MICROECONOMICS I

Lecture 13: Cost Curves (Ch. 21)

May 29, 2023

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Motivation
• We have looked at the behavior of a profit-maximizing firm for a given
output price 𝑝.
• Optimal production plan 𝑥1∗ , 𝑥2∗ ; 𝑦 ∗
• So where does 𝒑 come from?

• We have taken a step back and looked at cost minimization.

• Conditional factor demand functions 𝑥1∗ 𝑤1 , 𝑤2 , 𝑦 and 𝑥1∗ 𝑤1 , 𝑤2 , 𝑦 ,
which do not (directly) depend on 𝑝.
• So where does 𝒚 come from?

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Motivation
• To understand where 𝑦 and 𝑝 come from, we need to understand
competitive markets.

• But before we can come to that, we need to think harder about the
firms‘ cost structure.

• For that, cost curves are helpful.

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Motivating example: newspapers
• Cost structure (and, thus, cost curves) is important for understanding
what is happening in different industries

• We will take a short look at the newspaper industry as well as the digital
industry in the US

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Paid circulation of daily newspapers in US

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Revenues of US newspaper publishers

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Number of US newspapers

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Newspaper ownership concentration

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Competing daily newspapers in the US
• What do these numbers tell us?
• Apparently, newspapers cannot simply shrink in proportion to
the market
• And/or, the tendency goes towards bigger outlets

• Why is that?
• High fixed costs, low marginal/variable costs
• Increasing fixed costs and/or decreasing marginal variable costs
over time

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Digital industries (2010)

“The Internet has long been held up as a model for what the free market is
supposed to look like — competition in its purest form. So why does it look
increasingly like a Monopoly board? Most of the major sectors today are
controlled by one dominant company or an oligopoly. Google ‘owns’ search;
Facebook, social networking; eBay rules auctions; Apple dominates online
content delivery; Amazon, retail; and so on.”

Tim Wu: “In the grip of the Internet monopolists,” Wall Street Journal, 2010.

➢ Besides high fixed costs and low marginal costs,

there are also be important network effects.
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Fixed and variable costs
• Fixed costs
• Costs that are associated with fixed factors and independent of the level of output (𝐹)
• Must be paid regardless of the level of output

• Quasi-fixed costs
• Costs that are associated with quasi-fixed factors and independent of the level of
output
• Must be paid only if the level of output is positive

• Sunk costs
• Irrecuperable fixed costs. Have already been incurred

• Variable costs
• Costs that vary with the level of production (𝑣𝑐 𝑦 )
• In the short run they could be the costs of using the factor labor
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The cost function 𝑐(𝑦)
• Reminder: cost function c(𝑤1 , 𝑤2 , 𝑦) is the minimum cost of producing
output level 𝑦 when factor prices are (𝑤1 , 𝑤2 ).

• In today’s lecture, we fix 𝒘𝟏 , 𝒘𝟐 → we can then write the cost function

simply as 𝐜 𝒚 .

• Our focus:
• Average costs (variable, fixed, total)
• Marginal costs
• Short vs. long run cost functions

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Average cost
• The average cost function (AC(𝑦)) measures the cost per unit of
production.

• The average variable cost function (AVC(𝑦)) measures the variable cost
per unit of production.

• The average fixed cost function (AFC(𝑦)) measures the fixed cost per
unit of production.

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Average fixed and variable costs

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Fixed and variable costs

Copyright © 2019 Hal R. Varian

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Average fixed cost curve
AFC 𝑦 = 𝐹ൗ𝑦

Copyright © 2019 Hal R. Varian

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Average variable cost curve
𝑐𝑣 𝑦
AVC 𝑦 =
𝑦

Copyright © 2019 Hal R. Varian

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Average total cost curve
𝐹 + 𝑐𝑣 𝑦
ATC 𝑦 = AFC 𝑦 + AVC 𝑦 =
𝑦

Copyright © 2019 Hal R. Varian

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Average cost curves
𝐹 + 𝑐𝑣 𝑦
ATC 𝑦 = AFC 𝑦 + AVC 𝑦 =
𝑦

Figure 21.1 from Varian (2010), p. 379

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Marginal cost function
• The marginal cost is the rate of change of variable production cost as
the output level changes

𝜕𝑐𝑣 𝑦
MC 𝑦 =
𝜕𝑦

• Remember: 𝑐 𝑦 = 𝐹 + 𝑐𝑣 𝑦

• Thus:

𝜕𝑐 𝑦 𝜕𝑐𝑣 𝑦
= = MC 𝑦
𝜕𝑦 𝜕𝑦

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Marginal and variable cost
𝑦
𝑐𝑣 𝑦 = න MC 𝑦෤ d𝑦෤
0

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Marginal cost and average variable cost
• How does the average variable cost change when output marginally increases?

𝑐𝑣 𝑦
𝜕AVC 𝑦 𝜕 MC 𝑦 𝑦 −𝑐𝑣 𝑦
𝑦
= =
𝜕𝑦 𝜕𝑦 𝑦2

• Thus:

< 0 if MC 𝑦 < AVC 𝑦

𝜕AVC 𝑦
൞= 0 if MC 𝑦 = AVC 𝑦
𝜕𝑦
> 0 if MC 𝑦 > AVC 𝑦

• The MC curve intersects the AVC curve from below at the AVC curve’s minimum
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Marginal cost and average variable cost

Copyright © 2019 Hal R. Varian

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Marginal cost and average variable cost

Copyright © 2019 Hal R. Varian

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Marginal cost and average variable cost

Copyright © 2019 Hal R. Varian

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Marginal cost and average total cost
• How does the average total cost change when output marginally increases?

𝐹 + 𝑐𝑣 𝑦
𝜕ATC 𝑦 𝜕 MC 𝑦 𝑦 − 𝐹 − 𝑐𝑣 𝑦
𝑦
= =
𝜕𝑦 𝜕𝑦 𝑦2

• Thus:

< 0 if MC 𝑦 < ATC 𝑦

𝜕ATC 𝑦
൞= 0 if MC 𝑦 = ATC 𝑦
𝜕𝑦
> 0 if MC 𝑦 > ATC 𝑦

• The MC curve intersects the ATC curve from below at the ATC curve’s minimum
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Marginal cost and average total cost

Copyright © 2019 Hal R. Varian

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Marginal cost and total cost

• The intercepts of the MC and

AVC curves coincide
• If the MC initially decrease, the
AVC initially decrease
• With strictly positive fixed cost,
the ATC initially decreases
• The MC curve passes through
the minima of the AVC and
ATC curves

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Example I

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Example I

c(y)

VC(y)

FC

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Example I

MC(y)

AC(y)

AVC(y)

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Example I
MC(y) = AVC(y)
c(y)
MC(y) = AC(y)

VC(y)

FC

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Short run vs. long run
• In the short run:
• the amounts of some input factors are fixed
• we can have strictly positive fixed costs

• In the long run:

• the amounts of input factors are variable
• there might still be quasi-fixed costs

• Since there are more opportunities of optimizing: long-run costs (as

functions of output) must be weakly lower than short-run costs

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Short- vs. long-run cost functions
• Long-run cost function:

𝑐 𝑦 = 𝑐𝑆 𝑦, 𝑘 𝑦

• Fix some level of output 𝑦 ∗ and define 𝑘 ∗ = 𝑘 𝑦 ∗ . Then:

𝑐 𝑦 ∗ = 𝑐𝑆 𝑦 ∗ , 𝑘 𝑦 ∗ = 𝑐𝑆 𝑦 ∗ , 𝑘 ∗

• Generally, for any output level 𝑦:

𝑐 𝑦 ≤ 𝑐𝑆 𝑦, 𝑘 ∗

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Short- vs. long-run average cost

• The SAC curve is tangent to the LAC curve where the level of the fixed input factor
is equal to its long-run optimum (where 𝑘 ∗ = 𝑘 𝑦 , i.e., at 𝑦 ∗ ).

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Short- vs. long-run cost functions
With continuous units of factor 2

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

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Short- vs. long-run cost functions
With discrete units of factor 2

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

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Short- vs. long-run cost functions
With discrete units of factor 2

➢ The long-run MC curve consists of the relevant segments

of the short-run MC curves
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Cost functions and returns to scale

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Cost functions and returns to scale

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Cost functions and returns to scale

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Cost functions and returns to scale

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Cost functions and returns to scale
𝑐 𝑤1 , 𝑤2 , 𝑦
average cost =
𝑦

• Constant returns to scale: average cost is constant

• Increasing returns to scale: average cost is decreasing

• Decreasing returns to scale: average cost is increasing

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Cost functions and returns to scale
$/output unit

AC(y)

decreasing r.t.s.

constant r.t.s.

increasing r.t.s.

y
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Total cost functions and returns to scale

Figure 1 Figure 2 Figure 3 Figure 4

• Figure 1: decreasing returns to scale

• Figure 2: constant returns to scale

• Figure 3: increasing returns to scale

• Figure 4: increasing (𝑌 < 𝑌 ′ ), constant (𝑌 = 𝑌 ′ ), and

decreasing (𝑌 > 𝑌 ′ ) returns to scale
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Thanks. See you next week!

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