Chapter 7 H

Costs 7
Chapter Outline
7.1 Costs That Matter for Decision
Making: Opportunity Costs
7.2 Costs That Do Not Matter for
Decision Making: Sunk Costs
7.3 Costs and Cost Curves
7.4 Average and Marginal Costs
7.5 Short-Run and Long-Run Cost
Curves
7.6 Economies in the Production
Process
7.7 Conclusion
Copyright © 2013 Worth Publishers, All Rights Reserved  Microeconomics  Goolsbee/Levitt/ Syverson 1/e 7-1
Introduction 7
Costs and the manner in which costs are structured are key to a firm’s
production decisions
• How much to produce?
• Whether to expand or shrink in response to changing market conditions?
• Whether to switch to producing a different product?
We began thinking about costs with the expansion path introduced in the last
chapter; now, we examine cost structures more intimately
• Introducing different types of costs
• Differentiating between short-run and long-run
7.1
Costs That Matter for Decision
Making: Opportunity Costs 7
Costs are thought about differently in economics than in accounting
• Accounting cost includes the direct costs of operating a business, including costs
for raw materials
• Economic cost is the sum of a producer’s accounting and opportunity costs
• Opportunity cost is the value of what a producer gives up by using an input
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
7.1
Costs That Matter for Decision
Making: Opportunity Costs 7
Opportunity costs occur everywhere in a production process
• By choosing to start a business, you may give up your salary at your current position
• When you invest in building a factory, you give up any other investment
opportunities
• By choosing to use an office building you own, you cannot rent it to someone else
Why does this distinction matter?

• When firms make decisions on the use of inputs, they consider these opportunity
costs
• Economists try to describe behavior; it is necessary to understand opportunity costs
to know how firms make decisions
Economic vs. Accounting Cost figure it out
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?
Economic vs. Accounting Cost figure it out
1. Accounting cost is the direct cost of operating a business, including

supplies, utilities, and salaries
Accounting cost = $20,000 + $10,000 + $300,000 + $250,000 = $580,000
2. Economic cost includes the opportunity cost of ownership. In this
case, the opportunity costs include the forgone rent ($60,000) and the
difference between James’ current salary and what he would earn if he
took another job ($25,000)
Economic cost = $580,000 + $60,000 + $25,000 = $665,000
3. Economic profit is simply revenues minus economic cost,
Economic profit = $600,000 – $665,000 = –$65,000
While accounting profit is positive, economic profit is negative, and James
could do better by shutting down his business and taking his outside
opportunities
7.2
Costs That Do Not Matter for Decision
Making: Sunk Costs 7
While opportunity costs should be considered when making decisions, sunk
costs should be ignored
Sunk costs are a form of fixed costs: the cost of the firm’s fixed inputs,
independent of the quantity of the firm’s output
• Buildings, operating permits, durable equipment
• These costs are partially avoidable; some money can be recovered
Sunk costs cannot be recovered once spent

• Licensing fees, long-term lease contracts, etc.
• 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
7.2
Sunk Costs and Decisions
Once incurred, sunk costs should not affect decision making
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
If
7.2
Sunk Costs and Decisions
Often people and firms allow sunk costs to influence decisions
• Usually, this means continuing down one path because of a prior investment (e.g.,
going to a baseball game because you bought season tickets even if the weather is
horrible and there is something else you would rather do)
The sunk cost fallacy refers to the mistake of letting sunk costs affect a firm’s
operating decisions
Application 7
Do Sunk Costs Matter?
Economists and others have shown that consumers and
businesses often consider sunk costs in decision making
• For instance, people will choose to endure a blizzard to use season
passes to the theater, even if they would never purchase those tickets
outright
• Businesses may “throw good money after bad” with respect to
investment projects, even when better alternatives exist Images: FreeDigitalPhotos.net
 Is this rational behavior?
McAfee, et al. (2009) provide a number of reasons why

considering sunk costs may be rational
• Informational Content – The expenditure “sunk” in an investment
may correlate with the additional investment required for completion;
large losses correlate with high variance and high option value
Citation: McAfee, R. P., H. M.Mialon, S. H. Mialon, 2009. Do Sunk Costs Matter? Economic Inquiry 48(2): 323–336 .
Application 7
Do Sunk Costs Matter?
• Reputational Concerns – Sometimes, when investments are
publicly known, it may be rational to “finish what you start” (e.g.,
buying a ski pass with your friends; a coordinated investment
project)
• Financial and Time Constraints – Large past expenditures may
preclude future expenditures on new projects; time constraints may
make investment a “one-shot” choice
Images: FreeDigitalPhotos.net
Citation: McAfee, R. P., H. M. Mialon, S. H. Mialon, 2009. Do Sunk Costs Matter? Economic Inquiry 48(2): 323–336 .
7.3 Costs and Cost Curves 7
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
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
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
Figure 7.1 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)
The fixed cost curve is horizontal
• Costs do not vary with output; they are $50 per week regardless of production
Variable costs change with the amount of output, and the variable cost curve is
therefore not constant
• The slope of the variable cost curve is always positive
• In this example, the curve becomes flatter as output rises from 0 to 4 pairs, then
becomes steeper as the number of pairs produced per week increases
The total cost curve is the sum of variable cost and fixed cost
• The total cost curve will have the same shape as the variable cost curve, but it will
be shifted up at each level of output by the amount of fixed costs
7.4 Average and Marginal Costs 7
Understanding the cost structure of firms is important, but to understand how
costs affect production decisions, we must introduce two related measures:
average cost and marginal cost
Average cost is simply cost divided by output
• Average fixed cost (AFC )
AFC  FC / Q
• Average variable cost (AVC )
AVC  VC / Q
• Average total cost (ATC )
ATC  TC / Q   FC  VC  / Q
 FC / Q  VC / Q  AFC  AVC
Returning to the shoe example
Figure 7.2 Average Cost Curves
Average cost AFC always falls as quantity rises.
($/pair) This is because it is being
averaged across more and more
$70 units.
60 Average total cost (ATC )
50
40 Average fixed cost (AFC )
30
Average variable cost (AVC )
20
10
0 1 2 3 4 5 6 7 8
9 10 11 12
Marginal cost is another deciding factor in firms’ production decisions
• The additional cost of producing an additional unit of output
MC  TC / Q
• Returning to the previous table,
Figure 7.3 Marginal Cost
Marginal cost
MC falls at first
($/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
Picture Framing Shop figure it out
Frame de Art is an art framing shop in a small town. Frame de Art has one
storefront ($500 per week), and can hire workers for $300 per week per
worker. The table below shows how output of framed art (in hundreds-per-
week) varies with the number of workers
Labor Framed Art
(workers per week) (hundreds per week)
0 0
1 1
3 2
6 3
11 4
20 5
Calculate the marginal cost of 100 to 500 framing jobs for Frame de Art
(assume labor to be the only variable cost)
Picture Framing Shop figure it out
The simplest way to solve this is to add several columns to the previous table
representing fixed, variable, and total costs
Marginal cost is simply MC  TC / and
Q is measured in dollars
Labor Framed Art Fixed Variable Total Marginal

(workers per week) (hundreds per Cost Cost Cost Cost
week)
0 0 $500 $300 × 0 = $0 $500 —
1 1 500 $300 × 1 = 300 800 300
3 2 500 900 1,400 600
6 3 500 1,800 2,300 900
11 4 500 3,300 3,800 1,500
20 5 500 6,000 6,500 2,700
Relationships Between Average and Marginal Costs
• Since fixed costs do not change when a firm expands output, marginal cost only
depends on variable cost
MC  VC / Q   TC / Q 
 Example: What happens when marginal cost is less than average total cost? For
example, consider your GPA. What happens to your 3.0 average when you get a
2.5 for the semester?
• The same holds with costs; when marginal cost is less than the average total cost,
producing another unit will reduce average total cost, and vice versa
This observation helps to determine when average total costs are minimized
• Average total costs are minimized when ATC = MC
• This explains why ATC and AVC have a “U” shape
Figure 7.4 The Relationship Between Average and Marginal
Costs
MC always crosses
AVC and ATC at
Average cost their minimums.
and marginal MC
cost ($/unit) ATC
Minimum AVC
ATC
Minimum
AVC
Quantity
Minimizing Costs figure it out
Suppose a firm’s total cost curve is

TC  10Q 2  6Q  60
and marginal cost
MC =20Q + 6
1. Find expressions for the firm’s fixed cost, variable cost, average
total cost, and average variable cost
2. Find the output level that minimizes average total cost
3. Find the output level that minimizes average variable cost
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 2
 
TC  10 0  6 0  60  60  FC  
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,

2
10Q  6Q
AVC   10Q  6
Q
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
7.5
Short-Run and Long-Run Cost
Curves 7
We now analyze how the time horizon affects the cost structure facing a firm
• Remember, in the short run, the amount of capital is assumed to be fixed
Short-Run Production and Total Cost Curves

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
• An easy way to see this concept in action is with a graph
• Consider the production of engines
7.5
Curves 7
Capital and labor are used to produce engines (quantities are per week)
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
7.5
Curves 7
Short-Run Versus Long-Run Average Total Cost Curves
Figure 7.6 shows 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
Curves 7
Figure 7.8 The Long-Run Average Total Cost Curve Envelops the
Short-Run Average 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
Production of Wind Turbines figure it out
Suppose a wind turbine producer faces a production function
Q  0.25KL; MPL  0.25K ; MPK  0.25L

The wage rate (W) is $12 per hour, and the rental rate on capital (R)
is $22 per hour
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 figure it out
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 =$919.18
7.5
Curves 7
Short-Run Versus Long-Run Marginal Cost Curves
Just as with average costs,
• Short-run marginal cost is the cost of producing an additional unit of output
when capital is fixed
• Long-run marginal cost is the cost of producing an additional unit of output
when both capital and labor are variable
 What does this imply for the shape of the marginal cost curves?
• In general, the long-run marginal cost curve will be flatter than the short-run
marginal cost curve
Curves 7
Figure 7.9 Long-Run and Short-Run Marginal Costs
Average cost ATCSR,10
ATCSR,30 MCLR
and marginal
cost ($/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
7.6
Economies in the Production
Process 7
 What happens to the long-run ATC curve as a firm grows?
• The answer reveals information about economies in the production process
• Similar to returns to scale, but focused on the cost side
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
7.6
Process 7
 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), eventually, as
output rises considerably, diseconomies of scale take hold
 What factors might cause diseconomies of scale to set in?
Not the same as returns to scale
• Returns to scale describes how production changes when all inputs are changed by a
common factor
• Economies of scale does not impose this “common factor” rule in input proportions
Economies of Scale Figure it out
Suppose the long-run total cost function for a firm is LTC =

15,000Q – 200Q2 + Q3 and its long-run marginal cost function is
LMC = 15,000 – 400Q + 3Q2.
Answer the following:
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 15, 000Q - 200Q 2 +Q 3 2
LATC = =
Setting LMC = LATC yields =15, 000 - 200Q +Q
Q Q
15, 000 - 200Q +Q 2 =15, 000 - 400Q +3Q 2

200Q =2Q 2
Long-run average total cost is minimized
Q =100at 100 units of output; therefore, at
output levels below 100, the firm is experiencing economies of scale
2. Similarly, at output levels above 100, the firm faces diseconomies of scale
3. Yes, the LATC curve has the expected “U-shape”
7.6
Process 7
Economies of Scope
A related concept is the idea of economies of scope
• Refers to the simultaneous production of multiple products at a lower cost than if a
firm made each separately
 Why might a firm observe economies of scope?
• Flexible inputs or production processes
o For instance, oil refineries can produce many different petroleum products at
the same time through distillation at a much lower aggregate cost than if each
were produced separately
• Expertise is translatable across several products/services
o For instance, life and auto insurance
Application 7
Economies of Scope in the Insurance Industry
The financial industry has long been thought to exhibit both economies
of scale and scope
• For instance, recent years have seen institutional mergers,
acquisitions, and internal expansion of product offerings
Cummins et al. (2010) investigate whether economies of scope exist for
insurers that offer life/health insurance and/or property-liability
insurance
Images: FreeDigitalPhotos.net
• Conglomeration hypothesis: operating different business
enterprises adds value by exploiting scope economies
• Strategic focus hypothesis: firms are better off specializing on a
core business model
The authors find scope diseconomies exist, and companies offering both
products may do better by divesting from one, or splitting up operations
Citation: Cummins, J.D., M. A. Weiss, X. Xie, and H. Zi, 2010. Economies of Scope in Financial Services: A DEA Efficiency
Analysis of the U.S. Insurance Industry. Journal of Banking and Finance 34(7): 1525–1539.
7.7 Conclusion 7
We have now linked cost to production
• Opportunity costs, fixed costs, variable costs, sunk costs
• Marginal and average costs
• Short- and long-run costs
In the next chapters, we introduce market conditions to a firm’s
production decision
We begin with the case of a perfectly competitive market in Chapter 8

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Costs 7

Inclusion of opportunity cost means an economist’s interpretation of what

Why does this distinction matter?

1. Accounting cost is the direct cost of operating a business, including

Sunk costs cannot be recovered once spent

 Is this rational behavior?

McAfee, et al. (2009) provide a number of reasons why

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

Labor Framed Art Fixed Variable Total Marginal

0 0 $500 $300 × 0 = $0 $500 —

1 1 500 $300 × 1 = 300 800 300

3 2 500 900 1,400 600

6 3 500 1,800 2,300 900

11 4 500 3,300 3,800 1,500

20 5 500 6,000 6,500 2,700

Suppose a firm’s total cost curve is

Average total cost is simply total cost divided by output,

And the same applies to variable cost,

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

So, ATC is minimized when Q = 2.45

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

Short-Run Production and Total Cost Curves

Figure 7.5 Figure 7.6

Average ATCSR,10 ATCSR,30

Suppose a wind turbine producer faces a production function

Q  0.25KL; MPL  0.25K ; MPK  0.25L

Economies of scale: costs rise more slowly than production

Suppose the long-run total cost function for a firm is LTC =

15, 000 - 200Q +Q 2 =15, 000 - 400Q +3Q 2

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