Microeconomics

Chapter 5
Theories of Producer
Behavior The Cost of Production

Chapter 7

1


Topics to be Discussed


Measuring Cost: Which Costs Matter?



Cost in the Short Run



Cost in the Long Run



Long-Run Versus Short-Run Cost Curves



Production with Two Outputs-Economies of Scope

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Introduction




A firm’s costs depend on the rate of
output and we will show how these
costs are likely to change over time.
The characteristics of the firm’s
production technology can affect
costs in the long run and short run.

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Measuring Cost:
Which Costs Matter?


For a firm to minimize costs, we must
clarify what is meant by cost and how
to measure them



How are costs calculated here?

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Measuring Cost:
Which Costs Matter?




Accountants tend to take a retrospective
view of firms costs, where as 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



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


EC = AC +OC
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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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Prospective Sunk Cost


An Example









Firm is considering moving its headquarters
A firm paid $500,000 for an option to buy a
building.
The cost of the building is $5 million or a
total of $5.5 million.
The firm finds another building for $5.25
million.
Which building should the firm buy?
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Prospective Sunk Cost






Example (cont.)
The first building should be purchased.
The $500,000 is a sunk cost and should
not be considered in the decision to
buy
What should be considered is



Spending an additional $5,250,000 or
Spending an additional $5,000,000
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Measuring Cost:
Which Costs Matter?




1.

Some costs vary with output, while
some remain the same no matter
amount of output
Total cost can be divided into:
Fixed Cost


2.

Does not vary with the level of output

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), or…

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 affects fixed or variable costs
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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 have been incurred and cannot
be recovered
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Measuring Costs


Marginal Cost (MC):





The cost of expanding output by one
unit.
Fixed cost 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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Cost Curves




The following figures illustrate how
various cost measure change as
output change
Curves based on the information in
table 7.1 discussed earlier

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Cost Curves for a Firm

TC

Cost 400
($ per
year)

Total cost
is the vertical
sum of FC
and VC.

300

VC
Variable cost
increases with
production and
the rate varies with
increasing &
decreasing returns.

200

Fixed cost does not
vary with output

100
50
0


1

2

3

4

5

6

7

8

9

10

11

12

13

FC
Output
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Cost Curves

MC

ATC
AVC
AFC

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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



The Average – Marginal relationship

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Cost Curves for a Firm


The line drawn
from the origin to
the variable cost
curve:





TC

P
400

VC

Its slope equals AVC300
The slope of a point
on VC or TC equals 200
MC
Therefore, MC =

100
AVC at 7 units of
output (point A)

A
FC
1

2

3

4

5

6

7

8

9

10

11

12


13
Output

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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 Minimizing Input Choice


Assumptions
 Two Inputs: Labor (L) & capital (K)
 Price of labor: wage rate (w)
 The price of capital :r = depreciation
rate + interest rate

Or rental rate if not purchasing

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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


For each different level of cost, the
equation shows another isocost line

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