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Chapter 7 Costs
Chapter 7 Costs
Firms want to be technologically efficient (see chapter 6) but also economically efficient ( minimizing the cost of
producing a specified amount of output)
5 main topics:
1. Nature of costs
2. Short-run costs
3. Long-run costs
4. Lower costs in the long-run
5. Cost of producing multiple goods
Opportunity costs:
Economic cost or opportunity cost: value of the alternative of a resource
Takes into account both explicit and implicit costs if an input is purchased but not used in prod° process then is it
better to sell it at market price or keep it? what is the most profit maximizing and cost minimizing?
DIY is not rational and people ignore the opportunity cost of time why do something for hours when a professional
can do it in minutes?
In times of economic turmoil, opportunity cost of leaving a job is lower thus more people go back to school. Why?
During hard times, people might get fire or see no evolution in their career thus decide to study number of applicants
lowers when situation improves
Sunk Costs:
Sunk costs: past expenditure that cannot be recovered what is not an OC is a SC
If a good can be bought but not resold then no alternative for that good meaning that original expenditure is a sunk cost
(Good A costs $25,000 and can be sold for $10,000 so: OC (opportunity cost) = $10,000 and SC (Sunk cost) = $15,000)
Sunk costs should be ignored and firms should focus on having the best opportunity cost
7.2-Short-Run Costs:
-A firm’s cost rises as it increases its output
-More costly for a firm to increase output in the S-R than in L-R when all inputs can be varied
Short-run cost measures:
Fixed cost, variable cost and total cost:
Fixed cost (F): a production expense that changes with the quantity of output produced
Variable cost (VC): a production expense that changes with the quantity of output produced
Cost (total cost, TC or C): sum of a firm’s variable cost and fixed cost
𝑪 = 𝑽𝑪 + 𝑭
Marginal cost (MC): the amount by which a firm’s cost changes if the firm produces one more unit of input
∆𝑪
No calculus: 𝑴𝑪 = ∆𝒒, where ∆𝐶 is change in cost when output changes by ∆𝑞
𝒅𝑪(𝒒)
Calculus based: 𝑴𝑪 = , where C(q) is the cost function that shows how cost varies with output
𝒅𝒒
∆𝑽𝑪
In the short term, the change in cost is only VC (here, K) so: 𝑴𝑪 = ∆𝒒
Average costs:
3 average cost measure:
𝑭
1. Average fixed cost (AFC): fixed cost divided by the units of output produced: 𝑨𝑭𝑪 = 𝒒
𝑽𝑪
2. Average variable cost (AVC): variable cost divided by the units of output produced: 𝑨𝑽𝑪 = 𝒒
3. Average cost or average total cost (AC or ATC): total cost divided by the units of output produced:
𝑪
𝑨𝑪 = 𝒒 , C being itself 𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
C: Total Cost
VC: Variable Cost
F: Fixed Cost
If a firm has a franchise tax, a tax on its whole production, (T/q), the more a firm can spread the cost of the tax by
producing more
7.3-Long-Run Costs
In the L-R, all FDPs can be varied so the company can maximize its production while minimizing the costs
Minimizing costs:
In the long term, it decides how much L and K it needs while in S-R it only adjusts L L-R cost is lower than its S-R
cost of production because it can have a more appropriate amount of K making the prod° more efficient and less costly
There exists different technologically efficient combinations of inputs given by isoquants but companies also want an
economically efficient combinaison of inputs
Isocost line:
All possible combinations of 2 factors that can be used at given costs and for a given producer's budget Isocost line
represents a combination of inputs which all cost the same amount cost is fixed
̅ = 𝒘𝑳 + 𝒓𝑲
𝑪
Isocost resemble and have similar characteristics to budget lines:
• The greater the cost, the farther from the origin the Isocost line lies
• Straight lines
• Slope depends on relative prices
BUT a firm has more than one isocost may produce a little with low cost budget or pay more and produce more
(firm’s choice)
∆𝑲 𝒘
Slope of isocost line: ∆𝑳
=−𝒓
-Lowest-isocost rule combinaison of inputs on the isoquant that is on the lowest isocost line always works
-Tangency rule If an isocost line crosses the isoquant twice, another lower isocost line must also touch the isoquant
so the lowest possible isocost is tangent to the isoquant at a single bundle:
𝑤
Slope of the isoquant is Marginal Rate of Technical Substitution = 𝑀𝑅𝑇𝑆 = − 𝑟 and the cost minimization will be
where the slope of the isocost line and the MRTS are equal
-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
𝑴𝑷𝑳 𝑴𝑷𝒌
=
𝒘 𝒓
Factor price changes:
-When the lowest cost has been identified, the firm will keep it as long as the prices of the inputs remain constant
-If the price of in input changes then the firm will have to find minimize costs by finding the lowest-isocost line:
-The cost of L went down meaning that the isocost line is flatter so the quantity
needed of each FDP to minimize costs is cost minimization
-Change in price of inputs does not change the isoquant which only changes
with technological progress
L-R expansion path: the cost-minimizing combinaison of L and K for each output straight line that goes through
all the different tangency point
In this example, it
shows that as
output doubles,
cost also doubles
In L-R, firm chooses the plant size that minimizes its cost of prod° so it picks the plant size that has the lowest
average cost for each possible output level
Similarly for q2
(Left) Inkjet & laser printers example (page 209): until a certain quantity
(q<2000) of pages, buying an inkjet minimizes costs average cost of laser is
higher money when q<2000 pages then when q>2000, laser printer is the
cheapest option for consumer the more you print, the lower your
average cost per page
• L-R, firm can increase both L and K meaning that LREP is upward sloping
• S-R K is fixed so SREP is horizontal
‘Learning by doing’ is often seen through a cumulative output function: the total number of units of output produced
since the firm started production
Economies of scope: situation in which it is less expensive to produce goods jointly than separately SC can be
measured with the formula:
Production possibility frontier (PPF): maximum amount of outputs than can be produced from a fixed amount of
input:
• PPF can be concave less resources used if production jointly together = lowers costs
• PPF can be a straight line cost of producing the two goods jointly would not be lower meaning that producing
them together or not does not change anything