Cost MCON 2022

MICROECONOMICS
COST
S.P.PREMARATNE
DEPARTMENT OF ECONOMICS
1
COST
The theory of cost is important to
a manager because it provides
the foundation for two important
production decisions:
1) whether or not to shut down

2) how much to produce
2
Choosing Output:
COSTS REVENUES
Technology
& costs of Demand
hiring curve
factors of production
TC curves AC
(short & (short & AR
long run)
long run)
CHECK: produce in SR?

close down in LR?
MR
MC
Choose output level
3
Which Costs Matter?
 Opportunity vs. accounting cost

 Opportunity cost is the cost associated with
opportunities that are foregone by not
putting resources in their highest valued
use
 Accounting cost considers only explicit cost,
the out of pocket cost for such items as
wages, salaries, materials, and property
rentals
 Sunk cost
 A sunk cost is an expenditure that has been
made and cannot be recovered--they should
not influence a firm’s decisions
4
Costs in the Short Run
 Total output is a function of variable
inputs and fixed inputs
 Therefore, the total cost of production
equals the fixed cost (the cost of the
fixed inputs) plus the variable cost (the
cost of the variable inputs) TC = FC +
VC
 Fixed costs
 costs that do not vary with output levels
 Variable costs
 costs that do vary with output levels
5
Costs in the Short Run continued
Marginal Cost (MC) is the cost of

expanding output by one unit. Since
fixed cost have no impact on
marginal cost, it can be written as:
VC TC dTC

MC   
Q Q dQ
6
Costs in the Short Run continued
 Average Total Cost (ATC) is the cost
per unit of output, or average fixed
cost (AFC) plus average variable cost
(AVC)
 This can be written:
TFC TVC TC
ATC   
Q Q Q
7
Short run cost
Q TFC TC TVC AFC AVC AC MC

0 500 500
1 1000
2 1280
3 1480
4 1620
5 1800
6 2000
7 2250
9 2920
11 4350
8
The Determinants of Short-Run Cost
 The relationship between the

production function and cost
can be detected by looking at
the relationship between either
increasing returns (to a factor)
and cost, or decreasing returns
(i.e. when the law of
diminishing returns takes
effect) and cost:
9
The relationship between the production
function and cost
 Increasing returns and cost
With increasing returns, output
is increasing relative to input
and variable cost and total cost
will fall relative to output
 Decreasing returns and cost
 With decreasing returns, output

is decreasing relative to input
and variable cost and total cost
will rise relative to output
10
SR Cost Curves for a Firm
 Unit Costs
 AFC falls continuously and
 MC equals AVC and ATC at their minimum
 Minimum AVC occurs at a lower output than
minimum ATC due to FC
P
100 MC
75
50 ATC
AVC
25
AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output 11
The Firm’s Short-Run Output Decision
 Firm sets output at Q1, where SRMC=MR
 subject to checking the average condition:
 if price is above SRATC1 firm produces Q1 at a profit
 if price is between SRATC1 and SRAVC1 firm produces
Q1 at a loss
 if price is below SRAVC1, firm produces zero output
Rs
SRMC
SRATC
SRATC1
SRAVC1 SRAVC
SMC = MR
MR
Q1 Output 12
The firm’s long-run output decision
 The decision:
 If the price is at or above LAC1, the firm produces
Q1.
 If the price is below LAC1 the firm goes out of
business Rs
 LMC always LMC

passes
through the
minimum point LAC
of LAC.
AC1
LMC = MR
MR
Q1 Output
13
(goods per week)
The firm’s output decisions –
a summary
Marginal condition Check whether to

produce
Short-run Choose the output Produce this output
decision level at which MR = unless price lower than
SRMC SRAVC. If it is, produce
zero.
Long-run Choose the output
decision level at which MR = Produce this output
LRMC unless price is lower than
LRAC. If it is, produce
zero.
14
Long-Run Cost Function
The long-run total cost curve
describes the minimum cost of
producing each output level when the
firm is free to vary all input levels.
One of the first decisions to be made

by the owner/manager of a firm is to
decide the scale of operation (size of
the firm).
15
Long-Run Average Cost
The LAC is a graph that shows the different scales on

which a firm can choose to operate in the long run.
Long-run average cost (LRAC) is often assumed to be
U-shaped:
LRAC
Output
16
Economies of Scale
However, economies of scale occur when

long-run average costs decline as output
rises:
LRAC
Output
17
Economies of Scale continued
 A cost related concept

 When a company is experiencing
economies of scale its LRAC declines
as output is increasing
 Diseconomies of scale:
LRAC increasing as output increasing
18
Long-Run Cost Function: Displaying
Economies/Diseconomies of Scale
Rs
LRAC
MC increasing
MES
Q
Economies of scale Diseconomies of scale
19
Economies of scale can be
classified as
a) External economies of scale
advantages that a firm gains from
the expansion and size of the
industry as whole  industrial
clusters
b) Internal economies of scale

advantages that a firm gains from
increasing the scale of its own
operation
20
Why can a firm become more efficient as
the scale of production rises?
 Technical economies
 Marketing economies
 Financial economies
 Managerial economies
 Risk-bearing economies
 Administrative economies
21
Why can a firm become more inefficient
as the scale of production rises?
Diseconomies of scale:
 Large enough operation may increase input prices
 Disproportionate rise in transportation costs
 Management coordination problems
 Labor specialization and repetitive work too little
stimulation, productivity suffers
 Primary reason for long-run scale economies
(diseconomies) is the underlying pattern of returns
to scale in the firm’s long-run production function
 Increasing returns to scale lead to economies of scale
and decreasing returns to scale leads to diseconomies
of scale
22
The long-run average cost curve LRAC:
an envelope of short-run cost curves
Each plant size

Average cost
SRATC2 SRATC1
SRATC4 LRAC is designed for
SRATC3 a given output
level
So there is a
sequence of SRATC
curves, each
corresponding to
Output a different optimal
output level.
In the long-run, plant size itself is variable,
and the long-run average cost curve LRAC is
found to be the ‘envelope’ of the SRATCs
23
The existence of economies of scale means that
in the long run, as the firms increases its scale
of operation, the LRAC of production falls.
Each individual scale of

the firm will still be
SRMC subject to diminishing
returns and have a U-
Costs per unit (Rs)
SRAC
shaped SRAC curve.
SRMC
SRAC
SRMC
SRAC
LRAC
Units of output
Minimum Efficient Scale
 A firm can not expect always to achieve

economies of scale when it expands: at
some point it is likely that the further
increase in size does not produce any
reduction in the average cost per unit
 minimum efficient scale (MES)
Rs
LRAC
Scale of firm
MES 25
Increasing LRAC: Diseconomies of
Scale
LRAC
SRMC
Costs per unit (Rs) SRAC
SRMC
SRAC
SRMC
SRAC
Units of output
Constant Returns to Scale
 Constant RTS refers to when an
increase in scale of operation leads
to no change in average costs per
unit produced  LRAC is horizontal
 when the firm doubles the use of
inputs, it will double output as
well as its costs
27
Production with Two (or more)
Outputs--Economies of Scope
 Economies of scope exist when

the unit cost of producing two or
more products/services jointly is
lower than producing them
separately
 producing related products, products
that are complementary
 the average total cost of

production decreases as a result
of increasing the number of
different goods produced
28
Why Advantages May Exist
For example:
1) Both products use same inputs (capital
and labor)
2) The firms share management
resources
3) Both products use the same labor skills
and type of machinery
 Examples:
 Chicken farm--poultry and eggs
 Automobile company--cars and trucks
 University--teaching and research
29
An Example: PepsiCo, Inc.
30
Degree of Economies of Scope
 The degree of economies of scope

measures the savings in cost:
C(Q1)  C(Q2)  C(Q1, Q2)
SC 
C(Q1, Q2)
 C(Q1) is the cost of producing product Q1
 C(Q2) is the cost of producing product Q2
 C(Q1Q2) is the joint cost of producing both
products
 If SC > 0 -- Economies of scope
 If SC < 0 -- Diseconomies of scope
31
Dynamic Changes in Costs--
The Learning Curve
 The learning curve measures the impact of worker’s
experience on the costs of production
 It describes the relationship between a firm’s cumulative
output and amount of inputs needed to produce a unit of
output
 The learning curve implies:
1) The labor requirement per unit falls
2) Costs will be high at first and then will fall with
learning
32
The Learning Curve
 The horizontal axis

measures the
Hours of labor
per machine lot
cumulative number
of hours of machine
10 lots the firm has
produced
8
 The vertical axis
6 measures the
number of hours of
labor needed to
4 produce each lot
2
0 10 20 30 40 50
Cumulative # of machine lots produced
33
Economies of Scale Versus Learning
Cost
(Rs per unit
of output)
AC1
Output
34
Economies of Scale Versus Learning continued
Cost
(Rs per
unit
of output)
Economies of Scale
A
B
AC1
Output 35
Economies of Scale Versus Learning
continued
Cost
(Rs per unit
of output)
Economies of Scale
A
B
AC1
Learning C
AC2
Output 36
Bundles of Labor and Capital That Cost
the Firm $100
Isocost Lines
Isocost Equation
For each extra
unit of capital it C w
K, Units of capital per year
K= - L
uses, the firm r r
must use two
Initial Values
fewer units of
labor to hold its C = $100
cost constant. w = $5
$100 e r = $10
10 =
$10
d
7.5
c
5 Slope = -1/2 = -w/r
K = 2.5 b
2.5
L = 5 $100 isocost
a
5 10 15 $100
= 20
$5
L, Units of labor per year
A Family of Isocost Lines
Isocost Equation
C w
K= - L
r r
$150
15 = An increase in C…. Initial Values
$10
C = $150
w = $5
$100 e r = $10
10 =
$10
$100 isocost $150 isocost
a
$100 $150
= 20 = 30
$5 $5
A Family of Isocost Lines
Isocost Equation
C w
K= - L
r r
$150
15 = A decrease in C…. Initial Values
$10
C = $50
w = $5
$100 e r = $10
10 =
$10
$50
5=
$10
$50 isocost $100 isocost $150 isocost
a
$50 $100 $150
= 10 = 20 = 30
$5 $5 $5
Costs
 The firm’s total cost equation is:
C = wL + rK.
 Therefore,
rK  C  wL Note that if C is constant—as
C  wL
along an isocost line—then a
one-unit increase in L
K requires K to change by –w/r
units. That is, the slope of the
r isocost line is –w/r.
C w
K  L
r r
Cost-Minimizing Input Choices
 Note that this equation’s inverse is
also of interest
w v
 
fl f k
• The Lagrangian multiplier shows
how much in extra costs would be
incurred by increasing the output
constraint slightly
42
Given output q0, we wish to find the least
costly point on the isoquant
k per period
Costs are represented by
C1 parallel lines with a slope
C3 of -w/v
C2
C1 < C 2 < C 3
q0
l per period
43
The minimum cost of producing q0 is C2
k per period This occurs at the

tangency between the
C1
C3
isoquant and the total
cost curve
C2
k* The optimal
q0 choice is l*, k*
l per period
l*
44
Contingent Demand for Inputs
 we considered an individual’s
expenditure-minimization problem
 we used this technique to develop the
compensated demand for a good
 Can we develop a firm’s demand for
an input in the same way?
45
 In the present case, cost minimization
leads to a demand for capital and labor
that is contingent on the level of output
being produced
 The demand for an input is a derived
demand
 it is based on the level of the firm’s output
46
The Firm’s Expansion Path
 The firm can determine the cost-
minimizing 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 firm’s expansion path
47
The expansion path is the locus of cost-
minimizing tangencies
k per period The curve shows
how inputs
E increase as
output increases
q1
q0
q00
l per period
48
 The expansion path does not have to be
a straight line
 the use of some inputs may increase faster
than others as output expands
 depends on the shape of the isoquants
 The expansion path does not have to be
upward sloping
 if the use of an input falls as output
expands, that input is an inferior input
49
Cost Minimization
 Suppose that the production function is
Cobb-Douglas:
q = kl
 The Lagrangian expression for
cost minimization of producing
q0 is
L = vk + wl + (q0 - k  l )
50
Cost Minimization
 The first-order conditions for a
minimum are
L/k = v - k -1l = 0
L/l = w - k l -1 = 0
L/ = q0 - k  l  = 0
51
Cost Minimization
 Dividing the first equation by the
second gives us
w  k  l  1  k
  1 
   RTS
v k l  l
• This production function is

homothetic
– the RTS depends only on the ratio of
the two inputs
– the expansion path is a straight line 52
Cost Minimization
 Suppose that the production function is
CES:
q = (k  + l )/
 The Lagrangian expression for
cost minimization of producing
q0 is
L = vk + wl + [q0 - (k  + l )/]
53
Cost Minimization
 The first-order conditions for a
minimum are
L/k = v - (/)(k + l)(-)/()k-1 = 0
L/l = w - (/)(k + l)(-)/()l-1 = 0
L/ = q0 - (k  + l )/ = 0
54
Cost Minimization
 Dividing the first equation by the
second gives us
 1 1  1/ 
w  1 k  k 
     
v k  l l
• This production function is also

homothetic
55
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
C = C(v,w,q)
 As output (q) increases, total costs
increase
56
Average Cost Function
 The average cost function (AC) is
found by computing total costs per
unit of output
C (v , w , q )
average cost  AC (v , w , q ) 
q
57
Marginal Cost Function
 The marginal cost function (MC) is
found by computing the change in
total costs for a change in output
produced
C (v , w , q )
marginal cost  MC(v , w , q ) 
q
58
Graphical Analysis of
Total Costs
 Suppose that k1 units of capital and l1
units of labor input are required to
produce one unit of output
C(q=1) = vk1 + wl1
 To produce m units of output (assuming
constant returns to scale)
C(q=m) = vmk1 + wml1 = m(vk1 + wl1)
C(q=m) = m  C(q=1)
59
Total Costs
With constant returns to scale, total
Total
costs
costs
are proportional to output
AC = MC
C
Both AC and
MC will be
constant
Output
60
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 a third factor of production that
is fixed as capital and labor usage
expands
 total costs begin rising rapidly after
diminishing returns set in
61
Total Costs
Total C
costs
Total costs rise

dramatically as
output increases
after diminishing
returns set in
Output
62
Total Costs
Averag
e and MC is the slope of the C curve
margin
al
costs MC
If AC > MC,
AC AC must be
falling
If AC < MC,
min AC
AC must be
rising
Output
63
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
64
Some Illustrative Cost Functions
 Suppose we have a fixed proportions
technology such that
q = f(k,l) = min(ak,bl)
 Production will occur at the vertex of
the L-shaped isoquants (q = ak = bl)
C(w,v,q) = vk + wl = v(q/a) + w(q/b)
v w 
C (w , v , q )  a   
a b 
65
 Suppose we have a Cobb-Douglas
technology such that
q = f(k,l) = k l 
 Cost minimization requires that
w  k
 
v  l
 w
k   l
 v
66
 If we substitute into the production
function and solve for l, we will get
 /  
1/   
lq   w   /   v  /   

• A similar method will yield

 /  
1/   
k q   w  /   v  /   

67
 Now we can derive total costs as
1/    /    /  
C (v , w , q )  vk  w l  q Bv w
where
B  (    )   /       /   
which is a constant that involves

only
the parameters  and  68
 Suppose we have a CES technology
such that
q = f(k,l) = (k  + l )/
 To derive the total cost, we would use
the same method and eventually get
C (v , w , q )  vk  w l  q 1 /  (v  /  1  w  /  1 )(  1) / 
1/  1  1  1 / 1 
C (v , w , q )  q (v w )
69
Properties of Cost Functions
 Homogeneity
 cost functions are all homogeneous of
degree one in the input prices
 cost minimization requires that the ratio of
input prices be set equal to RTS, a doubling
of all input prices will not change the levels
of inputs purchased
 pure, uniform inflation will not change a
firm’s input decisions but will shift the cost
curves up
70
 Nondecreasing in q, v, and w
 cost functions are derived from a cost-
minimization process
 any decline in costs from an increase in one
of the function’s arguments would lead to a
contradiction
71
 Concave in input prices
 costs will be lower when a firm faces input
prices that fluctuate around a given level
than when they remain constant at that
level
 the firm can adapt its input mix to take
advantage of such fluctuations
72
Concavity of Cost Function
At w1, the firm’s costs are
C(v,w1,q1)
If the firm continues
to buy the same input
mix as w changes, its
Costs Cpseudo
cost function would be
Cpseudo
C(v,w,q1)
C(v,w1,q
1)
Since the firm’s input
mix will likely change,
actual costs will be
less than Cpseudo such
as C(v,w,q1)
w1 w
73
 Some of these properties carry over to
average and marginal costs
 homogeneity
 effects of v, w, and q are ambiguous
74
Input Substitution
 A change in the price of an input will
cause the firm to alter its input mix
 We wish to see how k/l changes in
response to a change in w/v, while
holding q constant
k 
 
l
w 
 
v 
75
Input Substitution
 Putting this in proportional terms as
(k / l ) w / v  ln( k / l )
s  
 (w / v ) k / l  ln( w / v )
gives an alternative definition of the
elasticity of substitution
– in the two-input case, s must be
nonnegative
– large values of s indicate that firms
change their input mix significantly if
input prices change 76
Partial Elasticity of Substitution
 The partial elasticity of substitution
between two inputs (xi and xj) with
prices wi and wj is given by
( x i / x j ) w j / w i  ln( x i / x j )
s ij   
 (w j / w i ) x i / x j  ln( w j / w i )
• Sij is a more flexible concept than 
because it allows the firm to alter
the usage of inputs other than xi
and xj when input prices change
77
Size of Shifts in Costs Curves
 The increase in costs will be largely
influenced by the relative
significance of the input in the
production process
 If firms can easily substitute
another input for the one that has
risen in price, there may be little
increase in costs
78
Technical Progress
 Improvements in technology also
lower cost curves
 Suppose that total costs (with
constant returns to scale) are
C0 = C0(q,v,w) = qC0(v,w,1)
79
Technical Progress
 Because the same inputs that produced
one unit of output in period zero will
produce A(t) units in period t
Ct(v,w,A(t)) = A(t)Ct(v,w,1)= C0(v,w,1)
 Total costs are given by
Ct(v,w,q) = qCt(v,w,1) = qC0(v,w,1)/A(t)
= C0(v,w,q)/A(t)
80
Shifting the Cobb-Douglas Cost
Function
 The Cobb-Douglas cost function is
1/    /    /  
C (v , w , q )  vk  w l  q Bv w
where
  /    /  
B  (    ) 
• If we assume  =  = 0.5, the
total cost curve is greatly
simplified:
C (v , w , q )  vk  w l  2 qv w
0 .5 0 .5
81
Function
 If v = 3 and w = 12, the relationship
is
C ( 3,12, q )  2 q 36  12 q
– C = 480 to produce q =40

– AC = C/q = 12
– MC = C/q = 12
82
Function
 If v = 3 and w = 27, the relationship
is
C ( 3,27, q )  2 q 81  18 q
– C = 720 to produce q =40

– AC = C/q = 18
– MC = C/q = 18
83
 Contingent demand functions for all
of the firms inputs can be derived
from the cost function
 Shephard’s lemma
 the contingent demand function for any
input is given by the partial derivative of
the total-cost function with respect to that
input’s price
84
 Suppose we have a fixed proportions
technology
 The cost function is
v w 
C (w , v , q )  a   
a b 
85
 For this cost function, contingent
demand functions are quite simple:
 C (v , w , q ) q
k (v , w , q ) 
c

v a
 C (v , w , q ) q
l (v , w , q ) 
c

w b
86
 Suppose we have a Cobb-Douglas
technology
 The cost function is
1/    /    /  
C (v , w , q )  vk  w l  q Bv w
87
 For this cost function, the derivation is
messier:
C  1/    /     /   
k (v ,w , q ) 
c
 q Bv w
v   
 /  
 1/    w 
 q B 
 v 
88
C 
l (v ,w , q ) 
c
  q 1/  Bv  /  w  /  
w   
  /  
 1/    w 
 q B 
 v 
 The contingent demands for inputs
depend on both inputs’ prices
89
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)
90
Short-Run Total Costs
 Short-run total cost for the firm is

SC = vk1 + wl
 There are two types of short-run
costs:
 short-run fixed costs are costs
associated with fixed inputs (vk1)
 short-run variable costs are costs
associated with variable inputs (wl)
91
 Short-run costs are not minimal
costs for producing the various
output levels
 the firm does not have the flexibility of
input choice
 to vary its output in the short run, the
firm must use nonoptimal input
combinations
 the RTS will not be equal to the ratio of
input prices
92
k per period
Because capital is fixed at k1,
the firm cannot equate RTS
with the ratio of input prices
k1
q2
q1
q0
l per period
l1 l2 l3
93
Short-Run Marginal and Average
Costs
 The short-run average total cost (SAC)
function is
SAC = total costs/total output = SC/q
 The short-run marginal cost (SMC)
function is
SMC = change in SC/change in output =
SC/q
94
Relationship between Short-Run and
Long-Run Costs
SC (k2)
Total
SC (k1)
cost
s C
SC (k0) The long-run

C curve can
be derived by
varying the
level of k
Output
q0 q1 q2
95
Long-Run Costs
Costs
SMC (k0) SAC (k0) MC The geometric

AC relationship
SMC (k1) SAC (k1)
between short-
run and long-ru
AC and MC can
also be shown
Output
q0 q1
96
Long-Run Costs
 At the minimum point of the AC curve:
 the MC curve crosses the AC curve
 MC = AC at this point
 the SAC curve is tangent to the AC curve
 SAC (for this level of k) is minimized at the
same level of output as AC
 SMC intersects SAC also at this point
AC = MC = SAC = SMC
97
Important Points to Note:
 A firm that wishes to minimize the
economic costs of producing a
particular level of output should
choose that input combination for
which the rate of technical
substitution (RTS) is equal to the
ratio of the inputs’ rental prices
98
 Repeated application of this
minimization procedure yields the
firm’s expansion path
 the expansion path shows how input
usage expands with the level of output
 it also shows the relationship between
output level and total cost
 this relationship is summarized by the total
cost function, C(v,w,q)
99
 The firm’s average cost (AC = C/q)
and marginal cost (MC = C/q) can
be derived directly from the total-
cost function
 if the total cost curve has a general
cubic shape, the AC and MC curves will
be u-shaped
100
 All cost curves are drawn on the
assumption that the input prices are
held constant
 when an input price changes, cost
curves shift to new positions
 the size of the shifts will be determined by
the overall importance of the input and the
substitution abilities of the firm
 technical progress will also shift cost
curves
101
 Input demand functions can be
derived from the firm’s total-cost
function through partial
differentiation
 these input demands will depend on the
quantity of output the firm chooses to
produce
 are called “contingent” demand functions
102
 In the short run, the firm may not be
able to vary some inputs
 it can then alter its level of production
only by changing the employment of its
variable inputs
 it may have to use nonoptimal, higher-
cost input combinations than it would
choose if it were possible to vary all
inputs
103
Long Run Cost Functions
Definition: The long run total cost function

relates minimized total cost to output, Q,
and to the factor prices (w and r).
TC(Q,w,r) = wL*(Q,w,r) + rK*(Q,w,r)
Where: L* and K* are the long run input

demand functions
104
As Quantity of
output increases
from 1 million to 2
million, with input
prices(w, r)
constant, cost
minimizing input
combination
moves from TC1 to
TC2 which gives
the TC(Q) curve.
105
What is the long run total cost function for production function Q =
50L1/2K1/2?
L*(Q,w,r) = (Q/50)(r/w)1/2
K*(Q,w,r) = (Q/50)(w/r)1/2
TC(Q,w,r) = w[(Q/50)(r/w)1/2]+r[(Q/50)(w/r)1/2]
= (Q/50)(wr)1/2 + (Q/50)(wr)1/2
= (Q/25)(wr)1/2
What is the graph of the total cost curve when w = 25 and r = 100?
TC(Q) = 2Q
106
A Total Cost Curve
TC ($ per year) TC(Q) = 2Q
$4M.
Q (units per year)
107
A Total Cost Curve
$2M.
Q (units per year)
1 M.
108
A Total Cost Curve
$4M.
$2M.
Q (units per year)
1 M. 2 M.
109
Long Run Total Cost Curve
Definition: The long run total cost curve

shows minimized total cost as output varies,
holding input prices constant.
Graphically, what does the total cost curve

look like if Q varies and w and r are fixed?
110
111
112
113
K
Q1
Q0
K1 • TC = TC0
K0
• TC = TC1
0
TC ($/yr) L0 L1
L (labor services per year)
Q (units per year)

0
114
K
Q1
Q0
K1 • TC = TC0
K0
• TC = TC1
TC ($/yr) 0 L0 L1
LR Total Cost Curve

TC0 =wL0+rK0
Q (units per year)

0 Q0
115
K
Q1
Q0
K1 • TC = TC0
TC ($/yr) K0
• TC = TC1
0 L0 L1
TC1=wL1+rK1
LR Total Cost Curve
TC0 =wL0+rK0
0 Q0 Q1 Q (units per year)

116
Graphically, how does the

total cost curve shift if
wages rise but the price of
capital remains fixed?
117
A Change in Input Prices
TC0/r
0 L
118
K
TC1/r
TC0/r
-w1/r
-w0/r
0 L
119
K
TC1/r
B
TC0/r •
A
•
-w1/r
-w0/r
0 L
K
TC1/r
B
TC0/r
•
A
• Q0
-w1/r
-w0/r
0 L
121
A Shift in the Total Cost Curve
TC ($/yr)
TC(Q) post
Q (units/yr)
TC ($/yr)
TC(Q) post
TC(Q) ante
Q (units/yr)
Chapter Eight 123
TC ($/yr)
TC(Q) post
TC(Q) ante
TC0
Q (units/yr)
124
TC ($/yr)
TC(Q) post
TC(Q) ante
TC1
TC0
Q0 Q (units/yr)
125
Input Price Changes
How does the total cost

curve shift if all input
prices rise (the same
amount)?
126
Long Run Average Cost Function
Definition: The long run average

cost function is the long run total
cost function divided by output, Q.
That is, the LRAC function tells us

the firm’s cost per unit of output…
AC(Q,w,r) = TC(Q,w,r)/Q
127
Long Run Marginal Cost Function
Definition: The long run marginal cost

function measures the rate of change
of total cost as output varies, holding
constant input prices.
MC(Q,w,r) =
{TC(Q+Q,w,r) – TC(Q,w,r)}/Q
= TC(Q,w,r)/Q
where: w and r are constant
128
Recall that, for the

production function
Q = 50L1/2K1/2, the
total cost function
was TC(Q,w,r) =
(Q/25)(wr)1/2. If w
= 25, and r = 100,
TC(Q) = 2Q.
129
a. What are the long run average and marginal cost

functions for this production function?
AC(Q,w,r) = (wr)1/2/25
MC(Q,w,r) = (wr)1/2/25
b. What are the long run average and marginal cost

curves when w = 25 and r = 100?
AC(Q) = 2Q/Q = 2.
MC(Q) = (2Q)/Q = 2.
130
Average & Marginal Cost Curves
AC, MC ($ per unit)
$2 AC(Q) =
MC(Q) = 2
Q (units/yr)
0
131
AC, MC ($ per unit)
$2 AC(Q) =
MC(Q) = 2
Q (units/yr)
0 1M
132
AC, MC ($ per unit)
$2 AC(Q) =
MC(Q) = 2
Q (units/yr)
0 1M 2M
133
Suppose that w and r are fixed:
When marginal cost is less than average

cost, average cost is decreasing in
quantity. That is, if MC(Q) < AC(Q), AC(Q)
decreases in Q.
134
When marginal cost is greater than

average cost, average cost is increasing in
quantity. That is, if MC(Q) > AC(Q), AC(Q)
increases in Q.
When marginal cost equals average cost,

average cost does not change with
quantity. That is, if MC(Q) = AC(Q), AC(Q)
is flat with respect to Q.
135
136
Economies & Diseconomies of Scale
Definition: If average cost decreases as

output rises, all else equal, the cost
function exhibits economies of scale.
Similarly, if the average cost increases as

output rises, all else equal, the cost
function exhibits diseconomies of scale.
Definition: The smallest quantity at which

the long run average cost curve attains its
minimum point is called the minimum
efficient scale.
137
Minimum Efficiency Scale (MES)
AC ($/yr) AC(Q)
Q (units/yr)
0 Q* = MES
138
Returns to Scale & Economies of Scale
When the production

function exhibits
increasing returns to
scale, the long run
average cost function
exhibits economies of
scale so that AC(Q)
decreases with Q, all else
equal. 139
Returns to Scale & Economies of Scale
• When the production function exhibits

decreasing returns to scale, the long run average
cost function exhibits diseconomies of scale so
that AC(Q) increases with Q, all else equal.
• When the production function exhibits

constant returns to scale, the long run average
cost function is flat: it neither increases nor
decreases with output.
140
Output Elasticity of Total Cost
Definition: The percentage change in total

cost per one percent change in output is
the output elasticity of total cost, TC,Q.
TC,Q = (TC/TC)(Q /Q)

= (TC/Q)/(TC/Q) = MC/AC
• If TC,Q < 1, MC < AC, so AC must be decreasing in Q.

Therefore, we have economies of scale.
• If TC,Q > 1, MC > AC, so AC must be increasing in Q.

Therefore, we have diseconomies of scale.
• If TC,Q = 1, MC = AC, so AC is just flat with respect to Q.
141
Short Run & Total Variable Cost Functions
Definition: The short run total cost function

tells us the minimized total cost of
producing Q units of output, when (at least)
one input is fixed at a particular level.
Definition: The total variable cost function

is the minimized sum of expenditures on
variable inputs at the short run cost
minimizing input combinations.
142
Total Fixed Cost Function
Definition: The total fixed cost function is a

constant equal to the cost of the fixed input(s).
STC(Q,K0) = TVC(Q,K0) + TFC(Q,K0)
Where: K0 is the fixed input and w and r are fixed

(and suppressed as arguments)
143
Key Cost Functions Interactions
TC ($/yr) Example: Short Run Total

Cost, Total Variable Cost and
Total Fixed Cost
TFC
Q (units/yr)
144

Total Fixed Cost
TVC(Q, K0)
TFC
Q (units/yr)
145

Total Fixed Cost
STC(Q, K0)
TVC(Q, K0)
TFC
Q (units/yr)
146

Total Fixed Cost
STC(Q, K0)
rK0 TVC(Q, K0)
TFC
rK0
Q (units/yr)
147
Long and Short Run Total Cost Functions
The firm can minimize costs at

least as well in the long run as
in the short run because it is
“less constrained”.
Hence, the short run total

cost curve lies everywhere
above the long run total cost
curve.
148
However, when the quantity is

such that the amount of the fixed
inputs just equals the optimal
long run quantities of the inputs,
the short run total cost curve and
the long run total cost curve
coincide.
149
TC0/r
0 L
TC0/w
150
K
TC1/r
TC0/r
K0 •B
0 L
TC0/w TC1/w
151
K
TC2/r
Q1
TC1/r
TC0/r C
•
A
K0 • •B
0 L
TC0/w TC1/w TC2/w
152
K
TC2/r
Q1
TC1/r Expansion Path
TC0/r C
Q0 • Q0
A
K0 • • B
0 L
TC0/w TC1/w TC2/w
153
Total Cost ($/yr) STC(Q,K0)
TC(Q)
K0 is the LR cost-minimising
quantity of K for Q0
0 Q0 Q1 Q (units/yr)
154
TC(Q)
A
TC0 •
155
TC(Q)
TC1 •C
A
TC0 •
156
TC(Q)
TC2 • B
TC1 •C
A
TC0 •
157
Short Run Average Cost Function
Definition: The Short run average cost

function is the short run total cost
function divided by output, Q.
That is, the SAC function tells us the

firm’s short run cost per unit of output.
SAC(Q,K0) = STC(Q,K0)/Q
Where: w and r are held fixed
158
Short Run Marginal Cost Function
Definition: The short run marginal cost

function measures the rate of change of
short run total cost as output varies,
holding constant input prices and fixed
inputs.
SMC(Q,K0)={STC(Q+Q,K0)–STC(Q,K0)}/Q
= STC(Q,K0)/Q
where: w,r, and K0 are constant
159
Summary Cost Functions
Note: When STC = TC, SMC = MC
STC = TVC + TFC

SAC = AVC + AFC
Where:
SAC = STC/Q
AVC = TVC/Q (“average variable cost”)
AFC = TFC/Q (“average fixed cost”)
The SAC function is the

VERTICAL sum of the AVC and
AFC functions
160
$ Per Unit
Example: Short Run

Average Cost, Average
Variable Cost and
Average Fixed Cost
AFC
0 Q (units per year)

161
$ Per Unit AVC
Example: Short Run

Variable Cost and
Average Fixed Cost
AFC

162
$ Per Unit SAC
AVC
Example: Short Run

Variable Cost and
Average Fixed Cost
AFC

163
$ Per Unit SAC
SMC AVC
Example: Short Run

Variable Cost and
Average Fixed Cost
AFC

164
$ per unit
SAC(Q,K3)
AC(Q)
•
• •

Q1 Q2 Q3
165
$ per unit
SAC(Q,K1)
AC(Q)
•
• •

Q1 Q2 Q3
166
$ per unit
SAC(Q,K1)
SAC(Q,K2) AC(Q)
•
• •

Q1 Q2 Q3
167
$ per unit
SAC(Q,K3)
SAC(Q,K1)
SAC(Q,K2) AC(Q)
•
• •

Q1 Q2 Q3
168
Example: Let Q = K1/2L1/4M1/4 and let L*(Q) = Q/8

w = 16, m = 1 and r = 2. For this M*(Q) = 2Q
production function and these input K*(Q) = 2Q
prices, the long run input demand curves
are:
Therefore, the long run total cost curve is:

TC(Q) = 16(Q/8) + 1(2Q) + 2(2Q) = 8Q
The long run average cost curve is:

AC(Q) = TC(Q)/Q = 8Q/Q = 8
169
Short Run Average Cost Function
Recall, too, that the short run total cost

curve for fixed level of capital K0 is:
STC(Q,K0) = (8Q2)/K0 + 2K0
If the level of capital is fixed at K0 what is

the short run average cost curve?
SAC(Q,K0) = 8Q/K0 + 2K0/Q
170
Cost Function Summary
$ per unit MC(Q)
Q (units per year)

0
171
$ per unit MC(Q)
AC(Q)
Q (units per year)

0
172
$ per unit MC(Q)
SAC(Q,K2) AC(Q)
•
SMC(Q,K )
•
1
Q (units per year)

0
Q1 Q2 Q3
173
MC(Q)
$ per unit MC(Q)
SAC(Q,K3)
SAC(Q,K1)
SAC(Q,K2) AC(Q)
•
SMC(Q,K )
• •
1
Q (units per year)

0
Q1 Q2 Q3
174
MC(Q)
$ per unit MC(Q)
SAC(Q,K3)
SAC(Q,K1)
SAC(Q,K2) AC(Q)
•
SMC(Q,K )
• •
1
Q (units per year)

0
Q1 Q2 Q3
175
Economies of Scope
Economies of Scope – a production characteristic in which
the total cost of producing given quantities of two goods in
the same firm is less than the total cost of producing those
quantities in two single-product firms.
Mathematically,
TC(Q1, Q2) < TC(Q1, 0) + TC(0, Q2)
Stand-alone Costs – the cost of producing a good in a

single-product firm, represented by each term in the right-
hand side of the above equation.
176
Economies of Experience
Economies of Experience – cost advantages that result from
accumulated experience, or, learning-by-doing.
Experience Curve – a relationship between average variable cost and
cumulative production volume
– used to describe economies of experience
– typical relationship is AVC(N) = ANB,
where N – cumulative production volume,
A > 0 – constant representing AVC of first unit produced,
-1 < B < 0 – experience elasticity (% change in AVC for
every 1% increase in cumulative volume
– slope of the experience curve tells us how much AVC
goes down (as a % of initial level), when cumulative
output doubles
177
Estimating Cost Functions
Total Cost Function – a mathematical relationship that shows how
total costs vary with factors that influence total costs, including
the quantity of output and prices of inputs.
Cost Driver – A factor that influences or “drives” total or average

costs.
Constant Elasticity Cost Function – A cost function that specifies

constant elasticity of total cost with respect to output and input
prices.
Translog Cost Function – A cost function that postulates a

quadratic relationship between the log of total cost and the logs
of input prices and output.
178

Cost MCON 2022

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Cost MCON 2022

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MICROECONOMICS

1) whether or not to shut down

CHECK: produce in SR?

 Opportunity vs. accounting cost

Marginal Cost (MC) is the cost of

VC TC dTC

Q TFC TC TVC AFC AVC AC MC

 The relationship between the

 With decreasing returns, output

 LMC always LMC

Marginal condition Check whether to

One of the first decisions to be made

The LAC is a graph that shows the different scales on

However, economies of scale occur when

 A cost related concept

b) Internal economies of scale

Each plant size

Each individual scale of

 A firm can not expect always to achieve

 Economies of scope exist when

 the average total cost of

 The degree of economies of scope

 The horizontal axis

$100 isocost $150 isocost

$50 isocost $100 isocost $150 isocost

rK  C  wL Note that if C is constant—as

k per period This occurs at the

• This production function is

• This production function is also

 Suppose instead that total costs

Total costs rise

 The cost curves are drawn under

• A similar method will yield

which is a constant that involves

– C = 480 to produce q =40

– C = 720 to produce q =40

 Short-run total cost for the firm is

SC (k0) The long-run

SMC (k0) SAC (k0) MC The geometric

Definition: The long run total cost function

TC(Q,w,r) = wL*(Q,w,r) + rK*(Q,w,r)

Where: L* and K* are the long run input

TC ($ per year) TC(Q) = 2Q

Q (units per year)

TC ($ per year) TC(Q) = 2Q

Q (units per year)

TC ($ per year) TC(Q) = 2Q

Q (units per year)

Definition: The long run total cost curve

Graphically, what does the total cost curve

Q (units per year)

LR Total Cost Curve

Q (units per year)

0 Q0 Q1 Q (units per year)

Graphically, how does the

How does the total cost

Definition: The long run average

That is, the LRAC function tells us

Definition: The long run marginal cost

where: w and r are constant

Recall that, for the

a. What are the long run average and marginal cost

b. What are the long run average and marginal cost

TC(Q,w,r) = wL(Q,w,r) + rK(Q,w,r)