Chapter 6

The Cost of Production

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 Chapter outline

• Measuring Cost: Which Costs Matter?

• Cost in the Short Run
• Cost in the Long Run
• Long-Run Versus Short-Run Cost Curves

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 Measuring Cost: Which Costs
Matter?
• For a firm to minimize costs, we must clarify what is meant by
costs and how to measure them
• It is clear that if a firm has to rent equipment or buildings, the
rent they pay is a cost
• What if a firm owns its own equipment or building?
• How are costs calculated here?

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 Measuring Cost: Which Costs Matter?
• Accountants tend to take a retrospective view of firms’ costs,
whereas economists tend to take a forward-looking view
• Accounting Cost
• Actual expenses plus depreciation charges for capital
equipment
• Economic Cost
• Cost to a firm of utilizing economic resources in production,
including opportunity cost

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 Measuring Cost: Which Costs Matter?
• Economic costs distinguish between costs the firm can
control and those it cannot
• Concept of opportunity cost plays an important role
• Opportunity cost
• Cost associated with opportunities that are foregone when
a firm’s resources are not put to their highest-value use

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 Opportunity Cost
• An Example
• A firm owns its own building and pays no rent for office
space
• Does this mean the cost of office space is zero?
• The building could have been rented instead
• Foregone rent is the opportunity cost of using the
building for production and should be included in the
economic costs of doing business

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 Opportunity Cost
• A person starting their own business must take into account
the opportunity cost of their time
• Could have worked elsewhere making a competitive
salary
• Accountants and economists often treat depreciation
differently as well

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 Measuring Cost: Which Costs Matter?

• Although opportunity costs are hidden and should be taken

into account, sunk costs should not
• Sunk Cost
• Expenditure that has been made and cannot be recovered
• Should not influence a firm’s future economic decisions

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 Sunk Cost
• Firm buys a piece of equipment that cannot be converted to
another use
• Expenditure on the equipment is a sunk cost
• Has no alternative use so cost cannot be recovered –
opportunity cost is zero
• Decision to buy the equipment might have been good or
bad, but now does not matter

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 Measuring Cost: Which Costs Matter?

• Some costs vary with output, while some remain the

same no matter the amount of output
• Total cost can be divided into:
1. Fixed Cost
• Does not vary with the level of output
2. Variable Cost
• Cost that varies as output varies

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 Fixed and Variable Costs

• 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

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 Fixed and Variable Costs

• Which costs are variable and which are fixed depends on the
time horizon
• Short time horizon – most costs are fixed
• Long time horizon – many costs become variable
• In determining how changes in production will affect costs,
must consider if fixed or variable costs are affected.

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 Fixed Cost Versus Sunk Cost
• Fixed cost and sunk cost are often confused
• Fixed Cost
• Cost paid by a firm that is in business regardless of the
level of output
• Sunk Cost
• Cost that has been incurred and cannot be recovered

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 Marginal and Average Cost
• In completing a discussion of costs, must also distinguish
between
• Average Cost
• Marginal Cost
• After definition of costs is complete, one can consider the
analysis between short-run and long-run costs

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 Measuring Costs
• Marginal Cost (MC):
• The cost of expanding output by one unit
• Fixed costs have no impact on marginal cost, so it can be
written as:

ΔVC ΔTC
MC  
Δq Δq

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 Measuring Costs
• Average Total Cost (ATC)
• Cost per unit of output
• Also equals average fixed cost (AFC) plus average
variable cost (AVC)

TC
ATC   AFC  AVC
q

TC TFC TVC
ATC   
q q q

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 A Firm’s Short Run Costs

Rate of Fixed Variable Total Marginal Average Fixed Average Variable Average Total
output Cost Cost Cost Cost Cost Cost Cost
Q FC VC TC=FC+VC MC AFC=FC/Q AVC=VC/Q ATC=TC/Q
0 50 0 50 - - - -
1 50 50 100 50 50.0 50.0 100.0
2 50 78 128 28 25.0 39.0 64.0
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28.0 40.5
5 50 130 180 18 10.0 26.0 36.0
6 50 150 200 20 8.3 25.0 33.3
7 50 175 225 25 7.1 25.0 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 5.0 30.0 35.0
11 50 385 435 85 4.5 35.0 39.5

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 Determinants of Short Run Costs
•The rate at which variable and total costs increase depends on
the nature of the production process
• The extent to which production involves diminishing
returns to variable factors
oDiminishing returns to labor: When marginal product of
labor is decreasing
• If labor is only variable input: to produce more output,
firm must hire more labor.

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 Determinants of Short Run Costs (cont.)
• If marginal product of labor decreases significantly as more labor
is hired
 Costs of production increase rapidly
 Greater and greater expenditures must be made to produce more
output
• If marginal product of labor decreases only slightly as increase
labor
 Costs will not rise very fast when output is increased

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 Determinants of Short Run Costs (cont.)
• MC is the change in variable cost for a one-unit change in output.
VC wL
MC  
q q

• The change in variable cost is the per-unit cost of the extra labor w
times the amount of extra labor needed to produce the extra output ΔL.
VC wL
MC  
q q

Q
• Remembering that MPL 
L

L 1
• And rearranging L for a 1 unit Q 
Q

MPL

• We can conclude:

• low marginal product leads to a high MC and vice versa

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Diminishing Marginal Returns and Marginal Cost
• Diminishing marginal returns means that the marginal product of labor
declines as the quantity of labor employed increases.
• As a result, when there are diminishing marginal returns, marginal cost
will increase as output increases.
• MC decreases initially: 0 through 4 units of output
• MC increases : 5 through 11 units of output
Rate of Variable Total Marginal Average Fixed Average Variable Average Total
Fixed Cost
output Cost Cost Cost Cost Cost Cost
Q FC VC TC=FC+VC MC AFC=FC/Q AVC=VC/Q ATC=TC/Q
0 50 0 50 - - - -
1 50 50 100 50 50.0 50.0 100.0
2 50 78 128 28 25.0 39.0 64.0
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28.0 40.5
5 50 130 180 18 10.0 26.0 36.0
6 50 150 200 20 8.3 25.0 33.3
7 50 175 225 25 7.1 25.0 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 5.0 30.0 35.0
11 50 385 435 85 4.5 35.0 39.5

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 The shapes of Cost Curves

Rate of Variable Total

Fixed Cost
output Cost Cost

Q FC VC TC=FC+VC

0 50 0 50

1 50 50 100

2 50 78 128

3 50 98 148

4 50 112 162

5 50 130 180

6 50 150 200

7 50 175 225

8 50 204 254

9 50 242 292

10 50 300 350

11 50 385 435

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 The shapes of Cost Curves
•Fixed cost FC does not
vary with output-it is
shown as a horizontal line
at $50.
•Variable cost VC is zero
when output is zero and
then increases contin-
uously as output increases.
•The total cost curve TC is
determined by vertically
adding the fixed cost curve
to the variable cost curve.
•Because fixed cost is
constant, the vertical
distance between the two
curves is always $50

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 The shapes of Cost Curves(cont.)

Rate
Margi Average Average Average
of
nal Fixed Variable Total
outp
Cost Cost Cost Cost
ut
Q MC AFC AVC ATC
0 - - - -
1 50 50.0 50.0 100.0
2 28 25.0 39.0 64.0
3 20 16.7 32.7 49.3
4 14 12.5 28.0 40.5
5 18 10.0 26.0 36.0
6 20 8.3 25.0 33.3
7 25 7.1 25.0 32.1
8 29 6.3 25.5 31.8
9 38 5.6 26.9 32.4
10 58 5.0 30.0 35.0
11 85 4.5 35.0 39.5

24
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 The shapes of Cost Curves(cont.)
•Because total fixed cost is
$50, the average fixed cost
curve AFC falls continuously
from $50 when output is 1,
toward zero for large output.
•The shapes of the remaining
curves are determined by the
relationship between the
marginal and average cost
curves.
•Whenever marginal cost lies
below average cost, the
average cost curve falls.
Whenever marginal cost lies
above average cost, the
average cost curve rises.
•Marginal cost MC crosses the
average variable cost and
average total cost curves at
their minimum points.
25
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 The Average – Marginal relationship

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 Cost in the Long Run

• In the long run a firm can change all of its inputs

• In making cost minimizing choices, must look at
the cost of using capital and labor in production
decisions

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 Cost in the Long Run (cont.)
USER COST OF CAPITAL
•Capital is either rented/leased or purchased
• We will consider capital rented as if it were purchased
•Assume Delta is considering purchasing an airplane for $150 million
• Plane lasts for 30 years
• $5 million per year – economic depreciation for the plane
•Delta needs to compare its revenues and costs on an annual basis
•If the firm had not purchased the plane, it would have earned interest on
the $150 million
•Forgone interest is an opportunity cost that must be considered
•The user cost of capital must be considered
• Def: The annual cost of owning and using the asset instead of selling or never
buying it
• Sum of the economic depreciation and the interest (the financial return) that
could have been earned had the money been invested elsewhere

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 Cost in the Long Run
• User Cost of Capital = Economic Depreciation + (Interest Rate)*(Value of Capital)
• = $5 mil + (.10)($150 mil – depreciation)
• Year 1 = $5 million + (.10)($150 million) = $20 million
• Year 10 = $5 million +(.10)($100 million) = $15 million

• User cost can also be described as:

• Rate per dollar of capital, r
• r = Depreciation Rate + Interest Rate
• In our example, depreciation rate was 3.33% and interest was 10%, so
• r = 3.33% + 10% = 13.33%

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 Cost Minimizing Input Choice
• How do firm select inputs to produce a given output at minimum
cost?
• Assumptions
• Two Inputs: Labor (L) and capital (K)
• Price of labor: wage rate (w)
• The price of capital

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 Cost in the Long Run (cont.)
The Iso-cost Line
•A line showing all combinations of L & K that can be purchased for the
same cost
•Total cost of production is sum of firm’s labor cost, wL, and its capital
cost, rK:
C = wL + rK
•For each different level of cost, the equation shows another isocost line
•Rewriting C as an equation for a straight line:
•K = C/r - (w/r)L
•Slope of the isocost:
• -(w/r) is the ratio of the wage rate to rental cost of capital.
• This shows the rate at which capital can be substituted for labor
with no change in cost.

K
L

  w
r


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Choosing Inputs

• We will address how to minimize cost for a given level of output by

combining iso-costs with isoquants
• We choose the output we wish to produce and then determine how to do
that at minimum cost
• Isoquant is the quantity we wish to produce
• Iso-cost is the combination of K and L that gives a set cost

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Producing a Given Output at Minimum
Cost
Capital

• Isocost curve C1 is Isocost C2 shows quantity Q1 can be

produced with combination K2,L2 or
tangent to isoquant q1 at K3,L3. However, both of these are
A and shows that output K2 higher cost combinations than
q1 can be produced at K1,L1.

minimum cost with labor

input L1 and capital
input K 1.
• Other input combi- A
nations– L2, K2 and L3, K1
K3–yield the same
output but at higher cost.  Q1
K3

C0 C1 C2
L2 L1 L3 Labor

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 Input Substitution When an Input Price
Change

• If the price of one input changes, then the slope of the iso-cost line
changes, -(w/r)
• It now takes a new quantity of labor and capital to produce the
output
• If price of labor increases relative to price of capital, and capital is
substituted for labor

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 Input Substitution When an Input Price Change
Capital
• Facing an iso-cost curve
C1, the firm produces If the price of labor rises, the
iso-cost curve becomes
output q1 at point A steeper due tothe change in
using L1 units of labor the slope -(w/L).
and K1 units of capital.
• When the price of labor The new combination of K and
increases, the iso-cost B
L is used to produce Q1.
Combination B is used in place
curves become steeper. K2 of combination A.
• Output q1 is now
produced at point B on A
K1
iso-cost curve C2 by
using L2 units of labor Q1
and K2 units of capital.
C2 C1

L2 L1 Labor
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 Cost in the Long Run
• How does the iso-cost line relate to the firm’s production process?
MPL
MRTS  - K  
L MPK

Slope of isocost line  K  w

L r

MPL w when firm minimizes cost

MPK r

• The minimum cost combination can then be written as:

MPL MPK

w r
• Minimum cost for a given output will occur when each dollar of input added to
the production process will add an equivalent amount of output.

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 Cost minimization with Varying Output Levels
• Expansion path Curve passing through points of tangency between
a firm’s isocost lines and its isoquants. A firm’s expansion path
shows the minimum cost combinations of labor and capital at each
level of output
The Expansion Path and Long-Run Costs
• To move from the expansion path to the cost curve, we follow three
steps:
1. Choose an output level represented by an isoquant. Then find the
point of tangency of that isoquant with an isocost line.
2. From the chosen iso-cost line determine the minimum cost of
producing the output level that has been selected.
3. Graph the output-cost combination.

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 Cost minimization with Varying Output Levels
Capital

150 $3000
Expansion Path Cost Long Run Total Cost

$2000 F
100 3000
C
75 E
B 2000
50
300 Units D
A
25 1000
200 Units

50 100 15 200 300

Labor 100 200 300 Output
0
in (a), the expansion path (from the origin through points A, B, and C) illustrates the lowest-
cost combinations of labor and capital that can be used to produce each level of output in the
long run— i. e. , when both inputs to production can be varied. In (b), the corresponding
longrun total cost curve (from the origin through points D, E, and F) measures the least cost
of producing each level of output.
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 Long Run Versus Short Run Cost
Curves
The Inflexibility of Short-Run Production
•In the short run, some costs are fixed
•In the long run, firm can change anything including plant size
• Can produce at a lower average cost in long run than in short run
• Capital and labor are both flexible
•We can show this by holding capital fixed in the short run and flexible
in long run

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 The Inflexibility of Short Run Production
•Suppose capital is fixed at a level
K1 in the short run. Capital
•To produce output Ql the firm E
would minimize costs by choosing
labor equal to L1 corresponding to C
the point of tangency with the
isocost line AB.
Long-Run
•The inflexibility appears when the
Expansion Path
firm decides to increase its output A
to Q2 without increasing its use of
capital. K2
Short-Run
•In the short run, output Q2 can be P Expansion Path
produced only by increasing labor K1 Q2
from L1 to L3 because capital is
fixed at K1.
Q1
• In the long run, the same output
can be produced more cheaply by L1 L2 B L3 D F
increasing labor from L1 to L2 Labor
and capital from K1 to K2.
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 Long-Run Average Cost (LAC)
Long-Run Average Cost (LAC)
• Most important determinant of the shape of the LR AC and MC curves is relationship between scale of the firm’s operation and inputs
required to minimize cost
1.Constant Returns to Scale
• If input is doubled, output will double
• AC cost is constant at all levels of output
2.Increasing Returns to Scale
• If input is doubled, output will more than double
• AC decreases at all levels of output
3.Decreasing Returns to Scale
• If input is doubled, output will less than double
• AC increases at all levels of output

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 Long Run Versus Short Run Cost Curves
In the long run: Cost
Firms experience increasing
and decreasing returns to scale LMC
and therefore long-run average
cost is “U” shaped. LAC
• Long-run marginal cost leads
long-run average cost:
• If LMC < LAC, LAC will fall
• If LMC > LAC, LAC will rise
• Therefore, LMC = LAC at the
A
minimum of LAC
• In special case where LAC is
constant, LAC and LMC are
equal

Output

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 Economies and Diseconomies of Scale
Economies of scale: Situation in which output can be doubled for less than
a doubling of cost.
•This can happen for the following reasons:
1.workers can specialize in the activities at which they are most
productive.
2.Scale can provide flexibility.
3.acquire some inputs at lower cost because--buying them in large
quantities.

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 Economies and Diseconomies of Scale
• Diseconomies of scale: Situation in which a doubling of output requires
more than a doubling of cost.
This can happen for the following reasons:
1.Factory space and machinery may make it more difficult for workers to
do their jobs efficiently
2.Managing a larger firm may become more complex
3.Bulk discounts can no longer be utilized. Limited availability of inputs
may cause price to rise.

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 Economies and Diseconomies of Scale
• Economies of scale are measured in terms of cost-output elasticity, E C
• EC is the percentage change in the cost of production resulting from a 1-
percent increase in output

EC  C C  MC
Q Q AC
• EC is equal to 1, MC = AC
• Costs increase proportionately with output
• Neither economies nor diseconomies of scale
• EC < 1 when MC < AC
• Economies of scale
• Both MC and AC are declining
• EC > 1 when MC > AC
• Diseconomies of scale
• Both MC and AC are rising

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 The R/S B/W Short-Run and Long-Run Cost
The optimal plant size will depend on the anticipated output
•If expect to produce q0, then should build smallest plant: AC = $8
•If produce more, like q1, AC rises
•If expect to produce q2, middle plant is least cost
•If expect to produce q3, largest plant is best
• What is the firm’s long run
cost curve?
• Firm will always choose
plant that minimizes the
average cost of production
• The long-run average cost
curve envelops the short-run
average cost curves
• The LAC curve exhibits
economies of scale initially
but exhibits diseconomies at
higher output levels
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 Economies and Diseconomies of Scope
• Economies Of Scope
Situation in which joint output of a single firm is greater than output
that could be achieved by two different firms when each produces a
single product.
• Diseconomies Of Scope
Situation in which joint output of a single firm is less than could be
achieved by separate firms when each produces a single product.

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 Economies and Diseconomies of Scope
The Degree of Economies of Scope
To measure the degree to which there are economies of scope, we
should ask what percentage of the cost of production is saved when
two (or more) products are produced jointly rather than
individually.

• degree of economies of scope (SC) Percentage of cost savings

resulting when two or more products are produced jointly rather
than Individually.

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 Production and cost theory –A mathematical treatment
Cost Minimization
If there are two inputs, capital K and labor L, the production function F(K,
L) describes the maximum output that can be produced for every possible
combination of inputs.
The cost-minimization problem can be written as
Minimize C  wL  rK
subject to the constraint that a fixed output q 0 be produced:
F (K ,L)  q 0
Step 1: Set up the Lagrangian.

  wL  rK  [F (K ,L)  q0]

Step 2: Differentiate the Lagrangian with respect to K, L, and λ and set equal to zero.

Φ K  r  λMPK (K,L)  0

Φ L  w  λMPL (K,L)  0
Φ   q 0  F (K ,L)  0
Step 3: Combine the first two conditions to obtain
MPK(K ,L) r  MPL(K ,L) w
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 Production and cost theory –A mathematical treatment

Rewrite the first two conditions to evaluate the Lagrange multiplier:

r  λMPK (K ,L)  0  λ  r
MPK (K ,L)

w
w  λMPL (K ,L)  0  λ 
MPL (K ,L)

r/MPK(K, L) measures the additional input cost of producing an additional unit

of output by increasing capital, and w/MPL(K, L) the additional cost of using
additional labor as an input. In both cases, the Lagrange multiplier is equal to
the marginal cost of production.

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 Duality in Production and Cost Theory
The dual problem asks what combination of K and L will let us produce the
most output at a cost of C0.
Maximize F (K ,L) subject to wL  rL  C 0

Step 1: Set up the Lagrangian.

Φ  F (K ,L)  μ(wL  rK  C 0)

Φ K  MPK (K ,L)  μr  0

Φ L  MPL (K ,L)  μw  0

Φ μ  wL  rK  C 0  0

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 Duality in Production and Cost Theory

Step 3: Combine the first two equations:

μ  MPK (K,L)
r

μ  MPL (K ,L)
w
 MPK (K ,L) r MPL (K ,L) w

This is the same result as obtained previously that is, the necessary condition for cost minimization.

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 The Cobb-Douglas Cost and Production Functions

Cobb-Douglas production function Production function of the form q = AKαLβ, where q is the rate
of output, K is the quantity of capital, and L is the quantity of labor, and where A,α, and β are
positive constants.

F (K ,L)  AK αLβ

We assume that a α< 1 and β < 1, so that the firm has decreasing marginal products of labor and
capital. If α + β = I, the firm has constant returns to scale, because doubling K and L doubles F. If α
+ β > I, the firm has increasing returns to scale, and if α + β < I, it has decreasing returns to scale.

©2005 Pearson Education, Inc. 53

 The Cobb-Douglas Cost and Production Functions

To find the amounts of capital and labor that the firm should utilize to
minimize the cost of producing an output q0, we first write the Lagrangian
Φ  wL  rK  λ( AK αLβ  q 0]
Differentiating with respect to L, K, and λ, and setting those derivatives equal to 0, we obtain

Φ  L  w  λ ( βAK αLβ 1  0

Φ  K  r  λ (AK α -1Lβ  0

Φ λ  AK αLβ  q0  0
From equation1 we have

  w A K  L 1
Substituting this formula into equation2 gives us
r AK  L 1  wAK  1L
or

L  r K
w
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 The Cobb-Douglas Cost and Production Functions

Now substitute for L in equation 3

 βr 
β
α
AK  
K   q0  0
 αw 

We can rewrite the new equation as:

 
β
K α  β  αw  q
 0


 βr  A
 

Or
β 1
 α  β  
K   αw   q 0 α  β
 βr   
  A

©2005 Pearson Education, Inc. 55

 The Cobb-Douglas Cost and Production Functions

To determine the cost-minimizing quantity of labor, we simply substitute k into

equation L.

  1 
     
  
L  r K  r  w 

 q0  
  
w w  r   A 
 
 

 1
    q0   
L   r 

 
 
 w   A

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 The Cobb-Douglas Cost and Production Functions

• Total cost of producing output

  (   )  (  ) 
(   )       q 1 (  )
C  w (   )r 

    
 
      A
    
 

This cost function tells us (1) how the total cost of production increases as the level of output q
increases, and (2) how cost changes as input prices change. When α + β equals 1, equation c
simplifies to

C  w r (  )   (  ) (1 A)q

 
 

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