MICROECONOMICS I

TOPIC V :
COST OF PRODUCTION
(Chapter 6, 7, GLS; Chapter 7, PR)
Purificación Granero Gómez
Universidad de Alcalá
ENI, Course 19-20, 2nd year, first term
 Microeconomics I – ENI
TOPIC V: Cost of production
INTRODUCTION
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

Timetable
1. Costs and the manner in which costs are structured are key to a firm’s production
decisions
2. 1 How much to produce?
3. 2 Whether to expand or shrink in response to changing market conditions?
4. 3 Whether to switch to producing a different product?
5. We examine cost structures:
 Introducing different types of costs
 Differentiating between short-run and long-run
 Microeconomics I – ENI
TOPIC V: Cost of production
INTRODUCTION
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

1. 1. Economic Costs
 Opportunity Costs
 Sunk Costs
2. 2. Costs and Cost Curves
 Fixed Costs
 Variable Costs
3. Average and Marginal Costs
4. Firm’s Cost Minimisation Problem
5. Short-Run and Long-Run Cost Curves
6. Economies in the Production Process
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

Accounting cost includes the direct costs of operating a business, including

costs for raw materials.

Economic cost
 sum of a producer’s accounting and opportunity costs:
 value of sacrificed opportunities. There are explicit costs (direct monetary
outlay) and implicit costs (forgone income by not choosing another
decision).
Opportunity cost
 value of what a producer gives up by using an input
 payoff associated with the best of the alternatives that are not chosen.
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

Opportunity costs do not always correspond to an actual expenditure.

Inclusion of opportunity cost means an economist’s interpretation of what
constitutes profit will generally be different from an accountant’s

Accounting profit is a firm’s total revenue minus accounting cost

Economic profit is a firm’s total revenue minus economic cost

 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

What is the cost to you of studying at the University?

Opportunity Cost
Tuition Fees (explicit cost) + Transportation (explicit cost) + Foregone
income if working instead of attending university (implicit cost)
Accounting Cost
Tuition Fees (explicit cost) + Transportation (explicit cost)
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

Jim’s Consulting is owned by James Smith. For the past year, Jim’s Consulting had the following
revenues and costs
• Revenues: $600,000
• Supplies: $20,000
• Electricity and water: $10,000
• Employee salaries: $300,000
• Jim’s salary: $250,000
James has the option of shutting down and renting out the building he owns for $60,000 per
year. Additionally, James could go work for a larger consulting house for $275,000 per year.
Answer the following questions:
1. What is Jim’s Consulting’s accounting cost?
2. What is Jim’s Consulting’s economic cost?
3. What is Jim’s Consulting’s economic profit?
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

While opportunity costs should be considered when making decisions, sunk

costs should be ignored
Sunk costs are costs that cannot be avoided, costs that have already been
incurred.
• A form of fixed costs (fixed inputs), independent of the quantity of the
firm’s output (e.g.: buildings, operating permits, durable equipment –
might be partially avoidable-)
• Costs cannot be recovered once spent (licensing fees, long-term lease
contracts, specific capital such as uniforms, menus, signs, etc.)
Sunk costs cannot be recouped and therefore should not be considered if a
firm is deciding whether or not to close
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

Sunk Costs and Decisions: Once incurred, sunk costs should not affect decision
making
Example: Consider a business deciding whether to close down
• Some of the costs associated with the business are unavoidable (e.g., permits, loss
of value in kitchen equipment, uniforms)
• Others costs disappear when operations cease (e.g., wages for employees, raw
materials, phone bills)

 If staying open will generate some revenue, what should the firm do?
• Stay open as long as operating revenues exceed operating costs
• Operating revenue is the money a firm earns from selling its output
• Operating cost is the cost a firm incurs in producing its output
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIC COSTS VS ACCOUNTING COSTS
Introduction
The economic concept of cost
Total long –term costs
Total short term costs
Relationship between short and long term costs

What is the cost to you of studying at the University?

Opportunity Cost
• Tuition Fees (explicit cost) + Transportation (explicit cost) + Foregone income if
working instead of attending university (implicit cost)
Accounting Cost
• Tuition Fees (explicit cost) + Transportation (explicit cost)
Sunk Costs
• If your tuition fees are paid at the beginning of the academic year, evaluating
sunk costs in February: Tuition Fees (explicit cost)
Nonsunk Costs
• Transportation (explicit cost)
 Microeconomics I – ENI
TOPIC V: Cost of production
COST AND COST CURVES
Introduction
The economic concept of cost
Total short term costs
Total long term costs
Relationship between short and long term costs

Economic analysis of costs divides operating costs into two categories:

• Fixed cost (FC ) is the cost of the firm’s fixed inputs, independent of the
quantity of the firm’s output (e.g., office lease)

• Variable cost (VC ) is the cost of inputs that vary with the quantity of the
firm’s output (e.g., raw materials)

The sum of fixed and variable costs is a firm’s total cost

TC =FC +VC
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
COST AND COST CURVES
Relationship between short and long term costs

Flexibility and Fixed versus Variable Costs

• Time horizon is the chief factor determining flexibility of different input levels
• Over short time horizons, many inputs are fixed costs (e.g., in a single day
for a restaurant most costs are fixed, including labor and capital)
• As the time horizon expands, wait staff can be hired or fired, new capital
can be purchased, and space can be expanded

Other Factors Affecting Flexibility

• The presence (or lack) of active capital rental and resale markets allow some
capital expenditures to become variable (e.g., renting an extra crane)
• Labor contracts may lead to stickiness in labor inputs; it may be difficult to fire
workers, and firms may become reluctant to hire unless absolutely necessary
 Microeconomics I – ENI
TOPIC V: Cost of production
COST AND COST CURVES
Introduction
The economic concept of cost
Total short term costs
Total long term costs
Relationship between short and long term costs

Deriving Cost Curves

A cost curve is the mathematical relationship between a firm’s production

costs and output

• Curves associated with fixed, variable, and total costs will have different
shapes
Consider Fleet Foot, a shoe company that produces running shoes

• Costs can be represented by a table or a graph

 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
COST AND COST CURVES
Relationship between short and long term costs
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
COST AND COST CURVES
Relationship between short and long term costs

Fixed, Variable, and Total Costs

Cost
($/week)
$300 TC is the sum of VC and FC

250
Total cost (TC )
200
Variable cost (VC )
150

100

50
Fixed cost (FC )

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of shoes (pairs)
7-16
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs

COST AND COST CURVES Total long term costs

Relationship between short and long term costs

The Fixed cost curve is horizontal

• Costs do not vary with output; they are $50 per week regardless of
production
Variable costs change with the amount of output, and the variable cost curve
is therefore not constant
• The slope of the variable cost curve is always positive
• In this example, the curve becomes flatter as output rises from 0 to 4 pairs,
then becomes steeper as the number of pairs produced per week increases

The total cost curve is the sum of variable cost and fixed cost
• The total cost curve will have the same shape as the variable cost curve, but
it will be shifted up at each level of output by the amount of fixed costs
 Microeconomics I – ENI
TOPIC V: Cost of production
COST AND COST CURVES
Introduction
The economic concept of cost
Total short term costs
Total long term costs
Relationship between short and long term costs

Average cost: cost divided by output

• Average fixed cost (AFC )
AFC  FC / Q

• Average variable cost (AVC )

AVC  VC / Q

• Average total cost (ATC )

ATC  TC / Q  FC  VC / Q
 FC / Q  VC / Q  AFC  AVC
 Microeconomics I – ENI
TOPIC V: Cost of production
COST AND COST CURVES
Introduction
The economic concept of cost
Total short term costs
Total long term costs
Relationship between short and long term costs
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
COST AND COST CURVES
Relationship between short and long term costs

Average Cost Curves

Average cost AFC always falls as quantity rises.
($/pair) This is because it is being averaged
across more and more units.
$70
60 Average total cost (ATC )
50
40 Average fixed cost (AFC )

30
Average variable cost (AVC )
20
10

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of shoes (pairs)
7-20
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
COST AND COST CURVES
Relationship between short and long term costs

Marginal cost is another deciding factor in firms’ production

decisions

• The additional cost of producing an additional unit of output

MC  TC / Q

• Since fixed costs do not change when a firm expands output,

marginal cost only depends on variable cost..
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
COST AND COST CURVES
Relationship between short and long term costs

Marginal Cost
Marginal cost
MC falls at first
($/pair)
because AFC is falling.
$80 Eventually MC rises.
70
Marginal cost (MC )
60
50
40
30
20
10

0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity of shoes (pairs)
 Microeconomics I – ENI
TOPIC V: Cost of production
COST AND COST CURVES
Introduction
The economic concept of cost
Total short term costs
Total long term costs
Relationship between short and long term costs

Marginal cost depends on variable cost and not on fixed costs

• Fixed costs do not change when a firm expands output

What happens when marginal cost is less than average total cost?
• When marginal cost is less than the average total cost, producing
another unit will reduce average total cost

And if MC > AVC?

Average total costs are minimised when ATC =MC

• This explains why ATC and AVC have a “U” shape
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Total short term costs
Total long term costs
Relationship between short and long term costs

The Relationship Between Average and Marginal Costs

MC always crosses
AVC and ATC at
Average cost their minimums.
and marginal MC
cost ($/unit) ATC
Minimum AVC
ATC

Minimum
AVC
Quantity

7-24
 Microeconomics I – ENI
TOPIC V: Cost of production
COST AND COST CURVES
Introduction
The economic concept of cost
Total short term costs
Total long term costs
Relationship between short and long term costs

Suppose a firm’s total cost curve is

TC  10Q 2  6Q  60

Answer the following questions:

1. Find the firm´s marginal Cost
2. Find expressions for the firm’s fixed cost, variable cost, average
total cost, and average variable cost
3. Find the output level that minimizes average total cost
4. Find the output level that minimizes average variable cost
Minimizing Costs figure it out

1. Find the firm’s fixed cost, variable cost, average total cost, and
average variable cost

Fixed cost does not vary with output, so solve for total cost when output
equals zero
TC  10 0   60   60  60  FC
2

Variable cost is the portion that does vary with output

 Fixed

TC  10Q  6Q  60  VC  10Q 2  6Q
2

Average total cost is simply total cost divided by output,

10Q 2  6Q  60 60
ATC   10Q  6 
Q Q
And the same applies to variable cost,
10Q 2  6Q
AVC   10Q  6
Q
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 7-26
Minimizing Costs figure it out

2. Minimum average total cost occurs when marginal cost is equal

to average total cost
10Q 2  6Q  60
ATC  MC   20Q  6
Q
10Q 2  6Q  60  20Q 2  6Q  10Q 2  60
 Q  6  2.45

So, ATC is minimized when Q = 2.45

3. Finally, average variable cost is minimized when marginal cost

is equal to average variable cost
10Q 2  6Q
AVC   10Q  6  20Q  6  Q  0
Q
And AVC is minimized when production ceases

Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 7-27
 Microeconomics I – ENI
TOPIC V: Cost of production
COST OF PRODUCTION
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

4. Firm’s Cost Minimisation Problem (GLS, 6)

5. Short-Run and Long-Run Cost Curves

• Expansion Path and Total Cost Curves
• Average Total Costs
• Marginal Costs
6. Economies in the Production Process
• Economies of Scale
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S COST MINIMISATION PROBLEM
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

• Cost minimization refers to the firm’s goal of producing a

specific quantity of output at minimum cost.
• This is an example of constrained optimization.
• The firm will minimize costs subject to a specific amount
of output that must be produced.
• The cost minimization model requires two concepts:
isoquants and isocost lines.
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S COST MINIMISATION PROBLEM
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

• ISOCOST LINE: shows all of the input combinations that yield the
same cost
• Similar to the budget constraint facing consumers
• C is total cost, R is the “rental rate” of capital, and W is the wage
rate
C=RK+WL
• Rearranging yields:
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S COST MINIMISATION PROBLEM
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Isocost lines and input price changes

When labor becomes more When capital becomes
expensive… more expensive…

…the isocost line becomes …the isocost line becomes

steeper flatter
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Short term costs
Long term costs
FIRM’S COST MINIMISATION PROBLEM Relationship between short and long term costs

• Identifying Minimum cost: to combine

Isoquants and Isocost Lines
• Graphically, cost minimization requires
tangency between the isoquant associated
with the chosen level of production (i.e., the
constraint), and the lowest isocost line.

•  Cost minimization is achieved by

adjusting the ratio of capital to labor Cc cannot produce ¯ Q
CA can produce ¯ Q but is more expensive
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S COST MINIMISATION PROBLEM
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

• Tangency point: Isocost line and isoquant have the same slope
• Slope of the isocost line: –w/r.
• Slope of the isoquant: – MRTSLK, which is equal to the ratio of MPL to MPK.
The tangency therefore implies:

Costs are minimised when the marginal product per dollar spent is equalised
across inputs

What if ? Cost minimization is achieved by adjusting the

ratio of capital to labor
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S COST MINIMISATION PROBLEM
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Changes in input prices & the firm’s optimal input mix

When labor becomes relatively more

expensive, the isocost line shifts from C1
to C2  With the steeper isocost line,
the cost-minimizing input choice shifts
from point A to point B
 the increase in the relative cost of
labor causes the firm to shift to an
input mix that has more capital and
less labor than before
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S COST MINIMISATION PROBLEM
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

• Example: A firm is employing 100 workers (W = $15/hour) and

50 units of capital (R = $30/hour).
• At the firm’s current input use, the marginal product of labor is
45 and the marginal product of capital is 60.
• Is the firm producing its current level of output at the minimum
cost or is there a way for the firm to do better? Explain.
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S EXPANSION PATH AND TOTAL COST CURVE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Summing up: firms seek to produce each level of output at the minimum
cost.
We can use the cost minimisation approach to describe how capital and
labor change as output increases:
If output changes, firms adjust their input mix in order to produce the
new level of output at the minimum cost
Expansion path: A curve that illustrates how the optimal mix of inputs
varies with total output.
For each optimal input combination, we can compute the total cost of
production (C=RK*+WL*)
Total cost curve: A curve that shows a firm’s (minimum) cost of producing
particular quantities.
 Microeconomics I – ENI
TOPIC V: Cost of production
FIRM’S EXPANSION PATH AND TOTAL COST CURVE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs
 Microeconomics I – ENI
TOPIC V: Cost of production
SHORT AND LONG RUN COSTS
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Remind Aim: How the time horizon affects the Firm’s cost structure.

Total cost curve: A curve that shows a firm’s cost of producing particular
quantities.

• A firm’s short-run total cost curve describes the total cost of

producing various quantities of output when the amount of capital
available for use is fixed
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Short term costs
Long term costs
SHORT AND LONG RUN COSTS Relationship between short and long term costs

Total cost curves

Figure 7.5 Figure 7.6
Capital Total Cost

C = 360

TCSR TCLR
Z′
Long-Run Expansion Path $360

$300
Z
C = 120
Z Short-Run Expansion
$180
X′ Z′ Path (K = 5) X′
Y
5 $120
Y $100
Q = 20 Q = 30 X
X
C = 180 C = 300
C = 100 Q = 10
0 0 10 20 30
Labor Output

The short-run total cost curve will never fall below the long-run total cost curve
 Microeconomics I – ENI
TOPIC V: Cost of production
SHORT AND LONG RUN COSTS
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

We have shown that the short-run total cost curve will never fall below the long-
run total cost curve.

• This further implies that the short-run average total cost curve will never fall
below the long-run average total cost curve

• This fact holds true for all short-run average total cost curves (each of which
corresponds to a different fixed capital level)

• This property means that the long-run ATC curve will envelop all of the short-
run ATC curves
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Short term costs
Long term costs
SHORT AND LONG RUN COSTS Relationship between short and long term costs

Average total cost curves

Average ATCSR,10 ATCSR,30

total cost
($/unit) ATCSR,20 ATCLR

X′ Z'
$12

X Y Z
9

0 10 20 30 Quantity
of engines
The Long-Run Average Total Cost Curve Envelops the Short-Run Average Cost Curves
 Microeconomics I – ENI
TOPIC V: Cost of production
SHORT AND LONG RUN COSTS
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Exercise:

Suppose a wind turbine producer faces a production function Q  0,25KL

The wage rate (w) is 12€ per hour, and the rental rate on capital (r) is 22€ per hour
Answer the following questions:
1. In the short run, capital is fixed at 8. What is the cost of producing 200
turbines?

2. What should the firm do in the long run to minimize the cost of
producing 200 turbines?
Production of Wind Turbines

1. If capital is fixed at 8 units, the amount of labor needed to produce 200

turbines is found by solving for L
200  0.25 8 L  L  100
Total cost is therefore given by
TC  RK  WL  $22  8  $12 100  $1,376
2. From Chapter 6, we know that costs are minimized when the MRTS of
labor for capital is equal to the ratio of the costs of labor to capital,
MPL 0.25K K K W 12 12
MRTS LK       Or, K  L
MPK 0.25L L L R 22 22
Subbing the expression for K into the production function yields
 12  3 2
Q  200  0.25 L  L  L  L  38.3
 22  22
And finally, solving for the amount of capital used yields K  20 .89
Finally, total costs are given by
TC = RK +WL = $22 ´ 20.89 +$12 ´38.3 = $919.18
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 7-43
 Microeconomics I – ENI
TOPIC V: Cost of production
SHORT AND LONG RUN COSTS
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Marginal Cost Curves

Just as with average costs,

• Short-run marginal cost is the cost of producing an additional unit of
output when capital is fixed
• Long-run marginal cost is the cost of producing an additional unit of
output when both capital and labor are variable

 What does this imply for the shape of the marginal cost curves?

• In general, the long-run marginal cost curve will be flatter than the short-
run marginal cost curve
 Microeconomics I – ENI Introduction
The economic concept of cost
TOPIC V: Cost of production
Short term costs
Long term costs
SHORT AND LONG RUN COSTS Relationship between short and long term costs

Marginal Costs

Average cost ATCSR,10

ATCSR,30 MCLR
and marginal
cost ($/unit) ATCSR,20
ATCLR

$12
B

Y
9 Note that each short
A run MC curve
intersects each ATC
MCSR,10 curve at its minimum.
MCSR,20 MCSR,30
0 10 20 30 Quantity
of engines
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Analysis of changes in costs after changes in the production.

• Similar to returns to scale, but focused on the cost side

What happens to the long-run ATC curve as a firm grows?

• Economies of scale: costs rise more slowly than production

• Diseconomies of scale: costs rise more quickly than production

• Constant economies of scale: costs rise at the same rate as

output
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Economies of scale:
• ATC falls as output grows
• LR ATC curve is downward sloping
AC,MC
ATC

MC Increasing ATC
ATC0
ATC1
ECONOMIES
OF SCALE
Q0 Q1 Q
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Diseconomies of scale:
• ATC increases as output grows
• LR ATC curve is upward sloping
AC,MC
CMg CMe

Increasing AC

CMe1 DISECONOMIES OF
SCALE
CMe0

Q0 Q1 Q

Microeconomía I: Tema 5. Los costes de

producción.
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Constant economies of scale:

• ATC remain constant as output grows
• LR ATC curve is flat
AC,MC

Constant AC

CONSTANT
AC = MC
AC =MC
ECONOMIES OF
SCALE

Q0 Q1 Q

Microeconomía I: Tema 5. Los costes de

producción.
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Given these relationships, what does the common ”U-shape” of the

long-run ATC curve imply for production?

• At first, average cost per unit produced falls (economies of scale),

total cost rises less than output

• Eventually, as output rises considerably, diseconomies of scale

take hold, total cost rises more than output
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE VS RETURN TO SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

The concept of Returns to Scale tells us how much output will increase
when all inputs are increased by a given percentage amount.

And Economies of scale do not impose this common factor rule in input
proportions, instead Economies of Scale reflect input proportions that
change optimally as output increases.
 Microeconomics I – ENI
TOPIC V: Cost of production
ECONOMIES OF SCALE
Introduction
The economic concept of cost
Short term costs
Long term costs
Relationship between short and long term costs

Suppose the long-run total cost function for a firm is LTC = 22,600Q – 300Q2 + Q3

Answer the following questions:

1. At what levels of output will the firm face economies of scale?
2. At what levels of output will the firm face diseconomies of scale?
3. Does the long-run ATC curve exhibit a typical U-shape?
Economies of Scale figure it out
1. We know that when LMC < LATC, long-run average total cost is falling,
and when LMC = LATC, long-run average total costs are minimized. First,
derive the equation for LATC
LTC 22,600 Q  300 Q 2  Q 3
LATC    22,600  300 Q  Q 2
Q Q
Setting LMC = LATC yields
22,600  300 Q  Q 2  22,600  600 Q  3Q 2
300 Q  2Q 2
Q  150
Long-run average total cost is minimized at 150 units of output;
therefore, at output levels below 150, the firm is experiencing economies
of scale
2. Similarly, at output levels above 50, the firm faces diseconomies of scale
3. Yes, the LATC curve has the expected “U-shape”

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