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chapter 8
Cost
Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
8-2
Learning Objectives• Describe various types of cost and the characteristics of
each.• Identify a firm’s least-cost input choice, and the firm’s
cost function, in the short-and long-run.• Understand the concepts of average and marginal cost.• Describe the effect of an input price change on the firm’s
least-cost input combination.• Explain the relationship between short-run and long-run
cost.• Define economies and diseconomies of scale and explain
their relationship to the concept of returns to scale.
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Overview
• There are several types of cost: fixed vs. variable; avoidable vs. sunk; out-of-pocket vs. opportunity costs.
• We will start with the simpler case of one variable input, then expand to cost minimization with two variable inputs.
• Along the way, we will learn several new tools, such as isocost lines, and average and marginal cost curves.
• Compared to the short run, costs can be lower in the long run.• As firms grow and increase the use of all inputs, average costs
may increase or decrease – economies of scale. A similar phenomenon may happen when new lines of products are introduced – economies of scope.
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Types of Cost
• Total cost• Variable cost: costs of inputs that vary with the firm’s
output level • Fixed cost: costs of inputs whose use does not vary with
the firm’s output level• Avoidable: the firm does not incur the cost (or recoups it) if it
produces no output • Sunk: cost that is incurred even if the firm decides not to operate
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Types of Cost
• Opportunity Cost: the cost associated with forgoing the opportunity to employ a resource in its best alternative use
• A firm’s true economic costs of production consists of both out of pocket expenditures and opportunity costs
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Types of Cost
•
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Types of Cost
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Cost with One Variable Input
•
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Deriving Variable Cost from Production Function
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Fixed, Variable, and Total Cost
Cost curve is equal to the variable cost plus the fixed cost curves
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Isocost Lines
• To find the cheapest combination of inputs to produce a given output, we will need a new tool.
• Isocost line: contains all the input combinations with the same cost
• Isocost lines in combination with isoquants will allow the firm to pick the least-cost combination of inputs to produce a certain level of output (or the largest possible output given a certain cost).
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Isocost Lines
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Isocost Lines
•
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Least-Cost Method
• To find the least-cost input combination for an output of 140, we look for the point in that isoquant that lies on the lowest isocost line (point D)
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Cost Minimization with Fixed Proportions
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Interior Solutions•
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Interior Solutions•
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Boundary Solutions
Boundary solution: the least-cost input combination excludes some inputs
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Output Expansion Path and Total Cost Curve
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Output Expansion Path with a Lumpy Input and Avoidable Fixed Costs
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Average and Marginal Costs
•
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Cost, Average Cost, and Marginal Cost
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From Total Cost to Average Cost
Efficient scale of production
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From Total Cost to Marginal Cost
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Relationship between Average and Marginal Cost
• When output is finely divisible, the AC curve is upward sloping at Q if MC > AC, downward sloping if MC < AC, and neither rising nor falling if MC = AC
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Three Kinds of Average Cost
•
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Three Kinds of Average Cost
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Effects of Input Price Changes
• After an increase in the price of an input, a cost-minimizing firm never uses more of that input to produce a given amount of output, and usually employs less.
• Point B reflects a higher cost of capital than in point A
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Effects of Input Price Changes
• When capital costs R, the least-cost combination is A.
• When the price of capital increases to R’, the new least-cost combination B must lie in the green region, because it must be no less costly than A when the price is R, and no more costly when the price is R’
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Short-Run Versus Long-Run Costs
• In the short run, capital is fixed (points B, E, F).
• In the long run, all inputs are variable, usually allowing the firm to produce at a lower cost (compare A to E, and D to F)
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Short-Run Versus Long-Run Costs
Keeping capital fixed
Keeping capital fixed
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Short-Run Versus Long-Run Average Costs
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Short-Run Versus Long-Run Marginal Costs
Marginal Costs rise more rapidly when we can only vary one input
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Economies and Diseconomies of Scale
• Economies of scale: average cost falls as firm produces more
• Diseconomies of scale: average cost rises as firm produces more
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Economies and Diseconomies of Scale
twice the cost of A
more than twice the cost of D
less than twice the cost of A
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Economies and Diseconomies of Scope
•
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Review• Costs can be either variable or fixed. Fixed costs can be either
avoidable or sunk.• Economic costs include not only out-of-pocket expenditures, but
also opportunity costs.• Firms minimize costs.• The marginal cost curve crosses the average cost curve from
below at the efficient scale of production.• If a firm cannot adjust one of its inputs in the short run but can
do so over the long run, its costs when its output level changes will be higher in the short run than in the long run.
• A firm enjoys economies of scale if its average cost decreases as the quantity produced increases. It suffers diseconomies of scale if its average cost increases as the quantity produced increases.
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Looking Forward
• Until now, we have focused on production and costs.• Next, we will incorporate sales and revenue into our
analysis, and we will analyze how firms maximize profits.
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