Lecture 10

Cost curves

1
Short-Run & Long-Run Total Costs
 In the long-run a firm can vary all its
input levels
 Consider a firm that cannot change
its input 2 level from x2’ units
 How does the short-run total cost of
producing y output units compare to
the long-run total cost of producing y
units of output?
Short-Run & Long-Run Total Costs
 The long-run cost-minimization
problem is min w 1x1  w 2x 2
x1 ,x 2  0
subject to f ( x1 , x 2 )  y.
 The short-run cost-minimization
problem is min w 1x1  w 2x 2
x1  0
subject to f ( x1 , x 2 )  y.

 A simpler, one variable problem

Short-Run & Long-Run Total Costs
 Note that the short-run cost-
minimisation problem is the long-run
problem subject to the extra constraint
that x2 = x2’
 If the long-run choice for x2 was x2’
then the extra constraint x2 = x2’ is not
really a constraint at all
 The long-run and short-run total costs
of producing y would be the same
Short-Run & Long-Run Total Costs

 But if the long-run choice for x2  x2’

then the extra constraint x2 = x2’
prevents the firm in this short-run from
achieving its long-run production cost
 The short-run total cost must then
exceed the long-run total cost of
producing y
Short-Run & Long-Run Total Costs
y 
x2 Consider three output levels
y 

y

x1
Short-Run & Long-Run Total Costs
y  In the long-run when the firm
x2 is free to choose both x1 and
y 
x2, the least-costly input
y bundles are ...

x1
Short-Run & Long-Run Total Costs
y  Long-run costs are:
x2 c( y  )  w 1x1  w 2x 2
y  c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
x 
2
x 2
x 2

x1 x1 x1 x1

Short-Run & Long-Run Total Costs
 Now suppose the firm becomes
subject to the short-run constraint
that x2 = x2”
Short-Run & Long-Run Total Costs
y 
Long-run costs are:
x2 c( y  )  w 1x1  w 2x 2
y 
c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
x 
2
x 2
x 2

x1 x1 x1 x1

Short-Run & Long-Run Total Costs
y 
Long-run costs are:
x2 c( y  )  w 1x1  w 2x 2
y 
c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
x 
2
x 2
x 2

x1 x1 x1 x1

Short-Run & Long-Run Total Costs
y 
x2 Long-run costs are:
c( y  )  w 1x1  w 2x 2
y 
c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
Short-run costs are:
x 
2 c s ( y  )  c( y  )
x 2
x 2

x1 x1 x1 x1

Short-Run & Long-Run Total Costs
y 
x2 Long-run costs are:
c( y  )  w 1x1  w 2x 2
y 
c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
Short-run costs are:
x 
2 c s ( y  )  c( y  )
x 2 c s ( y  )  c( y  )
x 2

x1 x1 x1 x1

Short-Run & Long-Run Total Costs
y 
x2 Long-run costs are:
c( y  )  w 1x1  w 2x 2
y 
c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
Short-run costs are:
x 
2 c s ( y  )  c( y  )
x 2 c s ( y  )  c( y  )
x 2

x1 x1 x1 x1

Short-Run & Long-Run Total Costs
y 
x2 Long-run costs are:
c( y  )  w 1x1  w 2x 2
y 
c( y  )  w 1x1  w 2x 
2
c( y  )  w 1x1 w 2x 
2
y
Short-run costs are:
x 
2 c s ( y  )  c( y  )
x 2 c s ( y  )  c( y  )
x 2
c s ( y  )  c( y  )
x1 x1 x1 x1
Short-Run & Long-Run Total Costs
 Short-run total cost exceeds long-run
total cost except for the output level
where the short-run input level is the
long-run input level choice
 This means that the long-run total
cost curve always has one point in
common with any particular short-
run total cost curve
 Short-Run & Long-Run Total Costs
A short-run total cost curve always has
£ one point in common with the long-run
total cost curve, and is elsewhere higher
than the long-run total cost curve
cs(y)
c(y)

F = w2x2’’

y y  y  y
 18
Fixed, Variable & Total Cost Functions
 F denotes the firm’s fixed cost, does not
vary with the firm’s output level
 Fixed costs come from short-run fixed
inputs
 The firm’s variable cost function cv(y) is
the cost of its variable inputs when
producing y output units
 cv(y) depends upon the levels of the
fixed inputs
 19
Fixed, Variable & Total Cost Functions
 c(y) is the total cost of all inputs,
fixed and variable, when producing y
output units
 c(y) is the firm’s total cost function
c( y )  F  c v ( y ).
 20
£
Fixed Costs

y
 21
£
Variable Costs

cv(y)

y
 22
£
Fixed and Variable Costs

cv(y)

y
 23
£
Total Costs
c(y)
cv(y)
c( y )  F  c v ( y )

y
Av. Fixed, Av. Variable & Av. Total 24
Cost Curves
The firm’s total cost function is
c( y )  F  c v ( y ).

The firm’s average total cost function is

F cv ( y)
AC( y )  
y y
 AFC( y )  AVC( y ).
Av. Fixed, Av. Variable & Av. Total 25
Cost Curves
 What does an average fixed cost
curve look like?
F
AFC( y ) 
y
 AFC(y) is a rectangular hyperbola
 26
£/output unit

AFC(y)   as y 

AFC(y)

AFC(y)  0 as y 

0 y
Av. Fixed, Av. Variable & Av. Total 27
Cost Curves
 In a short-run with a fixed amount of
at least one input, the Law of
Diminishing (Marginal) Returns must
apply, causing the firm’s average
variable cost of production to
increase eventually
 28
£/output unit

AVC(y)

0 y
 29
£/output unit

AVC(y)

AFC(y)

0 y
Av. Fixed, Av. Variable & Av. Total 30
Cost Curves
 And ATC(y) = AFC(y) + AVC(y)
 31
£/output unit

ATC(y) = AFC(y) + AVC(y)

ATC(y)

AVC(y)

AFC(y)

0 y
 32
£/output unit

AFC(y) = ATC(y) - AVC(y)

ATC(y)

AFC AVC(y)

AFC(y)

0 y
 33
£/output unit Since AVC(y)   as y 0,
ATC(y)  AFC(y) as y 

ATC(y)

AFC AVC(y)

AFC(y)

0 y
 34
£/output unit Since AFC(y)  0 as y ,
ATC(y)  AVC(y) as y 

ATC(y)

AFC AVC(y)

AFC(y)

0 y
 35
£/output unit Since AFC(y)  0 as y ,
ATC(y)  AVC(y) as y 
And since short-run AVC(y) must
eventually increase, ATC(y) must
eventually increase in a short-run

ATC(y)

AVC(y)

AFC(y)

0 y
 36
Marginal Cost Function
 Marginal cost is the rate-of-change of
variable production cost as the
output level changes
 That is,
 cv ( y)
MC( y )  .
y
 37
Marginal Cost Function
The firm’s total cost function is
c( y )  F  c v ( y )
and the fixed cost F does not change
with the output level y, so
 c v ( y )  c( y )
MC( y )   .
y y
MC is the slope of both the variable
cost and the total cost functions
 38
Marginal & Average Cost Functions
 How is marginal cost related to
average variable cost?
 39
Marginal & Average Cost Functions
cv ( y)
Since AVC( y )  ,
y
 AVC( y ) y  MC( y )  1  c v ( y )
 .
y y 2
 40
Marginal & Average Cost Functions
cv ( y)
Since AVC( y )  ,
y
 AVC( y ) y  MC( y )  1  c v ( y )
 .
y y 2
Therefore,
 AVC( y )  
0 as y  MC( y )  c v ( y ).
y  
 41
Marginal & Average Cost Functions
cv ( y)
Since AVC( y )  ,
y
 AVC( y ) y  MC( y )  1  c v ( y )
 .
y y 2
Therefore,
 AVC( y )   c ( y)
 0 as MC( y )  v  AVC( y ).
y   y
 42
£/output unit
 AVC( y )
MC( y )  AVC( y )  0
y

MC(y)

AVC(y)

y
 43
£/output unit  AVC( y )
MC( y )  AVC( y )  0
y

The short-run MC curve intersects

the short-run AVC curve from
MC(y)
below at the AVC curve’s
minimum!

AVC(y)

y
 44
Marginal & Average Cost Functions

The same applies to ATC(y)…

Since

then
 45
£/output unit
 ATC( y )  
 0 as MC( y )  ATC( y )
y  

MC(y)

ATC(y)

y
 46
Marginal & Average Cost Functions
 The short-run MC curve intersects
the short-run AVC curve from below
at the AVC curve’s minimum
 And, similarly, the short-run MC
curve intersects the short-run ATC
curve from below at the ATC curve’s
minimum
 47
£/output unit

MC(y)

ATC(y)

AVC(y)

y
Short-Run & Long-Run Total Cost 48
Curves
 A firm has a different short-run total
cost curve for each possible short-
run circumstance
 Suppose the firm can be in one of
just three short-runs;
x2 = x2
or x2 = x2 x2 < x2 < x2
or x2 = x2
 49
£

cs(y;x2)
F = w2x2

F
0 y
 50
£

cs(y;x2)
F = w2x2
F = w2x2
cs(y;x2)

F
F
0 y
 51
£

cs(y;x2)
F = w2x2
F = w2x2
A larger amount of the fixed cs(y;x2)
input increases the firm’s
fixed cost

F
F
0 y
 52
£

cs(y;x2)
F = w2x2
F = w2x2
A larger amount of the fixed cs(y;x2)
input increases the firm’s
fixed cost
Why does
a larger amount of
F the fixed input reduce the
F slope of the firm’s total cost curve?
0 y
 Short-Run & Long-Run Total Cost 53
Curves
Recall from lecture 9 that the marginal
cost of input 1 (the slope of the firm’s
total cost curve wrt x1) is w1
MC 
MP1
 Short-Run & Long-Run Total Cost 54
Curves
Recall from lecture 9 that the marginal
cost of input 1 (the slope of the firm’s
total cost curve wrt x1) is w1
MC 
MP1
If input 2 is a complement to input 1 then
MP1 is higher for higher x2
Hence, MC is lower for higher x2
 Short-Run & Long-Run Total Cost 55
Curves
Recall from lecture 9 that the marginal
cost of input 1 (the slope of the firm’s
total cost curve wrt x1) is w1
MC 
MP1
If input 2 is a complement to input 1 then
MP1 is higher for higher x2
Hence, MC is lower for higher x2
That is, the short-run total cost curve starts
higher and has a lower slope if x2 is larger
 56
£

F = w2x2 cs(y;x2)
F = w2x2
F = w2x2
cs(y;x2)

cs(y;x2)
F
F
F
0 y
Short-Run & Long-Run Total Cost 57
Curves
 This firm has three short-run total
cost curves
 In the long-run, the firm is free to
choose amongst these three since it
is free to select x2 equal to any of x2,
x2, or x2
 How does the firm make this choice?
 58
£

For 0  y  y, choose x2 = ? cs(y;x2)

cs(y;x2)

cs(y;x2)
F
F
F
0 y y y
 59
£

For 0  y  y, choose x2 = x2 cs(y;x2)

cs(y;x2)

cs(y;x2)
F
F
F
0 y y y
 60
£

For 0  y  y, choose x2 = x2 cs(y;x2)

For y  y  y, choose x2 = ?

cs(y;x2)

cs(y;x2)
F
F
F
0 y y y
 61
£

For 0  y  y, choose x2 = x2 cs(y;x2)

For y  y  y, choose x2 = x2

cs(y;x2)

cs(y;x2)
F
F
F
0 y y y
 62
£

For 0  y  y, choose x2 = x2 cs(y;x2)

For y  y  y, choose x2 = x2
For y  y, choose x2 = ?
cs(y;x2)

cs(y;x2)
F
F
F
0 y y y
 63
£

For 0  y  y, choose x2 = x2 cs(y;x2)

For y  y  y, choose x2 = x2
For y  y, choose x2 = x2
cs(y;x2)

cs(y;x2)
F
F
F
0 y y y
 64
£

For 0  y  y, choose x2 = x2 cs(y;x2)

For y  y  y, choose x2 = x2
For y  y, choose x2 = x2
cs(y;x2)

cs(y;x2)
c(y), the
F firm’s long-
F run total
F cost curve
0 y y y
Short-Run & Long-Run Total Cost 65
Curves
 The firm’s long-run total cost curve
consists of the lowest parts of the
short-run total cost curves
 The long-run total cost curve is the
lower envelope of the short-run total
cost curves
Short-Run & Long-Run Total Cost 66
Curves
 In our example, the firm could only
have three levels of input 2
 If input 2 is available in continuous
amounts, then there are infinitely
many short-run total cost curves
 But the long-run total cost curve
would still be the lower envelope of
all the short-run total cost curves
 67
£

cs(y;x2)

cs(y;x2)

cs(y;x2) c(y)
F
F
F
0 y
Short-Run & Long-Run Average Total68
Cost Curves
 For any output level y, the long-run
total cost curve always gives the lowest
possible total production cost
 Therefore, the long-run ATC curve must
always give the lowest possible
average total production cost
 The long-run ATC curve must be the
lower envelope of all the firm’s short-
run ATC curves
Short-Run & Long-Run Average Total69
Cost Curves

 E.g., suppose again that the firm can

be in one of just three short-runs;
x2 = x2
or x2 = x2 (x2 < x2 < x2)
or x2 = x2

then the firm’s three short-run

average total cost curves are ...
 70
£/output unit

ACs(y;x2)

ACs(y;x2)

ACs(y;x2)

y
 71
£/output unit

ACs(y;x2)

ACs(y;x2)

ACs(y;x2)

y y y
 72
£/output unit

ACs(y;x2)

ACs(y;x2)

ACs(y;x2)
The long-run ATC
AC(y)
curve is the lower envelope
of the short-run ATC curves
y
Short-Run & Long-Run Marginal Cost
73
Curves
 What about the long run MC?
 For any output level y > 0, the long-run
MC is the MC for the short-run when
the amount of fixed input x’2 coincides
with what the firm would choos x*2
 So, for the continuous case, where x2
can take any value, the relationship
between the long-run MC and the short-
run MC is ...
Short-Run & Long-Run Marginal Cost
74
Curves
£/output unit
ACs

AC(y)

y
Short-Run & Long-Run Marginal Cost
75
Curves
£/output unit
MCs

AC(y)

y
Short-Run & Long-Run Marginal Cost
76
Curves
£/output unit
SRMCs MC(y)

AC(y)

y
For each y > 0, the long-run MC equals the
MC for the short-run when x*2 = x’2