Theory of Cost: Managerial Economics: Lecture 10

Theory of Cost
Managerial Economics: Lecture 10
Ritwik Banerjee
IIM Bangalore
Recap
• Choices firms make
• Short and Long run
• Optimal Way to Produce in Long run
• Isoquants
• Different types of Production Technology
Banerjee (IIM Bangalore) ME Lecture 10: Cost PGP Term I, 2019 Slide 2
Lecture Overview
• Section 1: Firm’s Problem
• Section 2: Optimal Input Choice
• Section 3: Cost Functions
• Section 4: Economies of Scale
• Section 5: Economies of Scope
• Section 6: Takeaway
Firm’s Problem
Three Steps to Production
1. Production Technology: how inputs combine to produce output
2. Cost Constraints: consider costs of factors of production
3. Optimal Combination of Inputs: maximize production given

resource constraints
Isocost Line
• Total cost of production is sum of firm’s labor cost, 𝑤𝐿, and

its capital cost, 𝑟𝐾:
𝐶 = 𝑤𝐿 + 𝑟𝐾
• C represents the cost of employing L units of Labor and K

units of Capital
• For different levels of cost, the equation shows another

isocost line
Isocost Line
• Slope of the Isocost Line
∆𝐾! = −(𝑤⁄ )
∆𝐿 𝑟
• −(𝑤/𝑟) is the ratio of the wage rate to rental cost of capital
• This shows the rate at which capital can be substituted for labor
with no change in cost
• Tradeoff in terms of affordability
Isocost Lines
Lecture Overview
• Section 4: Economies to Scale
Producing a Given Output at Minimum Cost
Capital
per • Problem being solved: Minimize Cost
year subject to a certain level of output Q1.
• Q1 is an isoquant for output Q1.
B • There are three isocost lines, of which 2
K2 are possible choices in which to produce
Q1.
• Optimal choice of input: K*, L*.
A
K*
K3 𝑄-
C0 C1 C2
Labor per year
L2 L* L3
Using a Given Budget to Produce the Maximum
Output
Capital • Problem being solved: Maximize
per output subject to a certain level of
year output budget outlay.
• Q1 , Q2 , Q3 are three isoquants for
three different levels of output and
C1 is the budget outlay.
• The optimal input configuration is
K** and L**.
• Duality Theorem says: K*=K**

A and L*=L**
K**
𝑄.
𝑄-
𝑄.
C1
Labor per year
L**
Optimal Inputs
• Slope of the isoquant is MRTS

∆K MP/
MRTS = − =
∆L MP0
• Slope of Isocost line is the ratio of input prices

∆K w
− =
∆L r
Optimal Inputs
• The minimum cost combination can then be written as:
DEF H
MRTS = DEG
= I
𝑀𝑃M 𝑀𝑃N
⇒ =
𝑤 𝑟
• Increase in output for every dollar spent on an input is same for
all inputs.
• Equimarginal Principle?
Demonstration Problem 1
• Temporary Services uses four word processors and two typewriters to
produce reports.
• The marginal product of a typewriter is 50 pages per day, and the
marginal product of a word processor is 500 pages per day. The rental
price of a typewriter is $1 per day, whereas the rental price of a word
processor is $50 per day.
• Is Temporary Services utilizing typewriters and word processors in a
cost-minimizing manner?
Demonstration Problem 1: Solution
• Let 𝑀𝑃O be the marginal product of a typewriter and 𝑀𝑃H be the marginal product of a word
processor. And let 𝑃H and 𝑃O be rental prices of a word processor and a typewriter, respectively,
cost-minimization requires that:
𝑀𝑃I 𝑀𝑃H
=
𝑃I 𝑃H
• Substituting in the appropriate values, we see that:
50 𝑀𝑃I 𝑀𝑃H 500

= > =
1 𝑃I 𝑃H 50
• Thus, the marginal product per dollar spent on typewriters exceeds the marginal product per dollar
spent on word processors. Intuition?
• Word Processors are 10 times more productive than typewriters, but 50 times more expensive.
• The firm is not minimizing costs and should use fewer word processors and more typewriters.
Input price change
Capital • Mustard has to produce 𝑄- units of
output. But wage rate has
increased. What do we do?
• Original optimum at A
• Price of labor or 𝑤 increases but 𝑟
remains the same
• Relative price of labor increases
B
• In order to produce the same unit
of output, budget outlay has to
increase.
A • Optimal input choice changes from
A to B with increases outlay.
𝑄-
Labor
Input price change
• Mustard has to produce 𝑄Q units of output.
Capital But rental rate has increased. What do we
do?
• At input price 𝑤=20, r=20 , optimal input
choice at M is 40 units of L and 80 units of
K. Total cost is 20∗40+20∗80=Rs.2400.
• Suppose r increases to 40. What will the
manager do to minimize costs at the same
level of output?
M • At the new optimal point at N, 120 units of
L and 10 units of K. Find the increase in
budget outlay.
• Total cost is
N • 40∗10+20∗120=Rs.2800
• Increase in cost is Rs.400
𝑄-
Labor
Business Inside: Fringe Benefit and Import substitution
• Current federal tax law requires that firms provide fringe benefits in a
way as not to discriminate against lower-income workers. This policy
limits the employment opportunities of low-income workers. How?
• Research shows that
• Industries that offered more generous health care plans employed significantly
fewer clerical employees
• Industries with higher levels of fringe benefits hired more part-time workers
than did industries with lower fringe-benefit levels
Source: Frank Scott, Mark Berger, and Dan Black, “Effects of Fringe Benefits on Labor Market Segmentation,”
Industrial and Labor Relations Review 42 (January 1989), pp. 216–29
Application: Fringe Benefit and Import substitution
• Suppose the annual wage bill of a computer programmer is $30,000 and

that of a secretary is $15,000.
• Company is considering offering a family health care plan worth $3,600
annually to its employees
• W/o the policy: the relative price of a secretary to a computer programmer
is $15,000/$30,000 = 0.5
• When the cost of the health care plan is added in: it increases to a little over
0.55
• Isoquant and isocost analysis suggests that firms should substitute away
from the now higher-priced secretaries to minimize costs.
Source: Frank Scott, Mark Berger, and Dan Black, “Effects of Fringe Benefits on Labor Market
Segmentation,” Industrial and Labor Relations Review 42 (January 1989), pp. 216-29
Expansion Path
Capital
per The expansion path illustrates • Minimum cost
the least-cost combinations of
year $3000
labor and capital that can be needed to produce
150 used to produce each level of
output in the long-run.
different levels of
output
$2000 C
Expansion Path • Maximum amount of
100
output that can be
75 produced for different
B
300 Units levels of expenditure
50
A
25
200 Units
100 Units
Labor per year
50 100 150 200 300
Expansion Path
Capital
per The expansion path illustrates • Each isoquant
year $6000 the least-cost combinations of
labor and capital that can be
corresponds to
150 used to produce each level of different levels of
output in the long-run.
output
Expansion Path
• Each isocost line
100
$2000 C corresponds to
different levels of
75 cost
B
50
$1000 300 Units
• Cost increases with
A higher isoquants
25
200 Units • Cost function is 𝐶(𝑞)
100 Units
Labor per year
50 100 150 200 300
Long Run Total Cost
Cost/
• Cost as a Year
Long Run Total Cost
function of F
quantity 3000
produced
E
2000
D
1000
Output, Units/yr
100 200 300
• You manage a plant that mass-produces engines by teams of
workers using assembly machines. The technology is summarized
by the production function
𝑞 = 5𝐾𝐿
where 𝑞 is the number of engines per week, K is the number of
assembly machines, and L is the number of labor teams. Each
assembly machine rents for r = $10,000 per week, and each team
costs w = $5000 per week. Engine costs are given by the cost of
labor teams and machines, plus $2000 per engine for raw materials.
Your plant has a fixed installation of 5 assembly machines as part of
its design.
• How much will it cost to produce 𝑞 number of engines?
Lecture Overview
Types of Cost
• Fixed Cost: A cost that can not vary with the level of output
• Example: Cost of acquiring a plot of land, salaries of key executives, plant
maintenance etc.
• Variable Cost: A cost that varies with output

• Example: Cost of buying raw material, daily laborers etc.
• Sunk Cost: Sunk costs are costs which have been incurred and cannot be
recovered
• Example: R&D for developing a new drug, a very specialised machine to build silicon
chips
• Key difference between Fixed and Sunk Cost: Expenditure can be recovered by
shutting down in the former but not in the latter.
Application: Types of Cost
• Consider these three industries:
1. Textile industry (where most costs are variable)
• H&M
• Cost of the fabric
• Cost of labor
2. Software industry (where most costs are sunk)
• Microsoft and Apple
• High pre-sale investments
• High irrecoverable expenditures: developing a new software
3. Pizzeria business (where most costs are fixed)
• Domino’s Pizza
• High but recoverable fixed cost: rent, utilities, opportunity cost of owners time
• Fairly low variable cost
• ACME Coal paid $5,000 to lease a railcar from the Reading Railroad.
Under the terms of the lease, $1,000 of this payment is refundable if
the railcar is returned within two days of signing the lease. Upon
signing the lease and paying $5,000, how large are ACME’s fixed
costs? Its sunk costs?
• One day after signing the lease, ACME realizes that it has no use for
the railcar. A farmer has a bumper crop of corn and has offered to
sublease the railcar from ACME at a price of $4,500. Should ACME
accept the farmer’s offer?
Demonstration Problem 3: Solution
• ACME’s fixed costs are $5,000. For the first two days, its sunk costs
are $4,000 (this is the amount that cannot be recouped). After two
days, the entire $5,000 becomes a sunk cost.
• Yes, ACME should sublease the railcar. Note that ACME’s total loss
is $500 if it accepts the farmer’s offer. If it does not, its losses will
equal $4,000 (assuming it returns the railcar by the end of the next
business day).
Short Run Costs
• Short run is defined as a time frame where some inputs are fixed
• Assume a two factor production setting K (Capital) is fixed at 2, L

(Labor) varies with output
Short Run Cost Function
Fixed Input Variable Output (Q) Fixed Cost Variable Total Cost Marginal
(K) Input (L) (FC) Cost (VC) (TC) Cost (MC)
2 0 0 $2000 $0 $2000 -
2 1 76 2000 400 2400 400
2 2 248 2000 800 2800 400
2 3 492 2000 1200 3200 400
2 4 784 2000 1600 3600 400
2 5 1100 2000 2000 4000 400
2 6 1416 2000 2400 4400 400
2 7 1708 2000 2800 4800 400
2 8 1952 2000 3200 5200 400
2 9 2124 2000 3600 5600 400
2 10 2200 2000 4000 6000 400
Short Run Total Cost Function
Variable Cost (VC)
$5,000 TC,VC & FC
TC=FC+VC
$4,000
$3,000
VC
$2,000
$1,000
$0
0 500 1000 1500 2000 2500
• Total cost is the sum of fixed FC
costs and variable costs.

FC
• Thus, the distance between FC
FC
the TC and VC is simply Q
fixed costs. 0
Average Costs
• Average Fixed Cost: Fixed cost divided by number of units produced
𝐹𝐶
𝐴𝐹𝐶 =
𝑄
• Average Variable Cost: Variable cost divided by number of units produced
𝑉𝐶
𝐴𝑉𝐶 =
𝑄
• Average Total Cost: Total cost divided by number of units produced
𝑇𝐶 𝑉𝐶 + 𝐹𝐶
𝐴𝑇𝐶 = = = 𝐴𝑉𝐶 + 𝐴𝐹𝐶
𝑄 𝑄
Average Costs
• In the short run, the amount of capital is fixed. Labor is the only
variable input.
• Average Variable Cost: Variable cost divided by number of units
produced
𝑉𝐶 𝑤𝐿
𝐴𝑉𝐶 = =
𝑄 𝑄
𝑤
⟹ 𝐴𝑉𝐶 =
𝐴𝑃7
Average Costs
Output (Q) Fixed Cost Variable Total Cost Average Average Variable Average
(FC) Cost (VC) (TC) Fixed Cost Cost (AVC) Total Cost
(AFC) (ATC)
0 $2000 $0 $2000 - - -
76 2000 400 2400 $26.32 $5.26 $31.58
248 2000 800 2800 8.06 3.23 ?
492 2000 1200 3200 ? 2.44 6.50
784 2000 1600 3600 2.55 2.04 4.59
1100 2000 2000 4000 1.82 1.82 3.64
1416 2000 2400 4400 1.41 ? 3.11
1708 2000 2800 4800 1.17 1.64 2.81
1952 2000 3200 5200 1.02 1.64 2.66
2124 2000 3600 5600 0.94 1.69 ?
2200 2000 4000 6000 0.91 1.82 2.73
Marginal Cost
• Marginal Cost is the cost of producing an additional unit of output,
i.e. the additional cost of producing the last unit of output
∆𝐶
𝑀𝐶 =
∆𝑄
• In the short run, the amount of capital is fixed. Labor is the only
variable input.
∆𝑉𝐶
𝑀𝐶 =
∆𝑄
𝑤∆𝐿 𝑤
⟹ 𝑀𝐶 = =
∆𝑄 𝑀𝑃7
Marginal Cost
Output (Q) ∆𝑸 Variable ∆𝑽𝑪 Total Cost ∆𝑻𝑪 MC
Cost (VC) (TC)
0 - $0 - $2000 -
76 76 400 400 2400 400 400/76=5.26
248 172 800 400 2800 400 400/172=2.33
492 244 1200 400 3200 400 400/244=1.64
784 292 1600 400 3600 400 400/292=1.37
1100 316 2000 400 4000 400 ?
1416 316 2400 400 4400 400 400/316=1.27
1708 292 2800 400 4800 400 400/292=1.37
1952 244 3200 400 5200 400 400/244=1.64
2124 172 3600 400 5600 400 400/172=2.33
2200 76 4000 400 6000 400 400/76=5.26
TC,VC & FC
TC=FC+VC
VC
Relation among Costs
A
B
• AFC is a decreasing function of
output 0
Q
• As Q increases, ATC and AVC Cost

comes closer and closer ATC or AC
AVC
𝐶 𝑄 = 𝑉𝐶 𝑄 + 𝐹𝐶
𝐶(𝑄) 𝑉𝐶(𝑄) 𝐹𝐶
= +
𝑄 𝑄 𝑄
ATC=AVC+AFC AFC
Q
Relation among Costs MC
Cost
• MC intersects AVC at the
ATC or AC
lowest point of AVC
• MC intersects ATC at the AVC
lowest point of ATC

• Minimum of ATC is to the Minimum
of ATC
right of the minimum of AVC
Minimum
of AVC AFC
Q
Relation among Costs MC
Cost
• Mathematically, ATC or AC
𝐶(𝑄)
𝐴𝑉𝐶 𝑄 =
𝑄
𝑑𝐶
𝑑𝐴𝑉𝐶(𝑄) 𝑄 𝑑𝑄 − 𝐶(𝑄)
=
𝑑𝑄 𝑄.
𝑀𝐶(𝑄) − 𝐴𝑉𝐶(𝑄)
= Minimum
𝑄 of ATC
@ABC(D)
= 0 implies 𝑀𝐶 𝑄 = 𝐴𝑉𝐶(𝑄)
@D
@ABC(D)
> 0 implies 𝑀𝐶 𝑄 > 𝐴𝑉𝐶(𝑄)
@D
@ABC(D)
< 0 implies 𝑀𝐶 𝑄 < 𝐴𝑉𝐶(𝑄)
@D
@AC(D) FC D GABC D GAHC
Note: = Minimum
@D D
@AC(D) of AVC
So @D
= 0 implies 𝑀𝐶 𝑄 = 𝐴𝑉𝐶 𝑄 + 𝐴𝐹𝐶. As a AFC
result, minimum of AC is to the right of AVC Q
Demonstration Problem 2 (Continued)
• You manage a plant that mass-produces engines by teams of
workers using assembly machines. The technology is summarized
by the production function
𝑞 = 5𝐾𝐿
where 𝑞 is the number of engines per week, K is the number of
assembly machines, and L is the number of labor teams. Each
assembly machine rents for r = $10,000 per week, and each team
costs w = $5000 per week. Engine costs are given by the cost of
labor teams and machines, plus $2000 per engine for raw materials.
Your plant has a fixed installation of 5 assembly machines as part of
its design.
• How much will it cost to produce 𝑞 number of engines?
Demonstration Problem 2 (Continued)
• What are the average and marginal costs for producing 𝑞 engines?
• How do average and marginal costs vary with output?
• How many teams are required to produce 250 engines? What is
the average cost per engine?
• You are asked to make recommendations for the design of a new
production facility. What capital/labor (𝐾/𝐿) ratio should the
new plant accommodate if it wants to minimize the total cost of
producing at any level of output 𝑞?
• The cost function for Managerial Enterprises is given by :
𝐶(𝑄) = 20 + 3𝑄.
• Determine the marginal cost, average fixed cost, average variable cost,
and average total cost when 𝑄 = 10.
Demonstration Problem: Solution
• Using the formula for marginal cost (here 𝑎 = 𝑐 = 0), we know that
𝑀𝐶 = 6𝑄. Thus, the marginal cost when 𝑄 = 10 is $60.
• To find the various average costs, we must first calculate total costs.
The total cost of producing 10 units of output is
𝐶 10 = 20 + 3(10). = $320
• Fixed costs are those costs that do not vary with output; thus fixed
costs are $20. Variable costs are the costs that vary with output,
namely 𝑉𝐶(𝑄) = 3𝑄. . Thus, 𝑉𝐶 10 = 3(10). = $300.
• It follows that the average fixed cost of producing 10 units is $2, the
average variable cost is $30, and the average total cost is $32
Long Run Costs Cost (rupee
per unit of
LMC
output)
• Long run cost function
shows all the factors of LAC
productions can be adjusted
• When LAC is decreasing,
𝐿𝑀𝐶 < 𝐿𝐴𝐶
• When LAC is increasing, A
𝐿𝑀𝐶 > 𝐿𝐴𝐶
• LAC & LMC intersects at
A, where LAC is minimum
Output
Lecture Overview
Economies of Scale
• Container ships: 1950 –
480 TFU, 2006: 15000
TEU, 2017: 21413 TEU
• Buildings: Burj Khalifa,
Shanghai Tower …
• Trains: Powerful engines
and more compartments
Returns to Scale
• Long Run Average Cost curve is U shaped
• As Q increases , the average cost decreases up to a point and then increases
• Increasing returns to scale or economies of scale
• As Q further increases, LAC decreases
• Decreasing returns to scale or diseconomies of Scale
• As Q further increases, LAC decreases
• Constant returns to scale
• If LAC and Q are linearly related, constant returns to scale
Returns to Scale
Average Cost Average Cost
LAC
IRS DRS CRS

LAC
Output Output
Return to Scale
Increasing Returns to Constant Returns to Scale Decreasing Returns to Scale
Scale
K K K
300 Q
300 Q
300 Q
200 Q
200 Q 200 Q
100 Q
100 Q 100 Q
L L L
Returns to Scale
• Production function
𝑄 = 𝐴𝐾 K 𝐿L
• If 𝐾 and 𝐿 increases by a factor of 𝑡 then output increases by 𝑡 KML .
• If 𝛼 + 𝛽 = 1, then increasing 𝐾 and 𝐿 by a factor of 𝑡 increases 𝑄 by a factor
of 𝑡 : Constant Returns to Scale
• If 𝛼 + 𝛽 > 1, then increasing 𝐾 and 𝐿 by a factor of 𝑡 increases 𝑄 by a factor
of more than 𝑡 : Increasing Returns to Scale
• If 𝛼 + 𝛽 < 1, then increasing 𝐾 and 𝐿 by a factor of 𝑡 increases 𝑄 by a factor
of less than 𝑡 : Decreasing Returns to Scale
Application: Increasing Returns and
International Trade
• Dominant discourse in international trade was
comparative advantage
• Two countries, US and EU produce software and cars,
respectively
• There are considerable increasing returns in both
industries
• Even without comparative advantage, US and EU are
better off specializing in one of the goods
• Then they trade the produced goods with each other
Source: Krugman, P (1978). Increasing returns, monopolistic competition and
international trade. Journal of International Economics.
Application: Increasing Returns and
Economic Geography
• This paper proposes a framework to analyze geographical concentration from a
neoclassical approach, using a trade-off between economies of scale and
transportation costs
• Paul Krugman explained how a country can endogenously become
differentiated into an industrialized "core" and an agricultural "periphery.“
• Manufacturing firms tend to locate in the region with larger demand
• Enjoy benefits of economies of scale
• Minimizing transport costs
• The location of demand itself depends on the distribution of manufacturing
Source: Krugman P (1991). Increasing Returns and Economic Geography. Journal of Political Economy.
Lecture Overview
Economies of Scope
• Multi cuisine restaurants
• Why? Common factors of production such as ovens, restaurants, tables and
chairs, waiters etc.
• Apple produces computers, tablets, phones
• Google has a suit of products
• Tata produces trucks and cars
• Other examples?
Economies of Scope
• Economies of Scope is said to exist if the total cost of producing
two types of outputs together is less than the total cost of
producing each type of output separately.
𝑖. 𝑒. 𝐶 𝑄- , 0 + 𝐶 0, 𝑄. > 𝐶(𝑄- , 𝑄. )
• Cost complementarities are said to exist when marginal cost of
producing one type of output decreases when the output of another
good is increased
Δ𝑀𝐶- 𝑄- , 𝑄.
<0
Δ𝑄.
Demonstration Problem
• Firm A produces two goods. Cost function is given by
𝐶 = 100 − 0.5𝑄- 𝑄. + 𝑄- . + 𝑄. .
The firm wishes to produce 5 units of good 1 and 4 units of good 2.
• Do cost complementarities exist? Do economies of scope exist?
• Firm A is considering selling the subsidiary that produces good 2 to firm B, in
which case it will produce only good 1. What will happen to firm A’s costs if it
continues to produce 5 units of good 1?
Demonstration Problem - Solution
• For cost complementarities:
𝑀𝐶Q = −0.5𝑄j + 2𝑄Q
Δ𝑀𝐶Q
= −0.5 < 0
Δ𝑄j
• Marginal cost decreases with higher 𝑄j .
• For Economies of Scope
𝐶 5,0 = 100 + 25 = 125
𝐶 0,4 = 100 + 16 = 116
𝐶 5,4 = 100 − 0.5 ∗ 5 ∗ 4 + 25 + 16 = 131
• If Firm A continues to sell good 1 then then its cost will decrease by 6. but
the total combined cost of Firm A and B will be $110 more than the cost of
producing both the goods by Firm A.
Lecture Overview
Takeaway
• Long Run optimal combination of inputs
• Isoquant and Isocost Curves
• Type of Costs, their relations and cost functions
• Expansion Path
• Returns to Scale- Increasing, Decreasing & Constant
Banerjee (IIM Bangalore) ME Lecture 10: Cost 60

Theory of Cost: Managerial Economics: Lecture 10

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Theory of Cost: Managerial Economics: Lecture 10

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Theory of Cost

Managerial Economics: Lecture 10

1. Production Technology: how inputs combine to produce output

2. Cost Constraints: consider costs of factors of production

3. Optimal Combination of Inputs: maximize production given

• Total cost of production is sum of firm’s labor cost, 𝑤𝐿, and

• C represents the cost of employing L units of Labor and K

• For different levels of cost, the equation shows another

• −(𝑤/𝑟) is the ratio of the wage rate to rental cost of capital

• Duality Theorem says: K*=K**

• Slope of the isoquant is MRTS

• Slope of Isocost line is the ratio of input prices

50 𝑀𝑃I 𝑀𝑃H 500

• Suppose the annual wage bill of a computer programmer is $30,000 and

• Variable Cost: A cost that varies with output

• Assume a two factor production setting K (Capital) is fixed at 2, L

• Total cost is the sum of fixed FC

costs and variable costs.

• As Q increases, ATC and AVC Cost

lowest point of ATC

IRS DRS CRS

• Isoquant and Isocost Curves

• Type of Costs, their relations and cost functions

• Returns to Scale- Increasing, Decreasing & Constant

Banerjee (IIM Bangalore) ME Lecture 10: Cost 60

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