Advanced Microeconomics

Ivan Etzo

University of Cagliari
ietzo@unica.it
Dottorato in Scienze Economiche e Aziendali, XXXIII ciclo

Ivan Etzo (UNICA) Lecture 4: Cost Functions 1 / 22

Overview

1 Short-run Cost functions

Total Costs
Average Costs
Marginal costs

2 Long-run costs
Long Average Costs
Long Marginal Costs

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Short-run Cost functions

The cost function measures the minimum cost of producing a given

level of output for some fixed factor prices.
The cost function describes the economic possibilities of a firm.

Type of Short-run cost functions:

Average (total) costs
Average fixed costs
Average variable costs
Marginal costs

Cost functions are important in studying the determination of optimal

output choices.
How are these cost functions related to each other?
How are a firm’s long-run and short-run cost functions related?

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Total Costs

Consider the cost function c(w1 , w2 , y ) and let’s consider the factor
prices fixed, so that the cost function is a function of the output
alone, c(y ).
In the short-run there are some costs that are fixed, that is they do
not depend on the output level (e.g. plant size).
Contrarily, the variable costs change when output changes (e.g.
labor).
Accordingly, total short-run costs can be written as the sum of the
variable costs, cv (y ) and the fixed costs, FC :

c(y ) = cv (y ) + FC

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Average Costs

The average cost function measures the cost per unit of output
and can be written as follows:
c(y ) cv (y ) FC
AC (y ) = = + = AVC (y ) + AFC (y )
y y y

where AVC (y ) stands for average variable costs and AFC (y )

stands for average fixed costs.
What do these functions look like?

FC
Let’s consider the AFC (y ) = y :
when y → 0 then AFC (y ) → ∞
when y → ∞ then AFC (y ) → 0
Thus, AFC (y ) is a rectangular hyperbola

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Average Fixed Costs Curve

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Average variable costs
cv (y )
The average variable costs, AVC (y ) = y
As the output increases the average variable costs increase.
This is due to the presence of fixed factors which eventually bring
inefficiencies in production.

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Total average costs
The (total) average cost curve is the sum of the two previous curves:

Initially the average cost curve decreases because AFC are decreasing.
But as y increases AFC become smaller while AVC 0 increases, thus
eventually AC increases as well
the level of output which minimizes the AC is called minimal
efficient scale.
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Marginal costs

The marginal cost curve measures the change in costs for a given
change in output.

dc(y ) c(y + dy ) − c(y )

MC (y ) = = .
dy dy
or equivalently,

dcv (y ) cv (y + dy ) − cv (y )
MC (y ) = =
dy dy
.
because c(y ) = cv (y ) + FC
What is the relationship between the MC and the AVC curve?
The MC curve must lie below (above) the AVC curve when this one
is decreasing (increasing).

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Marginal costs and average cost curve
Formally

If the the AVC curve is decreasing then we must have that

 
d cv (y )
<0
dy y
By applying the quotient rule for derivates,
yc 0 (y ) − cv (y )
 
d cv (y )
= v <0
dy y y2

ycv0 (y ) − cv (y ) < 0
cv (y )
cv0 (y ) <
y

This also implies that the MC curve must intersect the AVC at its
minimum point.
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Marginal costs and average cost curves

Important points:
The AVC curve may initially slope down due to increasing average
products of the variable factor for small output levels.
the AC curve will initially slope down due to decreasing average fixed
costs.
The AFC curve can be obtained as a difference between AC curve and
AVC .
The MC and AVC are the same at the first unit of output.
The MC equals both the AC and the AVC at their minimum point.
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Marginal costs and variable costs

The area underneath the MC curve until y is the variable cost of

producing y units of output.
Z y0
dcv (x)
cv (y ) = dx = cv (y 0 ) − cv (0) = cv (y )
0 dx

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Cost curves: Examples with the Cobb-Douglas technology
(Short-run)

Suppose that, in the short-run, the factor 2 is fixed at x̄2 , then the
cost minimization problem is the following:

min w1 x1 + w2 x̄2
x1 ,x2

such that
f (x1 , x2 ) = x1a x̄2b

Solve the constraint for x1 and get

1 a
x1 = y a x̄2b

Thus a
1
c(w1 , w2 , x̄2 ) = y a x̄2b w1 + w2 x̄2
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Cost curves: Examples with the Cobb-Douglas technology
(Short-run)

The short-run Cobb-Douglas cost functions are the following:

1 a
The Short-run costs: cs (y , w1 , w2 , x̄2 ) = y a x̄2b w1 + w2 x̄2
1−a a
w2 x̄2
The Short-run Average Costs (SAC): SAC (y ) = y a x̄2b w1 + y
1−a a
The Short-run Average Variable Costs (SAVC): SAVC (y ) = y a x̄2b w1
w2 x̄2
The Short-run Average Fixed Costs (SAFC): SAFC (y ) = y
1−a a
w1
The Short-run Marginal Costs SMC (y ) = y a x̄2b a

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Long-run costs
By definition in the long-run all factors are variable, thus it will be
always possible to produce zero units of output at a zero costs.
Let’s consider x̄2 the optimal plant size for a firm that produces a
certain level of output.
Accordingly, and keeping the factor prices fixed, the short-run cost
function is cs (y , x̄2 ).
Think of the firm adjusting the plant size to a different level of
output, it turns out that when the fixed factor becomes variable, that
is in the long run, it is a function of y.
Then, the Long-run cost function can be written as follows:
c(y ) = cs (y , x̄2 (y ))

In other words, the minimum cost when all factors are variable (i.e.
the long run cost function) is just the minimum cost when factor 2 is
fixed at the level that minimizes the long-run costs.
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Long-run and short-run costs

Let’s consider some level of output y ∗ , the optimal plant size to

produce y ∗ is x̄2∗ = x̄2 (y ∗ )
We know that
c(y ∗ ) = cs (y ∗ , x̄2∗ )

Thus, in y ∗ the long-run costs are equal to the short-run costs.

It turns out that the long-run cost to produce y cannot be greater
than the short-run to produce the same level of output when factor 2
is fixed, that is:
c(y ) ≤ cs (y , x̄2∗ )

And, as a consequence it must be that:

AC (y ) ≤ ACs (y , x̄2∗ )

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Long-run and short-run costs
graphically

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Long-run and short-run costs
graphically

The LAC curve is the lower envelope of the SAC curves.

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The Long-run marginal costs
The economic intuition

The marginal cost measures the change in cost of production when

output changes
The long run marginal costs will consist of two components, namely:
1 how costs change when the plant size (i.e. factor 2) is fixed
2 how costs change when the plant size (i.e. factor 2) can be adjusted
Obviously, if the plant size is chosen optimally (i.e. if x̄2 = x̄2∗ ) then
the second component is equal to zero!
Thus, at the optimal choice the long-run marginal costs and the
short-run marginal costs are equal.

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The Long-run marginal costs = short-run marginal costs
Mathematical proof

We know that, by definition:

c(y ) ≡ cs (y , x̄2 (y ))

Let’s indicate x̄2 with k. Differentiating with respect to y gives

dc(y ) ∂cs (y , k) ∂cs (y , k) ∂k(y )
= + .
y ∂y ∂k ∂y

When we evaluate this expression for the output level y ∗ and the associated
optimal level of k, that is k ∗ , then we know that :
∂cs (y ∗ , k ∗ )
=0
∂k

In fact, this is the necessary condition for k ∗ to be the optimal level which
minimizes the costs when y = y ∗ . Thus, we are left with:
dc(y ) ∂cs (y , k)
= =⇒ LMC (y ) ≡ SMC (y )
y ∂y
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The Long-run marginal costs

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The Long-run marginal costs

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