COST THEORY

Alice T. Valerio, Ph.D. ABD, CBA

OUTLINE
1.

2.
3. 4. 5. 6. 7. 8. 9.

Concept of Production Total and marginal product Law of diminishing returns Different types of costs: explicit versus implicit costs, and fixed versus variable costs and sunk costs Total cost in terms of total fixed cost and total variable cost Marginal cost The least-cost rule Long-run average total cost curve in terms of economies of scale, constant returns to scale, and diseconomies of scale. Minimum efficient scale (MES) and how many firms will serve a market.

Costs
A firms total cost of producing a given level of output

is the opportunity cost of the owners Explicit (involving actual payments) Money actually paid out for the use of inputs Implicit (no money changes hands) The cost of inputs for which there is no direct money payment This is the core of economists thinking about costs
Costs can be measured in pesos or dollars

Production Costs
Opportunity Cost Principle - the economic cost of

an input used in a production process is the value of output sacrificed elsewhere. The opportunity cost of an input is the value of foregone income in best alternative employment. Implicit vs. Explicit Costs Explicit costs costs paid in cash Implicit cost imputed cost of self-owned or self employed resources based on their opportunity costs.

The Irrelevance of Sunk Costs

Sunk cost is one that already has been paid, or

must be paid, regardless of any future action being considered Should not be considered when making decisions Even a future payment can be sunk If an unavoidable commitment to pay it has already been made

7 Cost Concepts (Short-run)

1. Total Fixed Cost
2. 3.

4.
5. 6. 7.

(TFC) Total Variable Cost (TVC) Total Cost (TC=TVC+TFC) Average Fixed Cost (AFC=TFC/Q) Average Variable Cost (AVC=TVC/Q) Average Total Cost (AC=AFC+AVC) Marginal Cost (MC= AVC/Q

Costs in the Short-Run

Fixed costs

Costs of a firms fixed inputs Variable costs Costs of obtaining the firms variable inputs

Short-Run Analysis
Total fixed cost (TFC) is more commonly

referred to as "sunk cost" or "overhead cost." Examples: include the payment or rent for land, buildings and machinery. The fixed cost is independent of the level of output produced. Graphically, depicted as a horizontal line

Short Run Analysis

Total variable cost (TVC) refers to the cost that changes as

the amount of output produced is changed. Examples - purchases of raw materials, payments to workers, electricity bills, fuel and power costs. Total variable cost increases as the amount of output increases. If no output is produced, then total variable cost is zero; the larger the output, the greater the total variable cost.

Short Run Analysis

Total cost (TC) is the sum of total fixed cost

and total variable cost

TC=TFC+TVC
As the level of output increases, total cost of the firm also increases.

Measuring Short Run Costs: Total Costs

Types of total costs

Total fixed costs

Cost Cost

of all inputs that are fixed in the short run

Total variable costs

of all variable inputs used in producing a particular level of output

Total cost
Cost

of all inputsfixed and variable TC = TFC + TVC

Total Costs of Production

Units of Labor
L

Total Product
TPL

Total Fixed Cost

TFC

Total Variable Cost

TVC

Total Cost
TC 100 130

Marginal Cost
MC

Average Cost
AC -

0 1

0 6

100 100

0 30

30

130

2
3 4 5

10
12 13 15

100
100 100 100

50
60 65 75

150
160 165 175

20
10 5 10

75
53.3 41.25 35

6
7 8 9 10

19
25 33 43 55

100
100 100 100 100

95
125 165 215 275

195
225 265 315 375

20
30 40 50 60

32.5
32.14 33.12 35 37.5

Pesos

TC
(Total Cost)

TVC
(Total Variable Cost)

TFC
(Total Fixed Cost)

0 TOTAL COST CURVES

Pesos

AFC=TFC/Q.

As more output is produced, the Average Fixed Cost decreases.

AFC
(Average Fixed Cost)

Pesos

The Average Variable Cost at a point on the TVC curve is measured by the slope of the line from the origin to that point.
AVC=TVC/Q

TVC
(Total Variable Cost)

Minimum AVC

q1

Pesos

Inflection point

TVC
(Total Variable Cost)

q1 MC
(Marginal Cost)

q1

Average Costs
Average fixed cost (AFC)

Total fixed cost per unit of output produced

TFC AFC Q Average variable cost (TVC)

Total variable cost per unit of output produced

TVC AVC Q Average total cost (TC)

Total cost per unit of output produced

TC ATC Q

Marginal Cost
Marginal Cost

Increase in total cost from producing one more unit or output Marginal cost is the change in total cost (TC) divided by the change in output (Q)
TC MC Q Tells us how much cost rises per unit increase in output Marginal cost for any change in output is equal to shape of total cost curve along that interval of output

Pesos
The Average Variable Cost is U shaped. First it decreases, reaches a minimum and then increases. AVC
(Average Variable Cost)

Minimum AVC

q1

Pesos

The Marginal Cost curve passes through the minimum point of the AVC curve.
MC (Marginal Cost)

It is also U-shaped. First it decreases, reaches a minimum and then increases.

AVC
(Average Variable Cost)

Minimum AVC

q1

Pesos

MC AC

AVC

AFC 0 q1 Q

The PER UNIT COST CURVES

Average And Marginal Costs In The Short Run

Dollars $4

MC

3 AFC

ATC AVC

30

90

130

161

196

Units of Output

MPL APL APL

The average variable cost [AVC] and marginal cost [MC] are mirror images of the AP and MP functions.

APL
L1 L2
MC =

APL
The maximum of the AP is consistent with the minimum of the AVC.

L3

MPL

1 AVC = x PL AP

AVC
APL x L2 Q
Principles of Microeconomics

Slide -- 23

Fall 97

APL

MPL

1 x PL MP

L $

MPL
MC

AVC

MC will intersect the AVC at the minimum of the AVC [always].

ATC
ATC* AVC* TC = ATC* x Q** TVC = AVC* x Q* R J

AVC
MC will intersect the ATC at the minimum of the ATC.

The vertical distance between ATC and AVC at any output is the AFC. At Q** AFC is RJ.

Q* Q** Q At Q* output, the AVC is at a minimum AVC* [also max of APL]. At Q** the ATC is at a MINIMUM.

Slide -- 24

Fall 97

Principles of Microeconomics

Marginal Cost Curve

When the marginal product of labor (MPL) rises

(falls), marginal cost (MC) falls (rises)

Since MPL ordinarily rises and then falls, MC

will do the oppositeit will fall and then rise Thus, the MC curve is U-shaped

The Relationship Between Average And Marginal Costs

At low levels of output, the MC curve lies below the

AVC and ATC curves These curves will slope downward At higher levels of output, the MC curve will rise above the AVC and ATC curves These curves will slope upward As output increases; the average curves will first slope downward and then slope upward Will have a U-shape MC curve will intersect the minimum points of the AVC and ATC curves

Average Cost of Production

(Q)
0 1 2 3 4 5 6 7

(TC)
100 130 150 160 165 175 195 225

(AC)
130.00 75.00 53.33 41.25 35.00 32.50 32.14

8
9 10

265
315 375

33.13
35.00 37.50

Average Variable Costs of Production

Total Product (Q) 0 1

Total Variable Cost (AVC) 0 30

Average Variable Cost (AVC) 0 30.0

2
3 4 5 6 7 8 9 10

50
60 65 75 95 125 165 215 275

25.0
20.0 16.3 15.0 15.8 17.9 20.6 23.9 27.5

Production and Cost in the Long-Run

Goal: earn the highest possible profit

To do this, it must follow the least cost rule To produce any given level of output the firm will choose the input mix with the lowest cost Firm must decide what combination of inputs to use in producing any level of output Long-run total cost (LRTC) The cost of producing each quantity of output when the least-cost input mix is chosen in the long run Long-run average total cost (LRATC) The cost per unit of output in the long run, when all inputs are variable

LRTC LRATC Q

The Relationship Between Long-Run And Short-Run Costs

For some output levels, LRTC is smaller than TC
Long-run total cost of producing a given level of

output can be less than or equal to, but never greater than, short-run total cost (LRTC TC) Long-run average cost of producing a given level of output can be less than or equal to, but never greater than, shortrun average total cost (LRATC ATC)

LTC
All inputs are variable in the long run. There are no fixed costs.

LTC

Long Run Total Cost

Total Product

LONG-RUN TOTAL COST CURVE

The LAC
The LAC curve is an envelope curve of all

possible plant sizes. Also known as planning curve It traces the lowest average cost of producing each level of output. It is U-shaped because of Economies of Scale Diseconomies of Scale

Plant Size
Plant - collection of fixed inputs at a firms

disposal Can distinguish between the long run and the short run In the long run, the firm can change the size of its plant In the short run, it is stuck with its current plant size

Average Cost and Plant Size

ATC curve tells us how average cost behaves in the

short run, given plant size fixed

moving along the current ATC curve
To produce any level of output in the long run, the firm

will always choose that ATC curve with lowest ATC among all of the ATC curves available
move from one ATC curve to another by varying the size of its plant Will also be moving along its LRATC curve

This insight tells us how we can graph the firms LRATC curve

COST

LAC SAC1 SAC2

LONG-RUN AVERAGE COST CURVE

COST

SAC1

LAC

0 q0

COST

Building a larger sized plant (size 2) will result in a lower average cost of producing q0
SAC1 SAC2 LAC

0 q0

COST

Likewise, a larger sized plant (size 3) will result to a lower average cost of producing q1
SAC1 SAC2 SAC3 LAC

0 q0 q1

COST

LAC SAC1 SAC2

Economies of Scale
0 Q1

Diseconomies of Scale
Q

LONG-RUN AVERAGE COST CURVE

Economies and Diseconomies of Scale

Economies of Scale- long run average cost

decreases as output increases. Technological factors Specialization

Diseconomies of Scale: - long run average

cost increases as output increases. Problems with management becomes costly, unwieldy

Economies of Scale
An increase in output causes LRATC to decrease

The more output produced, the lower the cost per unit LRATC curve slopes downward Long-run total cost rises proportionately less than output Increasing return to scale Example

Economies of Scale
According to whether the LRATC decreases / does

not change / increase as output increases, there are three types of issues: Economies of scale (decreasing LRATC) at relatively low levels of output Constant returns to scale (constant LRATC) at some intermediate levels of output Diseconomies of scale (increasing LRATC) at relatively high levels of output LRATC curves are typically U-shaped

The Shape of LRATC

Dollars $4.00 3.00 2.00 LRATC

1.00
0 130 184

Economies of Scale

Constant Returns to Scale

Diseconomies of Scale
Units of Output

Why Should A Firm Experience The Economies of Scale?

Gains from specialization

greatest opportunities for increased specialization at a relatively low level of output More efficient use of lumpy inputs
Some types of inputs cannot be increased in tiny increments, but rather must be increased in large jumps, therefore must be purchased in large lumps Low cost per unit is achieved only at high levels of output More efficient use of lumpy inputs will have more impact on LRATC at low levels of outputs

Diseconomies of Scale
LRATC increases as output increases

LRATC curve slopes upward LRTC rises more than in proportion to output More likely at higher output levels As output continues to increase, most firms will reach a point where bigness begins to cause problems True even in the long run, when the firm is free to increase its plant size as well as its workforce

LONG-RUN AVERAGE and MARGINAL COST CURVES

LMC

COST
SMC2

LAC

SMC1

SAC1

SAC2

Q1

LAC and LMC

Long-run Average Cost (LAC) curve

is U-shaped. the envelope of all the short-run average cost curves; driven by economies and diseconomies of size. Long-run Marginal Cost (LMC) curve Also U-shaped; intersects LAC at LACs minimum point.

LRATC and the Size of Firms

Minimum efficient scale (MES) for the firm

Lowest level of output at which it can achieve minimum cost per unit The output level at which the LRATC first hits bottom By comparing the MES (from LRATC curve) for the typical firm and and the maximum potential market (from the market demand curve) we may say something about the market structure

Economic Profit vs Accounting Profit

Accounting profit

The businesss revenue minus the explicit cost and depreciation Depreciation occurs because machines war out over time Economic profit The businesss revenue minus opportunity cost In economics, profit is simplification of economic profit.