Lecture 7

Lecture 7
Theory of Costs
Topics
1. The Nature of Costs.
2. Short-Run Costs.
3. Long-Run Costs.
4. Lower Costs in the Long Run.
5. Cost of Producing Multiple Goods.
Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-2

The Nature of Costs
• Economists measure all relevant costs.

– Explicit costs – direct, out-of-pocket payments
for inputs to its production process within a given
time period
– Implicit costs – reflect only a forgone opportunity
rather than an explicit, current expenditure.
• Accountants measure costs in ways that are
more consistent with tax laws and other
laws.

Opportunity Costs
• Economic cost or opportunity cost - the

value of the best alternative use of a
resource.
• The economic or opportunity cost includes

both explicit and implicit costs.

Sunk Costs
• Sunk cost – a past expenditure that cannot

be recovered.
• Sunk cost is not relevant to a manager

when deciding how much to produce now.
• If an expenditure is sunk, it is not an

opportunity cost.

Short-Run Costs
• Fixed cost (F) – a production expense that

does not vary with output.
• Variable cost (VC) – a production expense

that changes with the quantity of output
produced.
• Cost (total cost, C) – the sum of a firm’s

variable cost and fixed cost:
C = VC + F

Marginal Cost
• Marginal cost (MC) – the amount by

which a firm’s cost changes if the firm
produces one more unit of output.
C
MC 
q
– And since only variable cost changes with
output:
VC
MC 
q

Average Costs
• Average fixed cost (AFC) – the fixed cost

divided by the units of output produced:
AFC = F/q.
• Average variable cost (AVC) – the

variable cost divided by the units of output
produced:
AVC = VC/q.
• Average cost (AC) – the total cost divided

by the units of output produced:
AC = C/q
AC = AFC + AVC.

Table 7.1 Variation of Short-Run
Cost with Output

(a)
Cost, $
400
VC
27
Figure 7.1 Short-Run 216
A 1
Cost Curves
20
1
B
120
48 F
0 2 4 6 8 10
Quantity, ,qUnits per day
(b)
Cost per unit, $

60
MC
AC
28 a
27 AVC
b
20
8
AFC
0 2 4 6 8 10
Quantity, ,qUnits per day

Relationship Between Average
and Marginal Cost Curves
Cost per unit, $
60
When MC is and when MC is
lower than AC, MC
When andlarger
whenthan
MCAC,
is
ACMCis is AC is increases
lower than larger than AVC,
decreasing…
AVC, AVC is AVC is increases
decreasing…
AC
28 a …so MC = AC, at the
27 AVC lowest point of the
b
20 AC curve!
…so MC = AVC, at
the lowest point of
8 the AVC curve!
0 2 4 6 8 10
Quantity, ,q Units per d
ay

Figure 7.2 Variable Cost and
Total Product of Labor
Quantity, q, Units per day
Total product,
d
13 Variable cost
c
10
b
5
a
1
0 5 20 46 77 , L
Hours of labor per day
50 200 460 770 VC =wL
, Variable cost, $

Shape of the Marginal Cost
Curve
MC = DVC/Dq.
• But in the short run,
DVC = wDL
– Therefore,
MC = wDL/Dq
• The additional output created by every additional

unit of labor is:
Dq/ DL = MPL
– Therefore,
MC = w/ MPL

Shape of the Average Cost
Curves
AVC = VC/q.
– But in the short-run, with only labor as an input:
AVC = VC/q = wL/q
– And since q/L = APL, then
AVC = VC/q = w/APL

Application: Short-Run Cost
Curves for a Beer Manufacturer

Effects of Taxes on Costs
• Taxes applied to a firm shift some or all of

the marginal and average cost curves.
• For example, suppose that the government

collects a specific tax of $10 per unit of
output from the firm.

Figure 7.3 Effect of a Specific
Tax on Cost Curves
Costs per unit, $ A $10.00 tax shifts MC a = MC b + 10

80
both the AC and
MC by exactly MC b
$10…
$10
AC a = AC b + 10
37
$10 AC b
27
0 5 8 10 15
,qUnits per d
ay

Solved Problem 7.2
• What is the effect of a lump-sum franchise

tax on the quantity at which a firm’s after
tax average cost curve reaches its
minimum? (Assume that the firm’s before-
tax average cost curve is U-shaped.)

Solved Problem 7.2: Answer

Long-Run Costs
• Fixed costs are avoidable in the long run.

– In the long-run, F = 0.
– As a result, the long-run total cost equals:
C = VC

Isocost Line
• Isocost line - all the combinations of inputs

that require the same (iso-) total
expenditure (cost).
• The firm’s total cost equation is:
C = wL + rK.
Capital
Labor Costs
Costs

Isocost Line (cont.)
• The firm’s total cost equation is:

C = wL + rK.
– We get the Isocost equation by setting the

costs at a particular level:
C = wL + rK.
– And then solving for K (variable along y-axis):
C - w L
K= r r

Table 7.2 Bundles of Labor and
Capital That Cost the Firm $200

Figure 7.4 A Family of Isocost
Lines
For each extra unit of Isocost Equation
year
Units of capital per
capital it uses, the

C - w L
firm must use two K= r
fewer units of labor r
to hold its cost Initial Values
constant.
$200 e C = $200
10 =
$20 w = $10
,K
7.5
d
r = $20
c
5 Slope = -1/2 = w/r
DK = 2.5 b
2.5
DL = 5 $200 isocost
a
5 10 15 $200
= 20
$10
, LUnits of labor per
year

Lines (cont.)
Isocost Equation
year
C - w L
$200 K= r
15 =
$20 r
An increase in C….
$200 e C = $300
10 =
$20 w = $10
,K
r = $20
$200 isocost $300 isocost
a
$200 $300
= 20 = 30
$10 $10
year

Lines (cont.)
Isocost Equation
year
C - w L
K= r
15 =
$200
$20
r
A decrease in C….
$200 e
C = $100
10 =
$20 w = $10
,K
r = $20
$100
5=
$20
$100 isocost $200 isocost $300 isocost
a
$100 $200 $300
= 10 = 20 = 30
$10 $10 $10
year

Combining Cost and Production
Information
• The firm can choose any of three equivalent

approaches to minimize its cost:
– Lowest-isocost rule - pick the bundle of
inputs where the lowest isocost line touches the
isoquant.
– Tangency rule - pick the bundle of inputs
where the isoquant is tangent to the isocost
line.
– Last-dollar rule - pick the bundle of inputs
where the last dollar spent on one input gives
as much extra output as the last dollar spent on
any other input.

Figure 7.5 Cost Minimization
of capital per hour
Which of these three Isocost Equation

Isocost would allow C - w L
the firm to produce K= r r
$3,000 the 100 units of
isocost output at the lowest Isoquant Slope
MPL
, Units
possible cost?
- = MRTS
K
$2,000
MPK
isocost
Initial Values
$1,000 q = 100
isocost
w = $24
r = $8
0 50 , Units
L of labor per hour

Figure 7.5 Cost Minimization
of capital per hour
Isocost Equation
q= 100 isoquant C - w L
K= r r
$3,000
isocost
Isoquant Slope
MPL
, Units
y - = MRTS
K
303
$2,000
MPK
isocost
Initial Values
$1,000 q = 100
isocost
100
x C = $2,000
w = $24
z
28 r = $8
0 24 50 116
, Units
L of labor per hour

Cost Minimization
• At the point of tangency, the slope of the

isoquant equals the slope of the isocost.
Therefore,
w
MRTS   last-dollar rule: cost is
r minimized if inputs are
MPL chosen so
MRTS  
MPK that the last dollar spent
MPL w on labor adds as much
 extra output as the last
MPK r
dollar spent on capital.
MPL MPK

w r
Figure 7.5 Cost
Minimization Initial Values
of capital per hour q = 100
MPL = 0.6q/L C = $2,000
q= 100 isoquant MPK = 0.4q/K w = $24
r = $8
$3,000
isocost
MPL MPK 1.2 0.4
= = 0.05
, Units
= =
y w r 24 8
K
303
$2,000
isocost
Spending one more dollar on
labor at x gets the firm as much
extra output as spending the
$1,000
isocost same amount on capital.
x
100
z
28
0 24 50 116
, Units
L of labor per hour

Figure 7.5 Cost Initial Values
Minimization q = 100
of capital per hour C = $2,000
MPL = 0.6q/L w = $24
q= 100 isoquant MPK = 0.4q/K r = $8
if So
the…the
firm shifts
firm one
$3,000 MPL 2.5 dollar
shouldfrom
shift
capital to
isocost = 24 = 0.1
w labor,
evenoutput
more falls by
, Units
MPK 0.017
resources
becausefromthere is
y
0.13
K
303
r = 0.017
8 =
less
capital
capital
to labor—
but also
$2,000
isocost increases
which increases
by 0.1 the
because
marginalthere
product
is more
labor
of capital
for a net
andgain of
$1,000 0.083
decreases
more the
output at
isocost themarginal
same cost….
product
x
100
of labor.
z
28
0 24 50 116
, Units
L of labor per hour

Figure 7.6 Change in Factor
Price
of capital per hour
Minimizing Cost Rule

q= 100 isoquant
Original MPL MPK
isocost,
$2,000 A decrease in w…. w = r
Initial Values
q = 100
, Units
C = $2,000
K
Ne
w isocost,
$1,032
w = $24
x
r = $8
100
w2 = $8
52
v C2 = $1,032
0 50 77 ers per hour

L, Work
The Long-Run Expansion Path
and the Long-Run Cost Function
• Expansion path - the cost-minimizing

combination of labor and capital for each
output level.

Figure 7.7(a) Expansion Path
and Long-Run Cost Curve
of capital per hour

$4,000
isocost
$3,000
isocost
, Units
K
Expansion path
$2,000
isocost
z
200
y
150
x
100
q = 200 Isoquant
q = 150 Isoquant
q = 100 Isoquant
0 50 75 100 L,Work
ers per hour

Figure 7.7(b) Expansion Path
and Long-Run Cost Curve
Long-run cost curve

C, Cost, $
4,000 Z
3,000 Y
2,000 X
0 100 150 200 q

, Units per hour

Economies of Scale
• Economies of scale - property of a cost

function whereby the average cost of
production falls as output expands.
• Diseconomies of scale - property of a cost
function whereby the average cost of
production rises when output increases.

Table 7.3 Returns to Scale and
Long-Run Costs

Table 7.4 Shape of Average Cost
Curves in Canadian Manufacturing

Lower Costs in the Long Run
• In its long-run planning, a firm chooses a

plant size and makes other investments so
as to minimize its long-run cost on the basis
of how many units it produces.
– Once it chooses its plant size and equipment,
these inputs are fixed in the short run.
• Thus, the firm’s long-run decision
determines its short-run cost.

Figure 7.9 Long-Run Average Cost as
the Envelope of Short-Run Average
age cost, $ Cost Curves
LRAC
Aver
SRAC 3
SRAC 1 SRAC 3 SRAC 2
b
12 d
10
a c
0 q1 q2 ,qOutput per ay
d

Why Costs Fall over Time
• Technological or organizational progress

may increase productivity.
• Operating at a larger scale in the long run
may lower average costs due to increasing
returns to scale.
• The firm’s workers and managers may
become more proficient over time due to
learning by doing.

Lecture 7 - Theory of Cost

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 7 - Theory of Cost

Uploaded by

Copyright:

Available Formats

1. The Nature of Costs.

4. Lower Costs in the Long Run.

5. Cost of Producing Multiple Goods.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-2

• Economists measure all relevant costs.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-3

• Economic cost or opportunity cost - the

• The economic or opportunity cost includes

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-4

• Sunk cost – a past expenditure that cannot

• Sunk cost is not relevant to a manager

• If an expenditure is sunk, it is not an

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-5

• Fixed cost (F) – a production expense that

• Variable cost (VC) – a production expense

• Cost (total cost, C) – the sum of a firm’s

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-6

• Marginal cost (MC) – the amount by

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-7

• Average fixed cost (AFC) – the fixed cost

• Average variable cost (AVC) – the

• Average cost (AC) – the total cost divided

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-8

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-9

Cost per unit, $

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-10

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-11

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-12

• The additional output created by every additional

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-13

– And since q/L = APL, then

AVC = VC/q = w/APL

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-14

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-15

• Taxes applied to a firm shift some or all of

• For example, suppose that the government

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-16

Costs per unit, $ A $10.00 tax shifts MC a = MC b + 10

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-17

• What is the effect of a lump-sum franchise

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-18

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-19

• Fixed costs are avoidable in the long run.

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-20

• Isocost line - all the combinations of inputs

• The firm’s total cost equation is:

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-21

• The firm’s total cost equation is:

– We get the Isocost equation by setting the

– And then solving for K (variable along y-axis):

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-22

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-23

capital it uses, the

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-24

$200 isocost $300 isocost

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-25

$100 isocost $200 isocost $300 isocost

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-26

• The firm can choose any of three equivalent

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-27

Which of these three Isocost Equation

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-28

Copyright ©2016 Pearson Education, Ltd. All rights reserved. 7-29