COST THEORY

 Opportunity cost
 Marginal and average cost

 Fixed and variable cost

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 Short run and long run cost

•Economic Cost: the monetary value of all inputs used in a
particular activity or enterprise over a given period.

Or
•Economic Cost: Cost to a firm of using resources in production.
Also called opportunity cost, the most valuable forgone
alternative .

•Opportunity cost is the value that is forgone in choosing one

activity over the next best alternative.

•Sunk Costs are costs that must be incurred no matter what the
decision.
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 Economic costs reflect the opportunity cost of
resources.

Explicit Costs: paid directly in money - money

costs. A firm incurs explicit costs when it pays
for a factor of production at the same time it
uses it.

• Explicit Cost = payments by a firm to

purchase the service of productive resources
(wages, interest, rent, capital)
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Implicit Costs: measured in units of money, but are
not paid for directly in money. The costs of no
purchased inputs, to which a cash value must be
imputed because the inputs are not purchased in a
market transaction. A firm incurs implicit costs when
it uses capital, inventories or owner’s resources.

• Implicit Costs = opportunity costs associated with

a firm’s use of resources that it owns (wages
foregone by owner, interest rates loss through
purchases)
Accounting Costs: Measures the explicit costs of
operating a business - RESULTS FROM 4
PURCHASES OF INPUT SERVICES.
FIGURE 1 ECONOMISTS VERSUS
ACCOUNTANTS

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Economic Profit

Economic profit is equal to total revenues less both implicit and explicit
costs.
For a firm to stay in business, both implicit and explicit costs must be
covered. If firms are receiving a negative economic profit in a market, they
will leave that market. A normal profit rate exactly covers wage costs and
the competitive rate of return on capital.

Accounting Profits

Accounting profits are generally higher than economic profits, as they omit
certain costs, such as the value of owner-provided labor and the firm's
equity capital.

When calculating "economic profit", explicit and opportunity costs are

taken into account.

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COST CURVES:

Fixed Costs (TFC) = costs that do not vary with output (present
even when output, q, = 0)
• Variable Costs (TVC) = costs that vary with the rate of output
• Total costs (TC) = TFC + TVC
• Average Variable Cost (AVC) = total variable cost/ number of units
produced
• Average Fixed Cost (AFC) = fixed costs/ output (units produced)
• Average Total Cost (ATC) = total cost (variable and fixed) /
number of units produced
• Marginal Cost (MC) = the change in total cost required to produce
an additional unit of output.
• Explicit Cost = payments by a firm to purchase the serviced of
productive resources (wages, interest, rent, capital)
• Implicit Costs = opportunity costs associated with a firm’s use of
resources that it owns (wages foregone by owner, interest rates
loss through purchases) 7
TIME HORIZON:
THE SHORT RUN AND THE LONG RUN

 Useful to categorize firms’ decisions into

 Long-run decisions—involves a time horizon long enough
for a firm to vary all of its inputs
 To guide the firm over the next several years (long run lens)
 Short-run decisions—involves any time horizon over
which at least one of the firm’s inputs cannot be varied
 To determine what the firm should do next week ( short run
lens)

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 FIXED VS. VARIABLE INPUTS
 Total Costs = Fixed Costs + Variable Costs

 Fixed input - an input whose quantity cannot be changed as output

changes in the short run.
or
 Fixed costs - costs that are spent and cannot be changed in the
period of time under consideration.
 costs of production that do not change as output change (i.e. land and capital)

 Variable input - an input whose quantity can be changed as output

changes in the short-run.
or
 Variable costs - costs of production that change as output
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changes (i.e. labor and raw materials)
THE SHORT RUN COST
FUNCTION

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THE SHORT RUN COST FUNCTION
 Graphically, these results are be depicted in the figure
below.

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THE FIRM’S TOTAL COST CURVES IN THE SHORT RUN
TOTAL COSTS = FIXED COSTS + VARIABLE COSTS

Dollars

$435 TC

375 TFC TVC

315
255
195
135
TFC

0 30 90 130 161 184 196

Units of Output 12
AVERAGE COSTS

 Average fixed cost (AFC)

 Total fixed cost per unit of output produced

TFC
AFC 
Q
• Average variable cost (TVC)
– Total variable cost per unit of output produced

TVC
AVC 
Q
• Average total cost (TC)
– Total cost per unit of output produced
TC 13
ATC 
Q
MARGINAL COST
 Marginal Cost
 Increase in total cost from producing one more unit
or output
 Marginal cost is the change in total cost (ΔTC) divided
by the change in output (ΔQ)
ΔTC
MC 
ΔQ
– Tells us how much cost rises per unit increase in output
– Marginal cost for any change in output is equal to shape
of total cost curve along that interval of output
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SHORT-RUN PRODUCTION COSTS
Fixed Costs
Total Fixed Costs
Total Fixed Costs
Average Fixed Costs = Quantity

Variable Costs
Total Variable Costs
Total Variable Costs
Average Variable Costs = Quantity
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 SHORT-RUN PRODUCTION COSTS
Total Cost
Total Fixed and Variable Costs
Total Costs
Average Total Cost = Quantity

Marginal Cost
Total Variable Costs
Change in Total Costs
Marginal Cost = Change in Quantity 16
SHORT-RUN COSTS GRAPHICALLY

MC
Plotting Average and
Marginal Costs

ATC
Costs (dollars)

AVC

AFC
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Quantity
Summary Cost Functions
$ Per Unit SAC
SMC AVC

Example:
Example: Short
Short Run
RunAverage
Average
Cost,
Cost, Average
Average Variable
Variable Cost
Cost
and Average Fixed Cost
and Average Fixed Cost

AFC
0 Q (units per year) 18
THE RELATIONSHIP BETWEEN
AVERAGE AND MARGINAL COSTS
 At low levels of output, the MC curve lies below
the AVC and ATC curves
These curves will slope downward
 At higher levels of output, the MC curve will
rise above the AVC and ATC curves
These curves will slope upward
 As output increases; the average curves will first
slope downward and then slope upward
Will have a U-shape
 MC curve will intersect the minimum points of
the AVC and ATC curves
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THE SHAPE OF THE MARGINAL
COST CURVE
 When the marginal product of labor (MPL) rises
(falls), marginal cost (MC) falls (rises)
 Since MPL ordinarily rises and then falls, MC will
do the opposite—it will fall and then rise
 Thus, the MC curve is U-shaped

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PRODUCTIVITY AND COST CURVES

Average product and

marginal product
AP
MP
Quantity of labor
MC
Costs (dollars)

AVC

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Quantity of output
Long Run Average Cost Function

$ per unit
SAC(Q,K3)

AC(Q)

•
• •
0 Q (units per year)
Q1 Q2 Q3 22
Long Run Average Cost Function

$ per unit

SAC(Q,K1)
AC(Q)

•
• •
0 Q (units per year)
Q1 Q2 Q3 23
Long Run Average Cost Function

$ per unit
SAC(Q,K3)
SAC(Q,K1)
SAC(Q,K2) AC(Q)

•
• •
0 Q (units per year)
Q1 Q2 Q3 24

Chapter Eight
Cost Function Summary
MC(Q)
$ per unit MC(Q)
SAC(Q,K3)
SAC(Q,K1)

SAC(Q,K2) AC(Q)

•
•
SMC(Q,K ) •
1

Q (units per year)

0
Q1 Q2 Q3 25
Cost Function Summary
MC(Q)
$ per unit MC(Q)
SAC(Q,K3)
SAC(Q,K1)

SAC(Q,K2) AC(Q)

•
•
SMC(Q,K ) •
1

Q (units per year)

0
Q1 Q2 Q3 26
LONG-RUN PRODUCTION COSTS

Unit Costs

Output 27
LONG-RUN PRODUCTION COSTS

Unit Costs

Output 28
LONG-RUN PRODUCTION COSTS

The long-run ATC just “envelopes”

Unit Costs all of the short-run ATC curves.

Output 29
Economies & Diseconomies of Scale

Definition: If average cost decreases as

output rises, all else equal, the cost
function exhibits economies of scale.

Similarly, if the average cost increases as

output rises, all else equal, the cost
function exhibits diseconomies of scale.

Definition: The smallest quantity at which

the long run average cost curve attains its
minimum point is called the minimum
efficient scale.
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 THE LONG-RUN COST FUNCTION

 Economies of scale - reductions in the minimum average cost

that come about through increasing plant size.

 Reasons for Economies of Scale

 Increasing returns to scale
 Specialization in the use of labor and capital
 Indivisible nature of many types of capital equipment
 Productive capacity of capital equipment rises faster than
purchase price
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 THE LONG-RUN COST FUNCTION
 Reasons for Economies of Scale
• Economies in maintaining inventory of
replacement parts and maintenance personnel
• Discounts from bulk purchases
• Lower cost of raising capital funds
• Spreading promotional and R&D costs
• Management efficiencies

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OTHER METHODS TO REDUCE COSTS
 The Strategic Use of Cost
 Reduction in the Cost of Materials

 Using IT to Reduce Costs

 Reduction of Process Costs

 Relocation to Lower-Wage Countries or Regions

 Mergers, Consolidation, and Downsizing

 Layoffs and Plant Closings

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THE LONG-RUN COST FUNCTION
 Diseconomies of scale - increases in plant size increase
minimum average cost.
• Reasons for Diseconomies of Scale

• Decreasing returns to scale

• Disproportionate rise in transportation costs
• Input market imperfections
• Management coordination and control problems
• Disproportionate rise in staff and indirect labor
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THE LONG-RUN COST FUNCTION
 The LRAC is the lower envelope of all of the SRAC
curves.
 Minimum efficient scale is the lowest output level for
which LRAC is minimized.

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LRATC AND THE SIZE OF FIRMS
 Minimum efficient scale (MES) for the firm
 Lowest level of output at which it can achieve
minimum cost per unit
 The output level at which the LRATC first hits

bottom
 By comparing the MES (from LRATC curve) for the
typical firm and and the maximum potential market
(from the market demand curve)
 we may say something about the market structure

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 ECONOMIES AND
DISECONOMIES OF SCALE

Economies
of scale
Unit Costs

long-run ATC
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Output
 ECONOMIES AND
DISECONOMIES OF SCALE

Economies Constant returns

of scale to scale
Unit Costs

long-run ATC
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Output
 ECONOMIES AND
DISECONOMIES OF SCALE

Economies Constant returns Diseconomies

of scale to scale of scale
Unit Costs

long-run ATC
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Output