Cost

Learning Objectives:

• What is a cost function?

• Difference between short run and long run costs

• What are average and marginal costs?

• What is meant by economies of scale?

• How do firms maximize profit?

Cost Function

• Minimum cost to produce a given level of output

• In order to produce more output, the firm has to pay more for the inputs. In other words, cost of production rises as output goes up.

Cost in Short Run and Long Run

• Variable cost includes the cost of the variable inputs, and changes with change in output.

• Fixed cost doesn’t change with change in output, as it includes the cost of inputs fixed in the short run.

• Total cost is the sum of fixed cost and variable cost.

• In the long run, all costs are variable costs.

• Example: Pricing at Dell

• Example: Egg prices likely to rise amid laws mandating cage-free henhouses

Average and Marginal Costs

• Average cost is cost per unit of output. • Marginal cost is the extra cost a incurs to produce one extra unit of output.• Example: Eurotunnel

Marginal Cost and Marginal Product

• Marginal cost is the reciprocal of marginal product times the input’s price.

Cost TableK L Q r w

5 0 0 1000 50 5000 0 5000 - - - -

5 1 5 1000 50 5000 50 5050 1000 10 1010 10

5 2 15 1000 50 5000 100 5100 333.33

6.67 340 5

5 3 30 1000 50 5000 150 5150 166.67

5 171.67

3.33

5 4 50 1000 50 5000 200 5200 100 4 104 2.5

5 5 75 1000 50 5000 250 5250 66.67

3.33 70 2

5 6 105 1000 50 5000 300 5300 47.62

2.86 50.48

1.67

5 7 125 1000 50 5000 350 5350 40 2.8 42.8 2.5

5 8 140 1000 50 5000 400 5400 35.71

2.86 38.57

3.33

5 9 141 1000 50 5000 450 5450 38.46

3.19 38.65

50

Fixed Cost and Sunk Cost

• Sunk cost is the unrecoverable part of the fixed cost.

• Example: Gerbang Perdana, 2006

Algebraic Form of Cost Function

𝐶=𝐶 (𝑄 )= 𝑓 +𝑎𝑄+𝑏𝑄2+𝑐𝑄3

Long Run Cost

• Long run average cost (LRAC) curve traces out the minimum average costs for producing different output levels, when all the inputs can be varied.

Economies of Scale

• If LRAC falls as a firm produces more and more output, then the firm is experiencing economies of scale.

• Example: Case: Airbus vs Boeing, 2006

• Example: Why gasoline is suddenly $3 a gallon and could go lower

• Example: Competition in the Wide-Body Aircraft Industry

Profit Maximization

• How do firms decide how many units of each input to be hired?

• Profit function: