Chapter 7

The Cost of Production

 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), or…

TC  FC  VC
©2005 Pearson Education, Inc. Chapter 7 2
 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 have been incurred and cannot be
recovered

©2005 Pearson Education, Inc. Chapter 7 3

 Measuring Costs

 Marginal Cost (MC):

ΔTC ΔVC
MC  
Δq Δq

©2005 Pearson Education, Inc. Chapter 7 4

 Measuring Costs

 Average Total Cost (ATC)

TC TFC TVC
ATC   
q q q

TC
ATC   AFC  AVC
q

©2005 Pearson Education, Inc. Chapter 7 5

 A Firm’s Short Run Costs

©2005 Pearson Education, Inc. Chapter 7 6

 Cost Curves for a Firm
TC
Cost 400
($ per Total cost
year) VC
is the vertical
sum of FC
and VC.
300
Variable cost
increases with
production and
the rate varies with
increasing &
200
decreasing returns.

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output

©2005 Pearson Education, Inc. Chapter 7 7

 Cost Curves
120
100
MC
80
Cost ($/unit)

60
ATC
40
AVC
20
AFC
0
0 2 4 6 8 10 12
Output (units/yr)
©2005 Pearson Education, Inc. Chapter 7 8
 Cost Curves

 When MC is below AVC, AVC is falling

 When MC is above AVC, AVC is rising
 When MC is below ATC, ATC is falling
 When MC is above ATC, ATC is rising
 Therefore, MC crosses AVC and ATC at
the minimums

©2005 Pearson Education, Inc. Chapter 7 9

 Cost Curves for a Firm
 The line drawn from
the origin to the P TC
variable cost curve: 400
VC
 Its slope equals AVC
 The slope of a point 300
on VC or TC equals
MC 200
 Therefore, MC = AVC A
at 7 units of output 100
(point A) FC

1 2 3 4 5 6 7 8 9 10 11 12 13
Output

©2005 Pearson Education, Inc. Chapter 7 10

 Cost in the Long Run

 Capital is either rented/leased or

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

©2005 Pearson Education, Inc. Chapter 7 11

 Cost in the Long Run

 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

©2005 Pearson Education, Inc. Chapter 7 12

 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

©2005 Pearson Education, Inc. Chapter 7 13

 Cost in the Long Run

 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%

©2005 Pearson Education, Inc. Chapter 7 14

 Cost in the Long Run

 The Isocost 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

©2005 Pearson Education, Inc. Chapter 7 15

 Cost in the Long Run

 Rewriting C as an equation for a straight

line:
K = C/r - (w/r)L
 
Slope of the isocost: K L   w r

©2005 Pearson Education, Inc. Chapter 7 16

 Producing a Given Output at
Minimum Cost
Capital
per Q1 is an isoquant for output Q1.
year There are three isocost lines, of
which 2 are possible choices in
which to produce Q1
K2

Isocost C2 shows quantity

Q1 can be produced with
combination K2L2 or K3L3.
However, both of these
A are higher cost combinations
K1 than K1L1.
Q1
K3

C0 C1 C2
Labor per year
L2 L1 L3
©2005 Pearson Education, Inc. Chapter 7 17
 Input Substitution When an
Input Price Change

 If the price of labor changes, then the

slope of the isocost line change, 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

©2005 Pearson Education, Inc. Chapter 7 18

 Input Substitution When an
Input Price Change
Capital
per If the price of labor
year rises, the isocost curve
becomes steeper due to
the change in the slope -(w/L).

The new combination of K

and L is used to produce Q1.
B Combination B is used in
K2 place of combination A.

A
K1

Q1

C2 C1

L2 L1 Labor per year

©2005 Pearson Education, Inc. Chapter 7 19
 Cost in the Long Run

 How does the isocost line relate to the

firm’s production process?

MRTS  - K  MP L
L MP K

Slope of isocost line  K  w

L r
MPL
w when firm minimizes cost
MPK r

©2005 Pearson Education, Inc. Chapter 7 20

 Cost in the Long Run

 Cost minimization with Varying Output

Levels
A firm’s expansion path shows the minimum
cost combinations of labor and capital at
each level of output.
Slope equals K/L

©2005 Pearson Education, Inc. Chapter 7 21

 A Firm’s Expansion Path
Capital
per The expansion path illustrates
the least-cost combinations of
year
labor and capital that can be
150 $3000 used to produce each level of
output in the long-run.

Expansion Path
$200
100 0
C
75
B
50
300 Units
A
25
200 Units

Labor per year

50 100 150 200 300
©2005 Pearson Education, Inc. Chapter 7 22
 Expansion Path & Long-run
Costs

 Firms expansion path has same

information as long-run total cost curve
 To move from expansion path to LR cost
curve
Find tangency with isoquant and isocost
Determine min cost of producing the output
level selected
Graph output-cost combination

©2005 Pearson Education, Inc. Chapter 7 23

 A Firm’s Long-Run Total Cost
Curve
Cost/
Year
Long Run Total Cost
F
3000

E
2000

D
1000

Output, Units/yr
100 200 300
©2005 Pearson Education, Inc. Chapter 7 24
 Short-Run vs. Long-Run
Capital E Capital is fixed at K1
per To produce q1, min cost at K1,L1
year If increase output to Q2, min cost
C is K1 and L3 in short run

In LR, can
Long-Run
change
Expansion Path
A capital and
min costs
falls to K2
K2 and L2
Short-Run
P Expansion Path
K1 Q2

Q1
Labor per year
L1 L2 B L3 D F
©2005 Pearson Education, Inc. Chapter 7 25
 Long-Run Average and Marginal
Cost
Cost
($ per unit
of output LMC

LAC

Output

©2005 Pearson Education, Inc. Chapter 7 26

 Economies and Diseconomies
of Scale
 Economies of Scale
Increase in output is greater than the
increase in inputs.
 Diseconomies of Scale
Increase in output is less than the increase in
inputs.
 U-shaped LAC shows economies of
scale for relatively low output levels and
diseconomies of scale for higher levels

©2005 Pearson Education, Inc. Chapter 7 27

 Long Run Costs

 Increasing Returns to Scale

Output more than doubles when the
quantities of all inputs are doubled
 Economies of Scale
Doubling of output requires less than a
doubling of cost

©2005 Pearson Education, Inc. Chapter 7 28

 Long-Run Cost with Economies
and Diseconomies of Scale

©2005 Pearson Education, Inc. Chapter 7 29

 Production with Two Outputs –
Economies of Scope

 Many firms produce more than one

product and those product are closely
linked
 Examples:
Chicken farm--poultry and eggs
Automobile company--cars and trucks
University--Teaching and research

©2005 Pearson Education, Inc. Chapter 7 30

 Production with Two Outputs –
Economies of Scope

 Advantages
1. Both use capital and labor.
2. The firms share management
resources.
3. Both use the same labor skills and type
of machinery.

©2005 Pearson Education, Inc. Chapter 7 31

 Production with Two Outputs –
Economies of Scope

 The alternative quantities can be

illustrated using product transformation
curves
Curves showing the various combinations of
two different outputs (products) that can be
produced with a given set of inputs

©2005 Pearson Education, Inc. Chapter 7 32

 Product Transformation Curve
Number Each curve shows
of tractors combinations of output
with a given combination
of L & K.

O2
O1 illustrates a low level
of output. O2 illustrates
a higher level of output with
two times as much labor
O1 and capital.

Number of cars

©2005 Pearson Education, Inc. Chapter 7 33

 Product Transformation Curve
 Product transformation curves are
negatively slope
To get more of one output, must give up
some of the other output
 Curve is concave
Joint production has its advantages

©2005 Pearson Education, Inc. Chapter 7 34

 Production with Two Outputs –
Economies of Scope

 There is no direct relationship between

economies of scope and economies of
scale.
May experience economies of scope and
diseconomies of scale
May have economies of scale and not have
economies of scope

©2005 Pearson Education, Inc. Chapter 7 35

 Production with Two Outputs –
Economies of Scope
 The degree of economies of scope (SC) can be
measured by percentage of cost saved
producing two or more products jointly:
C(q1 )  C(q 2 )  C(q1,q2 )
SC 
C(q1,q 2 )
 C(q1) is the cost of producing q1
 C(q2) is the cost of producing q2
 C(q1,q2) is the joint cost of producing both products

©2005 Pearson Education, Inc. Chapter 7 36