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

7.1-The nature of costs

-Explicit costs  direct out-of-pocket payments for inputs to its production (wages, bills etc.)
-Implicit costs  forgone opportunity; usually from durable capital (machines that get old cost)

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

Opportunity costs of capital:

Capital: a product that is usable for years
Renting K rather than buying it
• How should the cost of purchasing be spread over time? removes that problem because it is
• Value of capital might change over time (better technology) then calculated as other non-durable
inputs
The expected return from investments missed in favor of other investments  comparing various investment
alternatives (buy a vehicle and see its value go down with time, having negative implicit costs or keeping that money
and investing it?)

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

S-R cost curves:

C: Total Cost
VC: Variable Cost

Line that goes from origin and tangent to C in A = AC and MC

F: Fixed Cost

MC: Marginal Cost  slope of cost curve or variable cost curve

AC: Average Cost  sum of AVC and AFC

AVC: Average Variable Cost
AFC: Average Fixed Cost  falls as output increases because FC spread

Production functions and shape of cost curves:

-In the short-run, firms can only increase L to increase their production. Thus, 𝑉𝐶 = 𝑤𝐿 , where w represents wages
-If firm increases L too much then it will be a victim of diminishing marginal returns of labor
Shape of the variable cost curve:
- Diminishing marginal returns of labor  First, by adding another unit of L, productivity increases but reaches a point
where each additional unit of L lowers q
Shape of the marginal cost curve:
𝐿
-𝑀𝐶 = 𝑤 𝑞 , where w is the wage multiplied by the extra labor necessary to produce one more unit of output
𝑤
-𝑀𝐶 = , extra L to produce one more unit of output
𝑀𝑃𝐿
-Because of diminishing marginal returns of L  MC first falls and then rises

Shape of the Average cost curves:

𝑤𝐿
-𝐴𝑉𝐶 = 𝑞 , where wL is the VC divided by the quantity, q, of output produced
𝑤
- 𝐴𝑉𝐶 = 𝐴𝑃 , where APL is q/L
𝐿
-AVC and AC move in the opposite direction of the APL and falls and then rises (see curves page 2)  AVC gets closer
and closer to AC as F/q becomes smaller and smaller

Effect of taxes on costs:

-A tax on output affects AC, AVC, MC BUT NOT AFC
-With the tax:
• 𝐴𝑉𝐶 𝑎𝑓𝑡𝑒𝑟 = 𝐴𝑉𝐶𝑏𝑒𝑓𝑜𝑟𝑒 + Tax  creates a shift to the left of the curves by the amount of the tax
• 𝐴𝐶 𝑎𝑓𝑡𝑒𝑟 = 𝐴𝐶𝑏𝑒𝑓𝑜𝑟𝑒 + Tax  creates a shift to the left of the curves by the amount of the tax
• 𝑀𝐶 𝑎𝑓𝑡𝑒𝑟 = 𝑀𝐶𝑏𝑒𝑓𝑜𝑟𝑒 + Tax  creates a shift to the left of the curves by the amount of the tax

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

S-R cost summary:

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

All costs are avoidable in the long run:

In some cases, in L-R, firms can have fixed costs but those are avoidable (firm can shut down thus not pay rent = F
avoided)

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

Combining cost and production information:

A firm will use information from both isoquant and isocost to ensure a maximum output for the lowest cost
3 approaches to minimize costs:
1. Lowest-isocost rule  bundle of inputs where the lowest isocost line touches the isoquant
2. Tangency rule  bundle of inputs where the isoquant is tangent to the isocost line
3. Last-dollar rule  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

In this example, cost minimization is in x because the

isoquant curve is tangent to the $2,000 isocost line where
the quantity of inputs is also maximized

-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

The L-R expansion path and the L-R cost function:

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

Shape of L-R cost curves:

-L-R MC and AC slope downward and then slope upward
-Dismissing returns do not explain the upward slope of a L-R average cost curve:
• Return to scale:
o average cost of production falls as the output increases then economies of scale
o average cost curve is flat = constant return to scale = no economies of scale
o average cost of prod° rises as the output increases then diseconomies of scale
-AVC have different shapes (U-shape, L-shape etc.)  shapes of AVC indicates if production process has economies or
diseconomies of scale (Canadian companies usually have L-shaped

Estimating cost curves versus introspection:

Cost functions can also be found through casual observing and deductive reasoning  a delivery truck cannot function
without a driver
Textbook’s metal example (p.27)  metal and labor are substitutes because on one side labor can be expensive but the
amount of wasted metal is important because less labor is used but if metal is more expensive that L then L will be more
careful with the metal.
7.4-Lower costs in the long run
Because the firm cannot vary its K in the short run but can vary in the long run, S-R cost is at least as high as L-R
cost and is higher if the “wrong” level of K is used in the S-R

Long-run average cost as the envelope of short-run average cost curves:

-LRAC is always equal or below the SRAC

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

If firm sees that demand is q1 then it will

decide to build plant 1 (point a) because
average cost is lower than plant 2

Similarly for q2

The LRAC is tangent at one point to each

possible short-run ARC, making it the
envelope of the short-run curves but not
necessarily the minimum points on the
short-run curves (see point c)

Edges of all SRAC will form the LRAC

(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

Short-Run and long-run expansion paths:

L-R cost is lower than S-R cost because the firm has more flexibility in the L-R. To show the advantage of
flexibility, we can compare the S-R and L-R expansion paths which correspond to S-R and L-R cost curves

• L-R, firm can increase both L and K meaning that LREP is upward sloping
• S-R  K is fixed so SREP is horizontal

The learning curve:

Learning by doing: the productive skills an knowledge that workers and managers gain from experience
Firm’s AC may fall over time for 3 reasons:
1. Operation at a larger scale in the L-R may lower AC due to increasing returns to scale (IRS)
2. Technical progress may increase productivity thus lower AC
3. Learning by doing (see definition)
Workers, managers, engineers may take some time to perform a task the first few times but with time speed might
increase and this productivity as well  AC of production tend to fall over time

‘Learning by doing’ is often seen through a cumulative output function: the total number of units of output produced
since the firm started production

Learning curve: relationship between average costs and cumulative output

If a firm is operating in economies of scale section of its ACC then expanding output lowers its AC for 2 reasons:
• Economies of scale
• Average cost is lower later because firm has learned, by doing it again and again

(panel b) by producing q3 the firm

has even more economies of scale
and has also attained another level
of “learning by doing” so the costs
have lowered more

7.5-Cost of producing multiple goods

-The production of one good might depend on the output of the other
-For efficiency, a firm produces the two goods together if both require a single input (a sheep provide wool and mutton
and producing the two together is cheaper than doing it separately)

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