not make the change.

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Intuition for Setting MR = MC
 Suppose MR > MC.
 This implies that by producing more
output, you have a greater addition of
revenue than you do cost.
 Hence you would make the change.
 You would stop increasing output at the
point where the trade-off in additional
revenue is just equal to the trade-off in
additional costs. 20
Why Shutdown When
MR < AVC
 If MR < AVC, this implies that you are
not bringing in enough revenue from
each unit produced to cover your
variable costs.
 Hence you could minimize your loss if
you were to shutdown.

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Why Produce When
ATC > MR > AVC
 When MR < ATC, the company is making a
loss.
 Why would it produce?
 Since the firm is making something above
and beyond its variable cost, it can put some
of that revenue towards fixed cost.
 This implies that it minimizes its loss by
producing.

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Profit Scenario Graphically
$ Profit

MC

MR = py

ATC
ATC
AVC

AFC

Yprofit Y

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Loss Minimizing Graphically
$
MC

Loss

ATC

ATC
AVC
MR = py

AFC

Yloss Y

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Shutdown Decision Graphically
$
If we did not produce:
loss = B MC

Loss = A + B

ATC
ATC
B AVC

MR = py A AFC

Yloss Y

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Production Rules for the Long-
Run
 To maximize profits, the farmer should
produce when selling price is greater
than ATC at the production level where
MC = MR.
 To minimize losses, the farmer should
not produce when selling price is less
than ATC, i.e., shutdown the business.

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Note on Cost Concepts
 The producer’s supply curve is the part
of the MC curve that is above the
shutdown point.

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Long-Run Average Costs
 The long run average cost (LRAC) curve is
the envelope of the short run average cost
curves when the size of the operation is
allowed to increase or decrease.
 Note that a short run average cost curve
exists for every possible farm size, as defined
by the amount of fixed input available.

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Long-Run Average Costs Cont.
 In a competitive market, the long run
optimal production will occur at the
lowest point on the LRAC, i.e.,
economic profits are driven to zero.

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Size in the Long-Run
 A measure of size in the long run
between output and costs as farm size
increases (EOS) is the following:
 EOS = percent change in costs divided by
percent change in output value

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Size in the Long-Run Cont.
 If this ratio of EOS is less than one, then
there are decreasing costs to expanding
production, i.e., increasing returns to size.
 If this ratio is equal to one, then there are
constant costs to expanding production, i.e.,
constant returns to size.
 If this ratio is greater than one, then there
are increasing costs to expanding production,
i.e., decreasing returns to size.
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Economies of Size
 This exists when the LRAC is decreasing.
 Also known as increasing returns to size.
 Usually occurs because of full utilization of
capital (tractors and buildings) and labor.
 Also occurs because of discount pricing for
buying in bulk and selling price benefits for
selling large quantities.

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Diseconomies of Size
 This exists when the LRAC is increasing.
 Also known as decreasing returns to size.
 Usually occurs because a lack of managerial
skills.
 Also occurs because travel time increases as
farm increases.
 Livestock: disease control and manure disposal.
 Crops: geographical distance away from each
other.

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