Definitions of Costs

It is important to differentiate between accounting cost and economic cost

the accountants view of cost stresses out-ofpocket expenses, historical costs, depreciation, and other bookkeeping entries economists focus more on opportunity cost

Definitions of Costs

Labor Costs

to accountants, expenditures on labor are current expenses and hence costs of production to economists, labor is an explicit cost

labor services are contracted at some hourly wage (w) and it is assumed that this is also what the labor could earn in alternative employment

Definitions of Costs

Capital Costs

accountants use the historical price of the capital and apply some depreciation rule to determine current costs economists refer to the capitals original price as a sunk cost and instead regard the implicit cost of the capital to be what someone else would be willing to pay for its use

we will use r to denote the rental rate for capital

Economic Cost

The economic cost of any input is the payment required to keep that input in its present employment

the remuneration the input would receive in its best alternative employment

Two Simplifying Assumptions

There are only two inputs

homogeneous labor (L), measured in laborhours homogeneous capital (K), measured in machinehours

entrepreneurial costs are included in capital costs

Inputs are hired in perfectly competitive markets

firms are price takers in input markets

Economic Profits

Total costs for the firm are given by

total costs = TC = wL + rK

Total revenue for the firm is given by

total revenue = Pq = Pf(K,L)

Economic profits () are equal to

= total revenue - total cost = Pq - wL - rK = Pf(K,L) - wL - rK

Economic Profits

Economic profits are a function of the amount of capital and labor employed

we could examine how a firm would choose K and L to maximize profit

But for now we will assume that the firm has already chosen its output level (q0) and wants to minimize its costs

Cost-Minimizing Input Choices

To minimize the cost of producing a given level of output, a firm should choose a point on the isoquant at which the MRTS is equal to the ratio w/r

it should equate the rate at which K can be traded for L in the productive process to the rate at which they can be traded in the marketplace

Cost-Minimizing Input Choices

Costs are represented by parallel lines with a slope of -w/r
TC1 < TC2 < TC3
q0

K per period
TC1 TC3 TC2

L per period

Cost-Minimizing Input Choices

K per period
TC1 TC3 TC2 K*

The minimum cost of producing q0 is TC2 The optimal choice is L*, K*

L per period

q0

L*

The Firms Expansion Path

The firm can determine the costminimizing combinations of K and L for every level of output If input costs remain constant for all amounts of K and L the firm may demand, we can trace the locus of cost-minimizing choices

called the firms expansion path

The Firms Expansion Path

K per period

The expansion path is the locus of costminimizing tangencies

q1 q0

The curve shows how inputs increase as output increases

L per period

q00

Total Cost Function

The total cost function shows that for any set of input costs and for any output level, the minimum cost incurred by the firm is
TC = TC(r,w,q)

As output increases, total costs increase

Average Cost Function

The average cost function (AC) is found by computing total costs per unit of output

TC (r , w, q) average cost AC (r , w, q) q

Marginal Cost Function

The marginal cost function (MC) is found by computing the change in total costs for a change in output produced

TC (r , w, q) marginal cost MC (r , w, q) q

Graphical Analysis of Total Costs

Suppose instead that total costs start out as concave and then becomes convex as output increases

one possible explanation for this is that there is another factor of production that is fixed as capital and labor usage expands total costs begin rising rapidly after diminishing returns set in

Graphical Analysis of Total Costs

Total costs
TC

Total costs rise dramatically as output rises after diminishing returns set in
Output

Graphical Analysis of Total Costs

AC MC MC is the slope of the TC curve
MC

AC

If AC > MC, AC must be falling If AC < MC, AC must be rising

min AC

Output

Shifts in Cost Curves

The cost curves are drawn under the assumption that input prices and the level of technology are held constant

any change in these factors will cause the cost curves to shift

Short-Run, Long-Run Distinction

In the short run, economic actors have only limited flexibility in their actions Assume that the capital input is held constant at K1 and the firm is free to vary only its labor input The production function becomes
q = f(K1,L)

Short-Run Total Costs

Short-run total cost for the firm is STC = rK1 + wL There are two types of short-run costs:

short-run fixed costs (SFC) are costs associated with fixed inputs short-run variable costs (SVC) are costs associated with variable inputs

Short-Run Marginal and Average Costs

The short-run average total cost (SATC) function is

SATC = total costs/total output = STC/q

The short-run marginal cost (SMC) function is

SMC = change in STC/change in output = STC/q

Short-Run Average Fixed and Variable Costs

Short-run average fixed costs (SAFC) are

SAFC = total fixed costs/total output = SFC/q

Short-run average variable costs are

SAVC = total variable costs/total output = SVC/q

Relationship between Short-Run and Long-Run Costs

STC (K2)

Total costs
STC (K0)

STC (K1) TC

The long-run TC curve can be derived by varying the level of K

q2

q0

q1

Output

Relationship between Short-Run and Long-Run Costs

Costs
SMC (K0) SATC (K0) SMC (K1) MC

AC
SATC (K1)

The geometric relationship between shortrun and long-run AC and MC can also be shown
Output

q0

q1