Cost of Prodn PR8e GE Ch07

CHAPTER 7
The Cost of CHAPTER OUTLINE

Production 7.1 Measuring Cost: Which Costs
Matter?
7.2 Costs in the Short Run
7.3 Costs in the Long Run
7.4 Long-Run versus Short-Run Cost
Curves
7.5 Production with Two Outputs—
Economies of Scope
7.6 Dynamic Changes in Costs—The
Learning Curve
7.7 Estimating and Predicting Cost
Appendix: Production and Cost
Theory—A Mathematical Treatment
Prepared by:
Fernando Quijano, Illustrator
Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 1 of 55

Question 1
Draw a graph that shows marginal cost, average variable cost, and average total
cost in the short-run, with cost on the vertical axis and quantity on the horizontal
axis.
• Question 2
• Ramesh quits his job, where he was earning a salary of Rs 50,000 per month,
to start his own business in a building that he owns and was previously
renting out for Rs 24,000 per month.
• In his first month of his business, he has the following expenses:

(i) salary paid to himself= Rs 40,000
(ii) Rent=Rs0
(iii) other expenses=Rs 25,000.
Find the accounting cost and the economic cost associated with Ramesh’s
business.

Short-run cost functions
• Cost function is very useful because it provides essential
information a manager needs to determine profit
maximizing level of output.
• It also summarizes information about the production
process.
• Like production functions, we can have short-run and
long-run cost functions.
• Short-run is a period during which the manager is able
change the use of variable inputs but cannot change the
fixed inputs.
• Total cost (TC) of producing output(q) in the short-run
consists of (i) the cost of fixed inputs and (ii) the cost of
variable inputs.
• These two components of short-run total cost are called
fixed costs and variable costs, respectively.
Short-run cost functions
• Fixed costs are the costs incurred by a firm for fixed

inputs (capital). They do not vary with output.
• Variable costs are the cost incurred by a firm for variable
inputs (labour). They vary with output.
• The sum of fixed costs and variable costs is the total cost.
• The short-run cost function summarizes the minimum
cost of producing each level of output when one input is
variable and another input is fixed.
• TC=f (q)

Marginal and Average Cost
TABLE 7.1 A FIRM’S COSTS
AVERAGE
RATE OF VARIABLE MARGINAL AVERAGE AVERAGE
FIXED COST TOTAL COST VARIABLE
OUTPUT COST COST FIXED COST TOTAL COST
(DOLLARS (DOLLARS COST
(UNITS (DOLLARS (DOLLARS (DOLLARS (DOLLARS
PER YEAR) PER YEAR) (DOLLARS
PER YEAR) PER YEAR) PER UNIT) PER UNIT) PER UNIT)
PER UNIT)
(FC) (1) (VC) (2) (TC) (3) (MC) (4) (AFC) (5) (AVC) (6) (ATC) (7)
0 50 0 50 — — — —
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
AVERAGE
PER UNIT)
0 50 0 50 — — — —
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
AVERAGE
PER UNIT)
0 50 0 50 — — — —
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
AVERAGE
PER UNIT)
0 50 0 50 — — — —
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
AVERAGE TOTAL COST (ATC)
● average fixed cost (AFC) Fixed cost divided by the level of output.
● average variable cost (AVC) Variable cost divided by the level of output.
𝑞
AVC = 𝑇VCΤ𝑞 = 𝑤 ∗ LΤ𝑞 = 𝑤ൗ( ) = 𝑤ΤAP𝐿
𝐿
● average total cost (ATC) Firm’s total cost divided by its level of output.

MARGINAL COST (MC)
● marginal cost (MC) Increase in cost resulting from the production of one
extra unit of output.
∆𝑞
MC = ∆TCΤ∆𝑞 = ∆VCΤ∆𝑞 = ∆VCΤ∆𝑞 = 𝑤 ∗ ∆𝐿Τ∆𝑞 = 𝑤Τ( ) = 𝑤ΤMP𝐿
∆𝐿
Because fixed cost does not change as the firm’s level of output changes,
marginal cost is equal to the increase in variable cost or the increase in total
cost that results from an extra unit of output. We can therefore write marginal
cost as

𝑞
AVC = 𝑇VCΤ𝑞 = 𝑤 ∗ LΤ𝑞 = 𝑤ൗ( ) = 𝑤ΤAP𝐿
𝐿
∆𝑞
MC = ∆TCΤ∆𝑞 = ∆VCΤ∆𝑞 = ∆VCΤ∆𝑞 = 𝑤∆𝐿Τ∆𝑞 = 𝑤Τ(∆𝐿 ) = 𝑤ΤMP𝐿

When average cost is at a minimum,
𝐦𝐚𝐫𝐠𝐢𝐧𝐚𝐥 𝐜𝐨𝐬𝐭 𝐞𝐪𝐮𝐚𝐥𝐬 𝐚𝐯𝐞𝐫𝐚𝐠𝐞 𝐜𝐨𝐬𝐭𝐬.

7.1 Measuring Cost: Which Costs
Matter?
Economic Cost versus Accounting Cost
● Accounting Cost: Accounting cost of production is the actual cost incurred by a firm
to produce goods and services. It includes expenses on labour, raw materials etc.
Suppose you spend Rs 2,00,000 for labour, and 1,00,000 for raw materials. Then your
accounting cost will be Rs, 3, 00, 000. It is also known as explicit cost, as there is
actual cash outflow.
● Opportunity cost: Opportunity cost of production is the value of goods and services that
could be obtained in their best alternative use (or value of the best alternatives foregone).
It is the cost of utilizing economic resources in production.
It includes both explicit (or accounting) cost of resources and implicit cost of giving up the
best alternative use of the resources.
Explicit costs: When you spend Rs 3, 00, 000 to buy raw materials and labour to
produce ice cream, you are giving up the opportunity to produce something else. It costs
you the opportunity to produce sth else. You could have spent Rs 3,00,000 to buy some
other resources to produce sth else. So the explicit costs are part of opportunity cost of
production.
Implicit Costs: Opportunity cost also includes implicit costs (no actual cash outflows).
Suppose you are the manager of your company, but you do not take any salary. Similarly,
you own a building and use it for your office space, but do not take any rent.
What is the (opportunity) cost of using your own labour and building? Suppose you could
have earned Rs 1,00, 000 if you had worked in another company. Similarly, you could
have earned Rs 50,000, had you rented your own building.
Matter?
Economic Cost versus Accounting Cost
• ●So the cost of using your own labour and building is Rs 1, 50, 000 (1, 00, 000 is
“foregone” income +Rs 50,000 is “foregone” rent).
• Accordingly, the opportunity cost of producing ice cream is the sum of labour cost (Rs
2,00,000), raw material cost (Rs, 1, 00,000), foregone income (Rs1, 00,000), and
foregone rent (RS 50,000). It is 4,50,000.
• In contrast, accounting cost is only labour cost (Rs, 2, 00,000) and rawmaterial cost
(1, 00,000). It is Rs 3, 00, 000.
• The opportunity cost is also known as economic cost, as it measures the cost of
utilizing economic resources. It consider all costs relevant to production.
• The economic or opportunity cost is the sum of the cost of using resources (i) bought
in the market and (ii) supplied by the firms owners.
• Although an opportunity cost is often hidden, it should be taken into account when
making economic decisions.
Economic cost = Opportunity cost

Matter?
Fixed Costs and Sunk Costs
• Fixed cost A fixed cost is the cost incurred by a firm for its fixed inputs. It does not
change when output changes.
• Sunk cost A sunk cost is a cost that has been made by firm and is lost forever
(cannot be recovered).
• Suppose you decide to lease a truck for a year at Rs, 3,00,000 last year. As per the
lease agreement, last year you paid a commitment fee of Rs 1,00,000, which is not
refundable. You have to pay remaining amount of Rs 2,00,000 when you use it.
• Rs 3, 00, 000 is a fixed cost because it remains the same regardless of whether you
use it to transport 10 or 100 tons of coal.
• What about the sunk cost? How much of this 3,00,000 is sunk cost? If it does not
permit you to recover any of the 3,00,000, the entire 3,00,000 is a sunk cost. However,
as per the agreement, you will be refunded 2,00,000 if you decide not to use the truck,
then only 1,00,000 of the 3,00,000 in the fixed cost is the sunk cost.
• Sunk costs are the amount of the fixed costs that cannot be recovered.
• Fixed costs can be avoided if the firm shuts down a plant or goes out of business.( by
selling fixed inputs if you go out of business)
• Sunk costs, on the other hand, are costs that have been incurred and cannot be
recovered. (although you try to rocoup your investment and make profit through prodn
later)
• Because a sunk cost cannot be recovered, it should not influence the firm’s decisions.
• Suppose you come to know another truck owner is willing to lease a truck at Rs
2,50,000. Will you go for the first truck or the second truck? (the issue is not between
3,00,000 and 2, 50,000. The issue is between 2,00,000 and 2, 50,000). What if the
Copyright ©second truck isEducation
2015 Pearson available at 1, 90,000? • Pindyck/Rubinfeld, 8e, GE
• Microeconomics 19 of 55
Matter?
• Fixed cost A fixed cost is the cost incurred by a firm for its fixed inputs. It does not
change when output changes.
• Sunk cost A sunk cost is a cost that has been made by firm and is lost forever
(cannot be recovered).
• The relative sizes of sunk, fixed and variable costs can vary considerably across
industries.
• (i) Personal Computer Industry:
• Most of their costs are variable.
• Their cost increases in proportion to the number of computers they produce.
• Most important is the cost of components: the microprocessor, memory chips, hard
disk drives etc.
• Another important cost is labour as workers are needed to assemble computers and
then package and ship them.
• There is little in the way of fixed and sunk cost.
• To keep the cost of the production low, they strive hard to get better prices for
components and reducing the labour requirement.

Matter?
• (ii) Computer software industry:
• Most of the costs are sunk.
• A software company (Microsoft) spend a large amount of money to develop a new
application program.
• These expenditures cannot be recovered.
• Once the program is completed, the company can try to recoup its investment be
selling as many copies of the program as possible.
• The variable cost of producing copies of the program is very small (cost of copying the
program to CDs and then packaging and shipping the product)
• The fixed cost pf production is very small.
• Because most costs are sunk, it is very risky to enter a software business.
• (iii) The Pizzeria business:
• Most of the costs are fixed. It incurs cost on pizza ovens, chairs, tables, dishes etc. It
also incurs cost on rent, and utilities.
• Sunk costs are very low because it can sell these fixed inputs if goes out of business.
• Variable costs are also very low (costs of ingredients for pizza flour, tomato sauce,
cheese etc, say Rs 30 and wages of a couple workers to help produce, serve, and
deliver pizzas).
• Because of these high fixed costs, they may charge between Rs 200 to Rs 300.

Question 1
Draw a graph that shows marginal cost, average variable cost, and average total
cost, with cost on the vertical axis and quantity on the horizontal axis.
• Question 2
• Ramesh quits his job, where he was earning a salary of Rs 50,000 per month,
to start his own business in a building that he owns and was previously
renting out for Rs 24,000 per month.
• In his first month of his business, he has the following expenses:

(i) salary paid to himself= Rs 40,000
(ii) Rent=Rs0
(iii) other expenses=Rs 25,000.
Find the accounting cost and the economic cost associated with Ramesh’s
business.
• © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE

Copyright 22 of 55
•The accounting cost includes only the explicit expenses, which are
Ramesh’s salary and his other expenses: Rs 40,000 + 25,000 = Rs65,000.
• Economic cost includes these explicit expenses plus opportunity costs.

Therefore, economic cost includes the Rs 24,000 Ramesh gave up by not
renting the building and an extra Rs10,000 because he paid himself a salary
Rs 10,000 below market (Rs 50,000 - 40,000). Economic cost is then Rs
40,000 + 25,000 + 24,000 + 10,000 = Rs 99,000.

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CHAPTER 7

The Cost of CHAPTER OUTLINE

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 1 of 55

• In his first month of his business, he has the following expenses:

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 2 of 55

• Fixed costs are the costs incurred by a firm for fixed

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 4 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 9 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 13 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 14 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 16 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 18 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 20 of 55

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 21 of 55

• In his first month of his business, he has the following expenses:

• © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE

• Economic cost includes these explicit expenses plus opportunity costs.

Copyright © 2015 Pearson Education • Microeconomics • Pindyck/Rubinfeld, 8e, GE 23 of 55

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