COST CONCEPTS

Opportunity cost
Opportunity cost is the most fundamental cost concept.
The opportunity cost of doing or getting something is:

what you could have done or gotten instead

Opportunity cost is what you forgo.

Example: Your opportunity cost for taking this course includes: Whatever else you could have bought with your tuition and fee money
plus

the work, family participation, and recreation that you are not doing because you are here.

Money cost concepts

The cost-accounting concepts well discuss:
Total cost Fixed cost Variable cost Marginal cost Average cost

Total cost
... is a function of quantity
function in the mathematical sense

Total cost = TC(Q) TC(Q) = the total cost per unit of time of producing Q units of output per unit of time TC = TVC + TFC

Fixed Costs
Costs associated with owning a fixed input or resource Do not change as level of production changes Fixed cost is the cost of producing zero output in a given time period. Not under control of the manager in the short-run Present in the short-run only

Variable Cost
Variable cost equals total cost minus fixed cost. The variable cost is extra cost of producing Q, above the cost of producing 0. Can be increased or decreased at the managers discretion In the "long run," all costs are variable.

Fixed Costs, Variable Costs, and Total Costs

The sum of the variable and fixed costs are total costs.

TC = FC + VC

Total Cost Curves

The total variable cost curve has the same shape as the total cost curveincreasing output increases variable cost.

Total Cost Curves

$400 350 300 Total cost 250 200 150 100 50 0 2 4 6 8 10 20 Quantity of earrings 30 FC TC = (VC + FC)

TC
VC

Marginal Cost
Marginal cost is the increase (decrease) in total cost of increasing (or decreasing) the level of output by one unit. In deciding how many units to produce, the most important variable is marginal cost.

Marginal cost
Marginal cost is Total cost at output Q minus total cost at output Q-1. Marginal cost is the additional cost of producing one more. Or the reduction in cost from producing one less.

Average Costs
Average total cost (often called average cost) equals total cost divided by the quantity produced.

ATC = TC/Q

Average Costs
Average fixed cost equals fixed cost divided by quantity produced.

AFC = FC/Q

Average Costs
Average variable cost equals variable cost divided by quantity produced.

AVC = VC/Q

Average Costs
Average total cost can also be thought of as the sum of average fixed cost and average variable cost.

ATC = AFC + AVC

Per Unit Output Cost Curves

$30 28 26 24 22 20 18 16 14 12 10 8 6 4 2
0 2 4 6

MC ATC AVC

Cost

AFC 8 10 12 14 16 18 20 22 24 26 28 30 32 Quantity of earrings

Average cost & Marginal cost

Marginal cost is what to use to decide whether to do something. Average cost is good for telling you whether you're making money overall. Profit = Revenue minus cost. Average profit per unit = Revenue Units Average Cost per unit.

Average and Marginal Cost Curves

The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. Each of these curves is U-shaped. The average fixed cost curve slopes down continuously.

Downward-Sloping Shape of the Average Fixed Cost Curve

The average fixed cost curve starts out with a steep decline, then it becomes flatter and flatter. It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

The U Shape of the Average and Marginal Cost Curves

When output is increased in the short-run, it can only be done by increasing the variable input.

The U Shape of the Average and Marginal Cost Curves

The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. Marginal and average productivities fall and marginal costs rise.

The U Shape of the Average and Marginal Cost Curves

And when average productivity of the variable input falls, average variable cost rise.

The U Shape of the Average and Marginal Cost Curves

The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

The U Shape of the Average and Marginal Cost Curves

If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet.

The firms eye is focused on average total costit wants to keep it low.

Average and Marginal Cost Curves

$ MC ATC

AVC

AFC Output

Relationship Between Marginal and Average Costs

The marginal cost and average cost curves are related.
When marginal cost exceeds average cost, average cost must be rising. When marginal cost is less than average cost, average cost must be falling.

Relationship Between Marginal and Average Costs

Marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

Relationship Between Marginal and Average Costs

The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

Relationship Between Marginal and Average Costs

To summarize:
If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.

Relationship Between Marginal and Average Costs

Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost.
If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

Relationship Between Marginal and Average Costs

$90 80 70 60 50 40 30 20 10 0 MC 1 2 3 B AVC ATC Area A Area B Area C MC

ATC
AVC

A Q0
4

Q1 5 6 7 8 9 Quantity

Long-run and short-run

In the short run, it pays to sell to any customer who'll pay marginal cost. Even if youre losing money overall, you're losing less than if you had turned down the sale. In the long run, when you can get out of your fixed cost, you shut down if your average price is not more than average cost.

Long Run Costs

The long run average, LAC, and marginal, LMC, cost curves have the same basic shape that the equivalent short run cost curves. However, the reason why each is Ushaped is for different reasons, which are
Short run the Law of Diminishing Marginal returns Long run economies/diseconomies of scale 10.34

Production costs in the long run

1.Types of costs: TC; ATC; MC (ATC and MC: U shape) 2. Economies of scale and diseconomies of scale Economies of scale: when increasing the scale of production lead to a lower cost per unit of output. Q up----LAC down Reasons: labor and managerial specialization\ ability to purchase and use more efficient capital goods\ other factors such as advertising or other start up costs\ economy of bulk buying.

Diseconomies of scale: where costs per unit of output increase as the scale of production increases. Q up--LAC down. Reasons: the growing complexities of managing a larger organization\ distant management, worker alienation and problems with communication and coordination..

Short-Run & Long-Run Total Cost Curves

The firms long-run total cost curve consists of the lowest parts of the short-run total cost curves. The long-run total cost curve is the lower envelope of the short-run total cost curves.

The Envelope Relationship

Long-run costs are always less than or equal to short-run costs because: In the long run, all inputs are flexible In the short run, some inputs are fixed There is an envelope relationship between long-run and short-run average total costs. Each short-run cost curve touches the longrun cost curve at only one point.

In the short run all expansion must proceed by increasing only the variable input
This constraint increases cost
13-39

Costs per unit

The Envelope of Short-Run Average Total Cost Curves

LRATC
SRMC1 SRATC1 SRMC2 SRATC2 SRMC3 SRATC4 SRMC4 SRATC3

The long-run average total cost curve (LRATC) is an envelope of the short-run average total cost curves (SRATC1-4)

13-40

LONG-RUN VERSUS SHORT-RUN COST CURVES

Long-Run Average and Marginal Cost

Long-Run Average Cost

When a firm is producing at an output at which the long-run average cost LAC is falling, the long-run marginal cost LMC is less than LAC. Conversely, when LAC is increasing, LMC is greater than LAC. The two curves intersect at A, where the LAC curve achieves its minimum.

The Relationship Between Productivity and Costs

The shapes of the cost curves are mirror-image reflections of the shapes of the corresponding productivity curves.

The Relationship Between Productivity and Costs

When one is increasing, the other is decreasing.

When one is at a maximum, the other is at a minimum.

The Relationship Between Productivity and Costs

$18 16 14 12 10 8 6 4 2 0 4 8 12 16 20 24

Productivity of workers at this output

MC AVC

9 8 7 6 5 4 3 2 1 0 4

Costs per unit

A AP of workers MP of workers 8 12 16 20 24 Output

Output

Production Rules
Short-run
SP > ATC
Produce where MR=MC

Long-run

SP > ATC
Produce

ATC > SP > AVC

Making contribution to FC Produce where MR=MC

MR=MC

where

SP < ATC
Do

SP < AVC
Do not produce

not produce