Chapter 8: Cost Curves

A firm aims to MAXIMIZE PROFITS

In order to do this, one must understand
how to MINIMIZE COSTS
Therefore understanding of cost curves is
essential to maximizing profits

Chapter 8: Costs Curves

In this chapter we will cover:
8.1 Long Run Cost Curves
8.1.1 Total Cost
8.1.2 Marginal Cost and Average Cost
8.2 Economies of Scale
8.3 Short Run Cost Curves
8.3.1 Total Cost, Variable Cost, Fixed Cost
8.3.2 Marginal Cost and Average Cost
8.4 Economies of Scope
8.5 Economies of Experience
2

8.1 Long Run Cost Curves

In the long run, a firms costs equal zero
when zero production is undertaken
As production (Q) increases, the firm must
use more inputs, thus increasing its cost
By minimizing costs, a firms typical long
run cost curve is as follows:
3

K
Q1
Q0
K1
K0

0
TC ($/yr)

L0 L1

TC = TC0
TC = TC1

L (labor services per year)

LR Total Cost Curve

TC1=wL1+rK1
TC0 =wL0+rK0

Q0

Q1 Q (units per year)

An increase in the price of only 1 input will

cause a firm to change its optimal choice of
inputs
However, the increase in input costs will
always cause a firms costs to increase:
-(Unless inputs are perfect substitutes)
5

TC1/r

TC0/r

C1: Original isocost curve

Slope=w1/r (TC = $200)
C2: Isocost curve after
Price change (TC = $200)
A
C3: Isocost curve after

Price change (TC = $300)

B

C2
0

Q0
C1

Slope=w2/r
C3
L
6

TC ($/yr)

Change in Input Prices ->

A Shift in the Total Cost Curve
TC(Q) new

TC(Q) old

300
200

Q0

Q (units/yr)
7

Let Q=2(LK)1/2 MRTS=K/L,

W=5, R=20, Q=40
What occurs to costs when rent falls to 5?
Initially:
1/2
Q=2(LK)
MRTS=W/R
1/2
40=2(4KK)
K/L=5/20
40=4K
4K=L
10=K
40=L
8

Let Q=2(LK)1/2 MRTS=K/L,

W=5, R=20, Q=40
What occurs to costs when rent falls to 5?
After Price Change:
1/2
Q=2(LK)
MRTS=W/R
1/2
40=2(LL)
K/L=5/5
40=2L
L=K
20=L
20=K
9

What occurs when rent falls to 5?

Initial: L=40, K=10 Final: W=5, R=20
Initial:

TC=wL+rK
TC=5(40)+20(10)
TC=400

Final:

TC=5(20)+5(20)
TC=200

Due to the fall in rent, total cost falls by $200.

10

TC ($/yr)

Change in Rent
TC(Q) initial

TC(Q) final

400
200

40

Q (units/yr)
11

To calculate total cost, simply substitute labour

and capital demand into your cost expression:
Q= 50L1/2K1/2 (From Chapter 7:)
L*(Q,w,r) = (Q0/50)(r/w)1/2
K*(Q,w,r) = (Q0/50)(w/r)1/2
TC = wL +rK
TC= w [(Q0/50)(r/w)1/2 ] +r[(Q0/50)(w/r)1/2 ]
12
TC= [(Q0/50)(wr)1/2 ] +[(Q0/50)(wr)1/2 ]

Let Q= L1/2K1/2, MPL/MPK=K/L, w=10, r=40.

Calculate total cost.

MRTS=w/r
K/L=10/40
K=4L
Q=L1/2K1/2 =L1/2(4L)1/2
Q=2L
L=Q/2

13

Let Q= L1/2K1/2, MRTS=K/L, w=10, r=40.

Calculate total cost.

K=4L
L=K/4
L=Q/2

Q=L1/2K1/2
Q=(K/4)1/2K1/2
Q=1/2K
K=2Q
TC = wL +rK
TC = 10(Q/2)
+40(2Q)

14

When the prices of all inputs change by

the same (percentage) amount, the optimal
input combination does not change
The same combination of inputs are
purchased at higher prices

15

K (capital services/yr)

C1=Isocost
curve before
($200) and
after ($220) a
10% increase
in input prices
A
Q0
C1

L (labor
16
services/yr)

TC ($/yr)

Example: A Shift in the Total Cost Curve

When Input Prices Rise 10%
TC(Q) new
TC(Q) old
220
200

Q0

Q (units/yr)
17

Definition: The long run average cost

function is the long run total cost function
divided by output, Q.
That is, the LRAC function tells us the
firms cost per unit of output

TC (Q)
AC (Q)
Q
18

Definition: The long run marginal cost

function is rate at which long run total cost
changes with a change in output
The (LR)MC curve is equal to the slope of
the (LR)TC curve

TC (Q)
MC (Q)
Q
19

TC ($/yr)

Average vrs. Marginal Costs

Slope=LRMC

TC(Q) post

TC0

Slope=LRAC

Q0

Q (units/yr)
20

When marginal cost is less than average cost,

average cost is decreasing in quantity. That is, if
MC(Q) < AC(Q), AC(Q) decreases in Q.
When marginal cost is greater than average cost,
average cost is increasing in quantity. That is, if
MC(Q) > AC(Q), AC(Q) increases in Q.
When marginal cost equals average cost, average cost
is at its minimum. That is, if MC(Q) = AC(Q), AC(Q)
21
is at its minimum.

AC, MC ($/yr)

typical shape of AC, MC

MC

AC

AC at minimum when AC(Q)=MC(Q)

Q (units/yr)
22

If average cost decreases as output

rises, all else equal, the cost function
exhibits economies of scale.
-large scale operations have an
advantage
If average cost increases as output rises,
all else equal, the cost function exhibits
diseconomies of scale.
23
-small scale operations have an

Why Economies of scale?

-Increasing Returns to Scale for Inputs
-Specialization of Labour
-Indivisible Inputs (ie: one factory can
produce up to 1000 units, so increasing
output up to 1000 decreases average
costs for the factory)
24

Why Diseconomies of scale?

-Diminishing Returns from Inputs
-Managerial Diseconomies
-Growing in size requires a large
expenditure on managers
-ie: One genius cannot run more than
1
branch
25

AC ($/yr)

Typical Economies of
Scale

Minimum Efficient Scale smallest AC(Q)

Quantity where LRAC curve reaches
Its min.

Economies of scale

Diseconomies of scale

Q*

Q (units/yr)
26

Production functions and cost functions are related:

Production Function

Cost Function

Increasing returns to
scale

Economies of Scale

Decreasing returns to
scale

Diseconomies of Scale

Constant Returns to
Scale

Neither economies nor

diseconomies of scale
27

Example: Returns to Scale and Economies of

Scale
CRS
Production Function Q = L

IRS
Q = L2

DRS
Q = L1/2

Labor Demand

L*=Q1/2

L*=Q2

Total Cost Function

wQ2

L*=Q
TC=wQ

Average Cost Function AC=w

wQ
Economies of Scale

none

wQ1/2
w/Q1/2
EOS

28

Economies of Scale can be measured using

output elasticity of total cost; how cost changes
when output changes

%TC
TC ,Q
%Output
TC Q
TC ,Q
Q TC

29

Economies of Scale are also related to

marginal cost and average cost:

TC TC
TC ,Q
/
Q Q
TC ,Q MC / AC
30

If TC,Q < 1, MC < AC, so AC must be

decreasing in Q. Therefore, we have
economies of scale.
If TC,Q > 1, MC > AC, so AC must be
increasing in Q. Therefore, we have
diseconomies of scale.
If TC,Q = 1, MC = AC, so AC is just flat
with respect to Q.
31

Let Cost=50+20Q2
MC=40Q
IF Q=1 or Q=2, determine economies of
scale
(Let Q be thousands of units)
32

TC=50+20Q2
MC=40Q
AC=TC/Q=50/Q+20Q
Initially: MC=40(1)=40
AC=50/1+20(1)=70
Elasticity=MC/AC=40/70 Economies of Scale
Finally: MC=40(2)=80
AC=50/2+20(2)=65
E=MC/AC=80/65 Diseconomies of Scale

33

8.3 Short-Run Cost Curves

In the short run, at least 1 input is fixed
(ie: (K=K*)
Total fixed costs (TFC) are the costs associated with
this fixed input (ie: rk)
Total variable costs (TVC) are the costs associated with
variable inputs (ie:wL)
Short-run total costs are fixed costs plus variable costs:
STC=TFC+TVC
34

TC ($/yr)

Short Run Total Cost, Total

Variable Cost and Total Fixed Cost
STC(Q, K*)
rK*

TVC(Q, K*)

TFC
rK*
Q (units/yr)
35

Short Run Costs

Example:
Minimize the cost to build 80 units if Q=2(KL)1/2 and
K=25. If r=10 and w=20, classify costs.
Q=2(KL)1/2
80=2(25L)1/2
80=10(L)1/2
8=(L)1/2
64=L
36

Short Run Costs

Example:
K*=25, L=16. If r=10 and w=20, classify costs.
TFC=rK*=10(25)=250
TVC=wL=20(64)=1280
STC=TFC+TVC=1530
37

The firm can minimize costs

better in the long run because it
is less constrained.
Hence, the short run total cost
curve lies above the long run
total cost curve almost
everywhere.
38

Only at point A is short

run minimized as well as
long run
Long Run Expansion path

TC2/r
TC1/r
TC0/r
K

Q1

Q0

Q0
B

Short Run
Expansion path

TC0/w TC1/w TC2/w

L
39

TC ($/yr)
STC(Q)
LRTC(Q)
A

rK*

Q (units/yr)
40

Definition: The short run average cost

function is the short run total cost function
divided by output, Q.
That is, the SAC function tells us the firms
cost per unit of output

STC (Q)
SAC (Q)
Q
41

Definition: The short run marginal cost

function is rate at which short run total
cost changes with a change in input
The SMC curve is equal to the slope of the
STC curve

STC (Q)
SMC (Q)
Q
42

In the short run, 2 additional average costs

exist: average variable costs (AVC) and
average fixed costs (AFC)

TFC (Q)
AFC (Q)
Q
TVC (Q)
AVC (Q)
Q

43

Note :
STC TFC TVC
STC TFC TVC

Q
Q
Q
Therefore :
SAC AFC AVC

44

To make an omelet, one must crack a fixed number of

eggs (E) and add a variable number of other ingredients
(O). Total costs for 10 omelets were $50. Each omelets
average variable costs were $1.50. If eggs cost 50 cents,
how many eggs in each omelet?
AC=AVC+AFC
TC/Q=AVC+AFC
50/10=$1.50+AFC
$3.50=AFC
45

To make an omelet, one must crack a fixed number of

eggs (E) and add a variable number of other ingredients
(O). Total costs for 10 omelets were $50. Each omelets
average variable costs were $1.50. If eggs cost 50 cents,
how many eggs in each omelet?
$3.50=AFC
$3.50=PE (E/Q)
$3.50=0.5 (E/Q)
7=E/Q
There were 7 eggs in each omelet.

46

$ Per Unit

Average fixed cost is

constantly decreasing, as
fixed costs dont rise with
output.

AFC
0

Q (units per
47
year)

$ Per Unit

Average
variable cost
generally
decreases then
increases due to
economies of
scale.

AVC

AFC
0

Q (units per
48
year)

$ Per Unit

SAC is the
vertical sum
of AVC and
AFC

SAC
AVC

Equal
AFC
0

Q (units per
49
year)

$ Per Unit
SAC
SMC

AVC

SMC
intersects
SAC and
AVC at
their
minimum
points
AFC
Q (units per
50
year)

In the long run, a firm can adjust its capital

to a level that is then fixed in the short run.
The long run average cost curve (LRAC)
therefore forms an envelope or boundary
around the various short run average cost
curves (SAC) corresponding to different
capital levels.

51

$ per unit

SAC(Q,K3)

SAC(Q,K1)
SAC(Q,K2)

AC(Q)

Q1

Q2

Q3

Q (units per
year) 52

When a firm minimizes cost in the short

run, given capital chosen in the long run,
-AC=SAC (Point A, next slide)
-MC=SMC (Point B, next slide)
-SAC is not at its min (in general)
(Point C, next slide)
When a firm minimizes cost in the long run,
-AC=SAC=MC=SMC and SAC is at a
minimum (two slides hence)
53

$ per unit
MC(Q)

SAC(Q,K1)

AC(Q)

SMC(Q,K1)
A C

Q1

Q2

Q3

Q (units per
year) 54

$ per unit
Example: Putting It All
MC(Q)
Together

SAC(Q,K2)

AC(Q)

SMC(Q,K2)

D
0

Q1

Q2

Q3

Q (units per
year) 55

Often a firm produces more than one

product, and often these products are
related:
-Pepsi Cola makes Pepsi and Diet Pepsi
-HP makes Computers and Cameras
-Dennys Serves Breakfast and Dinner
Often a firm benefits from economies of
scope by producing goods that are related;
they share common inputs (or good A is an
56
input for good B). Efficiencies often exist in

If a firm can produce 2 products at a lower

total cost than 2 firms each producing their
own product:
TC(Q1,Q2)<TC(Q1,0)+TC(0,Q2)
That firm experiences economies of scope.

57

If the cities maintains local roads, it costs

are $15 million a year. If a private firm
covers park maintenance, it costs are $12
million a year. If the city does both, it
costs $25 million a year.
TC(Q1,Q2)=$25 million
TC(Q1,0)+TC(0,Q2)=$15 million + $12
million
TC(Q1,0)+TC(0,Q2)=$27 million 58

Often with practice a firm gets better at

producing a given output; it cuts costs by
being able to produce the good faster and
with fewer defects.
Ie: The first time you worked on elasticities,
each question took you 10 minutes and
10% were wrong. By the end of the course
youll be able to calculate elasticities in 4
minutes with only 5% error (for example).
59

Economies of experience are efficiencies

(cost advantages) resulting from
accumulated experience (learning-bydoing).
The experience curve shows the
relationship between average variable cost
and cumulative production volume.
-As more is produced (more experience
is gained), average cost decreases.
60

AVC

The Experience Curve

Eventually the curve

Flattens out

Cumulative Output

61

Economies of experience occur once,

while economies of scale are ongoing.
A large producer benefiting from
economies of scale will increase average
costs by decreasing production.
A large producer benefiting from
economies of experience may safely
decrease production

62

Chapter 8 Key Concepts

Long-Run Costs:
TC=wL+rK (if labor and capital are the only
inputs
AC=TC/Q
MC=TC/ Q
Economies of scale summarize how average
cost changes as Q increases
Economies of scale = AC decreases as Q
increases
Diseconomies of scale = AC increases as
Q increases
63

Chapter 8 Key Concepts

Short-Run Costs
TFC=All costs of the FIXED input
TVC=All total costs of the VARIABLE
input
STC=TFC+TVC
SAC=STC/Q
SMC=STC/ Q
AFC=TFC/Q
AVC=TVC/Q
SAC=AFC+AVC
64

Chapter 8 Key Concepts

If one firm has lower costs producing two
goods than two firms producing the goods
individually, that firm enjoys ECONOMIES
OF SCOPE
If AC decreases as cumulative output
increases, a firm enjoys ECONOMIES OF
EXPERIENCE
This effect decreases over time
Calculators are important in Econ 281
65