o Types of Costs o Short-run Cost o Long-run Cost o SR vs.

LR Cost Curves o Economies of Scope

Week 5

Chapter 7: The Cost of Production

Microeconomics 1 – I (Rasi Lucentezza)

TA:
Sendy Jasmine Karunia Hadi
E-mail: sendy.jasmine@ui.ac.id

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Outline
• Different Types of Costs
• Accounting, economic, opportunity, and sunk cost
• Fixed, variable, average, and marginal cost
• Cost in the Short Run
• Cost in Long Run
• Short Run vs. Long Run Cost Curves
• Economies of Scale
• Economies of Scope

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Types of Costs

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Total Cost (TC)

(+)
Accounting Economic Opportunity Sunk Cost Fixed Cost Variable Average Marginal Cost
Cost Cost Cost Cost Cost

Actual The cost of Cost Expenditure that Cost that A cost that • AC = ATC • MC =
expenses + utilizing associated with has been made doesn’t vary varies as = AEC Incremental
depreciation resources of opportunities and can’t be with the output • Compone Cost.
recovered
charges for production à that are anymore. à it
level of varies. nts: AFC + • Increase in
capital all costs forgone by not should always output & can AVC. cost as a
!"
equipment relevant to putting the be ignored when only be • A𝐶 = result of one
#
à financial production firm’s resource making future eliminated unit increase
report to their best decisions by going out in output.
It includes: alternative use. because it has of business $!"
• 𝑀𝐶 = $# =
costs linked no alternative (shutting
use. ∆&"
with FP + down). ∆#
opportunity Ex: specialized
cost. equipment.

Both are naturally different, but *Amortization: treating one-time

sunk cost can be considered as expenditure as annual cost by
fixed cost by amortization. spreading it out over the years.
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o Types of Costs o Short-run Cost o Long-run Cost o SR vs. LR Cost Curves o Economies of Scope

Firm’s Costs Table

Pindyck & Rubinfeld (2017)

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Cost in the Short Run

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o Types of Costs o Short-run Cost o Long-run Cost o SR vs. LR Cost Curves o Economies of Scope

In the short-run…. • Happens when one input is fixed (capital)

flow and one input is variable (labor) à
existence of LDMR à MPL is decreasing.
• What is the relationship of production with
cost?
𝑤
𝑀𝐶 =
𝑀𝑃𝐿
∆"# %.∆'
𝑀𝐶 = = … (1)
∆$ ∆$

∆$
𝑀𝑃𝐿 = ∆'
... (2)

∆' %
= … (3)
∆$ ()'

• MC and MPL have negative relationship. -

à as MPL decreases, MC increases.

Pindyck & Rubinfeld (2017)

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Cost in the Long Run

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The User Cost of Capital

• Cost of “owning” and “using” a capital asset, instead of selling it
or never buying it in the first place. Interest that could have been earned had
the money been invested elsewhere.

• Calculation:
• User cost of capital = economic depreciation + (interest rate)(value of
capital)
• User cost of capital (r) = depreciation rate + interest rate

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In the long-run, firms can change all of its inputs….

....so, they can choose the combination of inputs that minimizes the
cost of producing a certain output, that will depend on the prices of
these inputs.
• Price of Capital: rental rate (r) à rental rate should be equal to user cost (r)
in a competitive market.
• Price of Labor: wage (w).

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The Isocost Line

• Isocost line is a graph showing all possible combinations of labor
and capital that can be purchased for a given total cost.

𝐶 = 𝑤𝐿 + 𝑟𝐾

𝐶 𝑤
𝐾= − 𝐿
𝑟 𝑟
∆" $
• Slope of Isocost: =−
∆# %

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(cont.)

Pindyck & Rubinfeld (2017) Pindyck & Rubinfeld (2017)

A change in firm’s budget/expenditure will shift A change in the price of one input will change
the Isocost line. the slope of Isocost line.

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(cont.)
• How can we relate Isocost line with firm’s production process?
∆( *+)
• Recall Chapter 6: the slope of Isoquant curve à MRTS = ∆)
= *+(
∆( ,
• Recall the slope of Isocost curve: ∆)
=− -
• Then, the point of tangency between Isoquant and Isocost curve will
yield cost-minimizing production, so we can rewrite both slopes’
equations into:
𝑀𝑃𝐿 𝑤
=
𝑀𝑃𝐾 𝑟
𝑀𝑃𝐿 𝑀𝑃𝐾
=
𝑤 𝑟

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Expansion Path
• A curve passing through points of tangency between a firm’s Isocost
lines and its isoquants.
• A combination of K and L that a firm will choose to minimize its cost at each
output level.
• Shape: upward sloping à as long as higher output means higher
capital and labor.
∆"
• Slope:
∆#

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(cont.)

Pindyck & Rubinfeld (2017)

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Short Run vs. Long Run Cost Curves

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The Inflexibility of Short-run Prod.

Pindyck & Rubinfeld (2017)

• When a firm operates in the short-run, its cost may not be minimized due
to inflexibility in the use of (capital) inputs.

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o Types of Costs o Short-run Cost o Long-run Cost o SR vs. LR Cost Curves o Economies of Scope

Long-run Costs

Pindyck & Rubinfeld (2017)

• Long-run Average Cost: Curve relating AC to output when capital is variable.

• Long-run Marginal Cost: Curve showing the change in long-run total cost as
output is increased incrementally by 1 unit.
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o Types of Costs o Short-run Cost o Long-run Cost o SR vs. LR Cost Curves o Economies of Scope

Economies of Scale
• Economies of scale: situation in which output can be doubled for less
than a doubling of cost.
• Diseconomies of scale: situation in which output is doubled for more than
a doubling of cost.
• Difference between economies of scale and (increasing) returns to scale:
• IRS à output x input
• Economies of scale à output x cost
• Economies of scale requires a change in input proportions.
• Measuring Economies of Scale (cost-output elasticity, EC):
∆𝐶 • EC = 1 à no economies of scale
∆𝑞 𝑀𝐶 nor diseconomies of scale.
𝐸𝐶 = =
𝐶 𝐴𝐶 • EC > 1 à diseconomies of scale.
• EC < 1 à economies of scale.
𝑞
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Relationship Between SR and LR

Pindyck & Rubinfeld (2017)

• The LRAC is the envelope of SRAC.

• LRAC exhibits economies of scale initially, then diseconomies of scale at higher output levels.
• The LRMC is not the envelope of SRMC.
• It’s only associated with SRMC with the most cost-efficient plant.
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Economies of Scope

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It is associated with production with 2

outputs..
• Example: automobile company produces both automobiles and trucks.
• To show the relationship between the two outputs, we can use Product
Transformation Curve (curve showing the various combinations of 2 different
outputs that can be produced with a given set of inputs).

• Negative sloping à to get more of one

output, a firm must give up some other
output.
• Concave à there are economies of scope
in production.

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(cont.)
• Economies of scope: a situation in which joint output of a single firm is greater
than output that could be achieved by two different firms when each produces a
single product.
• Diseconomies of scope: a situation in which joint output of a single firm is less
than could be achieved by separate firms when each produces a single product.
• There is no direct relationship between economies of scope and economies of
scale.
• Measuring economies of scope à degree of economies of scope (SC):
• SC (Saving Cost): percentage of cost savings resulting when two or more products are
produced jointly rather than individually.

• SC > 0 à economies of scope

• SC < 0 à diseconomies of scope

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