Chapter 8 Theory of Cost

Input Cost s
Classif ication

Explic it
and
Implicit
Costs

Fixed
and
Variable
Costs
Normal

Cost
Minimization
Pr ofit

Shifts in
Cost Curves

Long
Run

Pur e

Isocost

Short
Run

Isoquant

Isocost

Least-Cost
Combinat ion

Long-R un
Total Cost

Short-Run
Tot al Cost

Returns
to Scale

Const ant
Returns

Short- Run
Total
Variable
Cost
Short-Run
Mar ginal
Cost

Dec reasing
Returns

Short-Run
Average
Variable
Cost

Total
Fixed
Cost

Average
Fixed
Cost

Stages of
Pr oduct ion

CHAPTER OUTLINE
Classification of Costs and Profits
Explicit and Implicit Costs
What is the cost of your time in completing a college degree?
Fixed and Variable Costs
Do you pay both a fixed and variable rate for your monthly telephone service?
Profits
Cost-Minimizing Input Choice
Long-Run Costs
How do you produce a low-cost pizza?
Application: Labor Unionization and Cost of Production
Is bigger better?
Application: Economies of Scale in Electricity Production
Is an additional drivers cost of road congestion the same as all current drivers?
Short-Run Costs
Is marginal cost just some adjustment to average cost?
Why will average costs rise with increases in output?
Application: Shapes of the Short-Run Average Variable Cost Curves
Relationships Between Short- and Long-Run Cost Curves

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New
Technologies

Isoquant

Least-Cost
Combinat ion

Long-R un Long-R un
Mar ginal
Average
Cost
Cost

Increasing
Ret urns

Input
Pr ice
Change

Short-Run
Average
Tot al
Cost

Positive
Fe edbac k

Chapter 8 Theory of Cost

Shifts in the Cost Curves
Input Price Change
How will marginal cost shift with a change in fixed cost?
New Technologies

CHAPTER SUMMARY
1.

Under the assumptions that prices are fixed, profits are nonstochastic, and firm managers can be controlled by
owners, the objective of a profit-maximizing firm is consistent with maximizing the utility of the firms owners.

2.

Total cost may be divided into explicit and implicit costs. Explicit costs are costs of employing inputs not
owned by the firm; implicit costs are costs charged to inputs owned by the firm.

3.

Total cost may also be divided into fixed and variable costs. Fixed costs are costs associated with the fixed
inputs; variable costs are costs that vary with output and are associated with variable inputs.

4.

Normal profit is the minimum total return to the inputs necessary to keep a firm in some production activity.
Pure profit is total revenue minus total cost. If pure profit is zero, the firm is earning a normal profit. A negative
level of pure profit indicates the firm is operating at loss.

5.

An isocost curve represents a locus of points where the total cost is the same for alternative input combinations.

6.

The least-cost combination of inputs for a given level of output is determined where the marginal rate of
technological substitution is equal to the economic rate of substitution. At this least-cost combination, the price
per marginal product for each input is equal to the firms marginal cost.

7.

Increasing (decreasing) returns to scale results when total cost increases proportionally less (more) than an
increase in output. Constant returns to scale corresponds to total cost increasing proportionally with output.

8.

Short-run total cost is equal to short-run total variable plus total fixed costs. Dividing through by output results
in short-run average total cost equaling short-run average variable plus average fixed costs. Short-run marginal
cost is the slope of both the short- run total and total variable cost curves.

9.

The Law of Diminishing Marginal Returns results in the U-shaped short-run average total, average variable, and
marginal cost curves. Given diminishing marginal returns, Stage II of production corresponds to where shortrun marginal cost is rising and above short-run average variable cost. A firms profit-maximizing level of output
will be somewhere within Stage II of production.

10. In the long run, an increase in the price of an input will tilt the long-run total cost curve upward. Similarly, an
increase in the price of a variable input will tilt the short-run total variable and total cost curves upward. The tilt
in the totals will shift the average and marginal curves upward. Only the curves solely associated with the fixed
inputs (total fixed cost and average fixed cost curves) will not shift.
11. An increase in fixed costs shifts the short-run total cost curve upward. The short-run average total cost will then
also shift upward; however, the short-run total variable cost, average variable cost, and marginal cost curves do
not shift.

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Chapter 8 Theory of Cost

KEY EQUATIONS
Isocost Equation

TC wL vK
This is the locus of points where the total cost is the same for alternative input combinations.
Least-cost combination of inputs

* w / MPL v / MPK LMC

The least-cost combination of inputs is determined by equating the price per marginal product to marginal cost.
Relationship between marginal cost and average cost

LMC LAC (LAC / q )q

Marginal cost is equal to average cost plus an adjustment factor.

TEST YOURSELF
Multiple Choice
1.

The costs of employing inputs not owned by the firm are called __________ costs.
a.)
fixed
b.)
short-run
c.)
explicit
d.)
normal
e.)
implicit

2.

Francine owns her own business. Her revenues for the year were $200,000. Her explicit costs were
$150,000. To start her own business, Francine gave up her job managing a store where she earned $40,000.
She also used $50,000 from her savings account where she was earning 3% interest. Which of the
following statements is correct?
a.)
Francine is earning an economic loss (negative profit).
b.)
Francines implicit costs are $90,000.
c.)
Francine is just breaking even and earning a normal profit.
d.)
Francine is earning a positive economic profit.
e.)
Both (a) and (b) are correct.

3.

The slope of the isocost line is

a.)
TC/v
b.)
-w/v
c.)
-TC/w
d.)
-v/w
e.)
-(w/v)(K/L)

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Chapter 8 Theory of Cost

4.

When the price of labor rises, the isocost line

a.)
becomes horizontal.
b.)
shifts out but the slope remains the same.
c.)
becomes steeper.
d.)
shifts in but the slope remains the same.
e.)
becomes flatter.

5.

Suppose that the total cost of producing 12 units of output is $120. The price of labor is $8 and the price of
capital is $12. The equation for the isocost line is
a.)
12q = 120 8L 12K
b.)
12 = 8L + 12K
c.)
120/12 = 8L + 12K
d.)
120 = 20(L + K)
e.)
120 = 8L + 12K

6.

The least-cost combination of inputs occurs only at that point where

a.)
MRTS (K for L) = MPL/MPK
b.)
w/v = MRTS (K for L)
c.)
w/MPK = v/MPL
d.)
wv = (MPL)(MPK)
e.)
w/MPL = MRTS (K for L)

7.

The additional cost associated with an additional unit increase in output when all inputs are variable is
known as __________ cost.
a.)
long-run marginal
b.)
long-run total
c.)
short-run average total
d.)
short-run marginal
e.)
implicit

8.

Suppose that long-run average cost falls as output rises. This implies that the firm is experiencing
a.)
decreasing returns to scale.
b.)
diminishing returns to labor.
c.)
increasing returns to scale.
d.)
diseconomies of scale.
e.)
constant returns to scale.

9.

At a production level of 200 units, long-run average cost is $45 and long-run marginal cost is $55. If
another unit is produced,
a.)
long-run marginal cost and long-run average cost will both fall.
b.)
long-run average cost will rise.
c.)
long-run marginal cost will fall.
d.)
long-run average cost will be unaffected.
e.)
None of the above is correct.

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Chapter 8 Theory of Cost

10.

In the short run,

a.)
all costs are explicit.
b.)
some costs are fixed.
c.)
all costs are variable.
d.)
marginal cost cannot be determined.
e.)
output can never vary.

11.

When short-run average cost is equal to short-run marginal cost,

a.)
short-run marginal cost is at its maximum.
b.)
short-run average cost is at its maximum.
c.)
short-run marginal cost is minimized.
d.)
short-run marginal cost is equal to short-run variable cost.
e.)
short-run average cost is minimized.

12.

Stage I can be defined as the stage through which

a.)
short-run marginal cost is rising.
b.)
short-run average variable cost is declining.
c.)
short-run average total cost is declining.
d.)
short-run marginal cost is declining.
e.)
short-run average variable cost is rising.

13.

Which of the following is true?

a.)
Short-run average variable cost can never be less than short-run average total cost.
b.)
Short-run average variable cost and short-run marginal cost are equal when short-run marginal
cost is at its minimum.
c.)
Short-run total cost can never be less than long-run total cost.
d.)
Long-run marginal cost is minimized when it is equal to short-run marginal cost.
e.)
Long-run average cost can never fall as output expands.

14.

Which of the following shift up when the price of a fixed input rises?
I.
Short-run average variable cost
II.
Short-run average total cost
III.
Short-run marginal cost
a.)
I only
b.)
II only
c.)
II and III only
d.)
I and II only
e.)
I, II, and III

15.

Suppose a firm discovers a new technology that alters its production function. This will result in
a.)
an outward shift of the firms isoquants.
b.)
an upward shift of the firms short-run cost curves.
c.)
a drop in the firms short-run total cost.
d.)
a change in the slope of the firms isocost line.
e.)
a drop in the firms profits.

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Chapter 8 Theory of Cost

Short Answer
1.

Explain the difference between explicit and implicit costs. How are implicit costs related to normal profit?
Explain.

2.

Explain why the slope of the isocost line is called the economic rate of substitution.

3.

Suppose that total cost is $400, the price of labor is $10 and the price of capital is $25. Write an equation
describing the firms isocost line and draw it on the axes below. What is the slope of the isocost line?

4.

Firm XYZ produces widgets. At the current level of production, the marginal product of labor is 15 and the
marginal product of capital is 20. If the price of labor is $7 and the price of capital is $12, is the firm
producing at minimum cost? Explain. If not, how should the firm alter its input use to lower its costs?

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Chapter 8 Theory of Cost

5.

What is an expansion path? Draw a graph showing how a firms expansion path can be derived.

6.

Explain how the shape of the firms long-run average cost curve is related to returns to scale.

7.

True, false, or uncertain: Short-run average variable cost and short-run marginal cost will be equal when
short-run average total cost is at its minimum. Explain.

8.

Describe the three stages of production in terms of short-run cost. Explain how the law of diminishing
returns determines the shapes of the short-run cost curves.

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Chapter 8 Theory of Cost

9.

Explain why short-run total cost can never be less than long-run total cost.

10.

Draw isoquants for two different levels of output. Show the expansion path between these outputs.
Suppose that the price of labor falls. Show the shift that will occur in the expansion path as a result.

Problems
1.

Given the following data for a firm:

Cost
Fixed
Explicit
Implicit

100,000
50,000

Explicit
Implicit

500,000
150,000

Variable

Revenue

950,000

Find the firms pure profit and normal profit.

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Chapter 8 Theory of Cost

2.

Suppose that a firms production function is q = 20K0.4L0.6. If w = 12 and v = 16, find the cost-minimizing
input combination to produce 40 units of output.

3.

Suppose that a firms production function is q = 2K + 6L. If w = 6 and v = 10, find the cost-minimizing
input combination to produce 60 units of output.

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Chapter 8 Theory of Cost

4.

Suppose that a firms production function is q = 5KL. If w = 10 and v = 12, derive the equation for longterm cost (LTC). What is long-term marginal cost (LMC)?

5.

Refer to Problem 4. Derive the firms short-run total cost curve assuming that capital is fixed. Derive the
firms short-run average and marginal cost curves.

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Chapter 8 Theory of Cost

6.

Suppose that a firms production function is q = 2K0.5L0.5. If w = 4 and v = 6, find the firms expansion path.
Suppose that w rises to 6. Find the new expansion path.

7.

Suppose that a firms short-run total cost curve is STC = 15q2 +8q + 45. Find the firms
a.)
short-run variable cost
b.)

fixed cost

c.)

short-run average total cost

d.)

short-run average variable cost

e.)

short-run average fixed cost

f.)

short-run marginal cost

g.)

level of output for which short-run average total cost is minimized.

h.)

level of output for which short-run average variable cost is minimized.

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Chapter 8 Theory of Cost

8.

Suppose that the firms in problem 7 experiences an increase in fixed costs, which rise to $60. Show what
happens to the firms short-run average total cost, short-run average variable cost, and short-run marginal
cost.

86