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Managerial

Economics
MBAFT 6103

Today
Costs and Cost Minimization

Overview

1. Introduction: Bestar
2. Opportunity Cost
3. Long Run Cost Minimization
The constrained minimization problem
Comparative statics
Input demands

4. Short Run Cost Minimization

Motivation
Bestar

2003

2004

2005

Revenue (C$ 000)

44,300

43,700

38,700

Restructuring costs
(C$ 000)

n.a.

1,400

n.a.

Net earnings (C$


000)

254

-442

174

Bestar

How do changes in wood prices affect furniture
industry?
Should Bestar shut down?
Also, check the case of DND Flyover
http://www.docstoc.com/docs/33337793/NOIDATOLL-BRIDGE

Opportunity Cost

One relevant concept of cost is opportunity cost:
based the value of a resource in its best alternative
use.
The only alternative we consider is the best
alternative which is not chosen
Opportunity cost includes all explicit and implicit
costs.

Opportunity Cost
Example

Opportunity Cost of using Steel to produce Cars
Purchase steel for Rs. 10 lakhs. Since then, price has
gone up so that it is worth Rs. 12 lakhs.
Two alternatives:
i) making cars, or ii) reselling the steel.
What is the opportunity cost of using the steel to
produce cars?
Explicit cost of producing cars + Rs. 12 lakhs
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Opportunity Cost

Opportunity cost is forward looking. What does the
decision-maker give up at the time the decision is
being made?
Opportunity costs have an implicit component
Accounting costs (total explicit cost incurred in the
past) different from economic (opportunity) costs.

Accounting Costs and


Opportunity Costs

Is it necessarily true that opportunity cost of a
decision/project is ALWAYS higher than the
accounting costs?

Explicit Costs

Common Misconceptions

Capital Expenditure = Fixed cost
Labor = Variable cost
Fixed cost and Sunk cost are the same

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Sunk Costs

Sunk Costs are costs that have been already incurred and
cannot be recovered. These costs are not part of
opportunity costs. Depends on the stage of decision
making.
Example: Bowling Ball Factory
Costs Rs. 50 lakh to build and has no alternative uses
Rs. 50 lakh is not sunk cost for the decision of whether or
not to build the factory
After the factory is built, Rs. 50 lakh is sunk cost for the
decision of whether to operate or shut down the factory
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Long-run vs. Short-run



Short Run: The period of time in which the quantity of
at least one of the inputs that a firm use cannot be
changed.
Long Run: The period of time that is long enough so
that the quantity of all the inputs that a firm use can
be changed.

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Long-Run Cost Curves



Long-Run Total Cost = LTC = f(Q)
Long-Run Average Cost = LAC = LTC/Q
Long-Run Marginal Cost = LMC = LTC/Q

Long-run cost minimization


with two inputs

A manager uses two inputs, K and L for production.
Cost of K=r (rental rate) and cost of L=w (wage rate).
Total cost, TC=rK+wL
Desired output Q0. This is how much the manager has
to produce. Technology: Q = f(L,K)
Managers problem:
minimize TC = rK + wL
subject to Q0 = f(L,K)
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Graphical Solution: Isocost Line


K

TC1/r
TC0/r

TC2/r

For a given value of TC0 we can draw,


TC0 = rK + wL,
or, K = TC0/r (w/r)L
This is called an isocost line.
Direction of
increase in
total cost

Slope = -w/r

TC0/w TC1/w TC2/w

L
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Solving Cost Minimization


TC2/r K
TC1/r
TC0/r

Isoquant Q = Q0 is given

TC0/w TC1/w TC2/w

L
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Cost Minimization:
Tangency Condition

Cost minimization subject to satisfaction of the
isoquant equation: Q0 = f(L,K)
Note: analogous to expenditure minimization for the
consumer
Tangency Condition:
MRTSL,K = MPL/MPK = w/r ---- (1)
(w = price of labor, r = price of capital)
Constraint:
Q0 = f(K,L) ---- (2)
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Comparative Statics

A change in the relative price of inputs changes the
slope of the isocost line.
All else equal, an increase in w must decrease the
cost minimizing quantity of labor and increase the
cost minimizing quantity of capital with diminishing
MRTSL,K.
All else equal, an increase in r must decrease the
cost minimizing quantity of capital and increase the
cost minimizing quantity of labor.
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An Example

Change in Relative Price of Inputs


K

Cost minimizing input combination w=2, r=1

Cost minimizing input combination, w=1, r=1

Isoquant Q = Q0

L
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Input Demand Functions



The cost minimizing quantities of labor and capital for
various levels of Q, w and r are the input demand
functions.
L = L*(Q,w,r)
K = K*(Q,w,r)
Note: These are obtained from Producers cost
minimization just as we got the demand functions
from Consumers utility maximization
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Input Demand Functions:


An Example

Q = 50L1/2K1/2. Find the input demand functions L* and K* when
the manager has to produce Q0 amount of output.
Optimality condition: MPL/MPK = w/r => K/L = w/r,
or, K=(w/r)L
Substituting K in production function,
Q0 = 50L1/2[(w/r)L]1/2 => L*(Q,w,r) = (Q0/50)(r/w)1/2
Similarly, K*(Q,w,r) = (Q0/50)(w/r)1/2
Generally, labor is a decreasing function of w
and capital is a decreasing function of r

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Short-Run Cost Functions



Total Cost = TC = f(Q)
Total Fixed Cost = TFC
Total Variable Cost = TVC
TC = TFC + TVC

Short-Run Cost Functions



Average Total Cost = ATC = TC/Q
Average Fixed Cost = AFC = TFC/Q
Average Variable Cost = AVC = TVC/Q
ATC = AFC + AVC
Marginal Cost = TC/Q = TVC/Q

Short-Run Cost Functions



Average Variable Cost
AVC = TVC/Q = w/APL
Marginal Cost
TC/Q = TVC/Q = w/MPL

Example

Short Run Cost Minimization


An Example: Q = f(L,K*,M)

Suppose one factor (say, K) is fixed.
The short run cost minimization problem is to choose
quantities of the variable inputs so as to minimize total
costs given that the manager wants to produce an
output level Q0 and under the constraint that the
quantities of the fixed factors do not change.

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Short-run Cost
Minimization

Minimize wL + mM + rK*
(L,M)

Subject to Q0 = f(L,M,K*)
Note: L,M are the variable inputs and:
wL+mM is the total variable cost
K* is the fixed input and
rK* is the total fixed cost
To solve: Tangency condition: MPL/w = MPM/m
Constraint: Q0 = f(L,K*,M)
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Tangency Condition:
Long Run

What is the solution to the firms long run cost minimization
problem given that the manager wants to produce Q0 units of output?
MPL/MPM = w/m
MPL/MPK = w/r
Constraint: Q0 = f(L,K,M)
Three equations and three unknowns. Combining these, we get the
long run demand functions for labor, capital and materials.

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Next

Cost Curves

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