Handout for Chapter 6: The Cost of Production

I. Relevant Cost Concepts.

1. Opportunity cost: the benefits forgone in the next best alternative.
2. Explicit costs: input costs that require an outlay of money by the firm; the costs
that are measured by accountants; incurred when using resources owned by
others.
3. Implicit costs: input costs that do not require an outlay of money by the firm;
accountants do not measure implicit costs; incurred when using self-owned
resources.
4. Economic profit: Total revenue – explicit costs – implicit costs.
5. Accounting profit: Total revenue – explicit costs.
6. Sunk cost: an expense that has already been incurred and cannot be recovered;
irrelevant to the firm’s current decision.
Type of Cost Relevant to Accountant? Relevant to Decision
Maker?
Fixed Cost Yes No
Sunk Cost Yes No
Variable Cost Yes Yes

II. Short-Run Costs

1. C=FC+VC.
2. SMC=∆C/∆Q=∆VC/∆Q
3. Average costs.
1) AFC=FC/Q
2) AVC=VC/Q
3) SAC=C/Q=AFC+AVC
4. SMC=PL/MPL: marginal cost and marginal product move in opposite directions.
5. SMC and AVC:
1) If SMC<AVC, AVC ↓;
2) If SMC>AVC, AVC ↑;
3) If SMC is a constant, AVC = SMC.
6. SMC and SAC:
1) If SMC<SAC, SAC ↓;
2) If SMC>SAC, SAC ↑;
3) If SMC is a constant, SAC ↓.
7. The shapes of the cost curves.
1) AFC always declines.
2) Three shapes of SMC: SMC keeps rising; SMC is U-shaped; SMC is constant.
3) The AVC curve:
a. If the SMC curve keeps rising, the SMC curve lies above the AVC curve
and the AVC curve keeps rising.
b. If the SMC curve is U-shaped, the AVC curve is also U-shaped, and the
SMC curve crosses the AVC curve at the minimum AVC.

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 c. If SMC is constant and horizontal, AVC is the same as
SMC.
4) The SAC curve:
a. If the SMC curve keeps rising or is U-shaped, the SAC curve is U-shaped,
and the SMC curve crosses the SAC curve at its minimum.
b. If SMC is constant and horizontal, the SAC curve keeps declining like
AFC.

III. Long-Run Costs

1. LAC=C/Q, all costs are variable.
2. Constant returns to scale: LAC constant.
Increasing returns to scale: LAC falls as Q rises.
Decreasing returns to scale: LAC rises as Q rises.
3. Minimum efficient scale: the lowest output at which minimum average cost can
be achieved.

IV. Economies of Scope and the Learning Curve

1. Economies of Scope: the cost of producing multiple goods is less than the
aggregate cost of producing each item separately.
2. The learning curve: As the firm’s cumulative output increases, its average cost
tends to fall.

V. Cost Analysis and Optimal Decisions

1. In the short run, if contribution R – VC>0, or, equivalently, P>AVC, the
firm should continue production; shut down if P<AVC.
2. In the long run, continue production if π>0, or, equivalently, contribution
is higher than “fixed cost”; exit if π<0.
3. Multiple products: similar shut-down rule as for a single product;
Do not allocate fixed costs for decision making.