Econ - Unit - 5 - Cost Theory
Econ - Unit - 5 - Cost Theory
Opportunity cost
Marginal and average cost
Or
•Economic Cost: Cost to a firm of using resources in production.
Also called opportunity cost, the most valuable forgone
alternative .
•Sunk Costs are costs that must be incurred no matter what the
decision.
2
Economic costs reflect the opportunity cost of
resources.
5
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.
6
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
8
FIXED VS. VARIABLE INPUTS
Total Costs = Fixed Costs + Variable Costs
10
THE SHORT RUN COST FUNCTION
Graphically, these results are be depicted in the figure
below.
11
THE FIRM’S TOTAL COST CURVES IN THE SHORT RUN
TOTAL COSTS = FIXED COSTS + VARIABLE COSTS
Dollars
$435 TC
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
14
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
15
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
17
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
19
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
20
PRODUCTIVITY AND COST CURVES
AVC
21
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
SAC(Q,K2) AC(Q)
•
•
SMC(Q,K ) •
1
Unit Costs
Output 27
LONG-RUN PRODUCTION COSTS
Unit Costs
Output 28
LONG-RUN PRODUCTION COSTS
Output 29
Economies & Diseconomies of Scale
32
OTHER METHODS TO REDUCE COSTS
The Strategic Use of Cost
Reduction in the Cost of Materials
33
THE LONG-RUN COST FUNCTION
Diseconomies of scale - increases in plant size increase
minimum average cost.
• Reasons for Diseconomies of Scale
35
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
36
ECONOMIES AND
DISECONOMIES OF SCALE
Economies
of scale
Unit Costs
long-run ATC
37
Output
ECONOMIES AND
DISECONOMIES OF SCALE
long-run ATC
38
Output
ECONOMIES AND
DISECONOMIES OF SCALE
long-run ATC
39
Output