Microeconomics: Lecture 9

The Cost of Production

Last lecture

Input allocation (L,K)

Isoquant map Combinations of L and K producing a given

output Q

Now we look for optimal combination, so we need to introduce cost of inputs (note: consumer problem)

Roadmap
Cost Function: Derived from optimal choice
of inputs (Long-Run Perspective)

Short-Run Costs - Distinction: Fixed vs.

Variable Cost

Long Run Costs and Returns to Scale Economic vs. Accounting Costs Sunk Costs
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Cost Minimizing Input Choice for given Output level

Select inputs to produce a given output at minimum cost Assumptions

Two Inputs: Labor (L) and capital (K) Price of labor: wage rate (w)

The price of capital r r = depreciation rate + interest rate

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The Isocost Line A line showing all combinations of L & K

that can be purchased for the same cost

Total cost of production is sum of firms

labor cost, wL, and its capital cost, rK:

C wL rK
For each different level of cost, the equation
shows another isocost line
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The Isocost Line

Rewriting

Slope of the isocost: -(w/r) is the ratio of the wage rate to rental
cost of capital.

This shows the rate at which capital can be

substituted for labor with no change in cost
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Choosing Inputs

Look for the cheapest way to produce a

given level of output: Isoquant is the quantity we wish to produce

Isocost Line: combinations of K and

L that cost the same $ given inpit prices w and r
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Producing a Given Output at Minimum Cost

Capital per year

Labor per year

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Input Substitution When an Input Price Change

If the price of labor changes (w), then the slope

of the isocost line changes, -(w/r)

It now takes a new quantity of labor and capital

to produce the output

If price of labor increases relative to price of

capital, capital is substituted for labor
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Input Substitution When an Input Price Change

Capital per year

Labor per year

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Cost Minimizing Condition

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Cost Minimizing Condition: A Reinterpretation

The minimum cost combination can then be written as:

MPL

MPK

Minimum cost for a given output will occur when each dollar of input added to the production process will add an equivalent amount of output.
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Example

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Example

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Marginal and Average Cost

Important concepts in production costs:

Average Cost Marginal Cost

Later we introduce
short-run & long-run costs
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Short Run:Fixed and Variable Costs

Total output is a function of variable inputs and fixed inputs Total cost of production equals

the fixed cost (the cost of the fixed inputs) variable cost (the cost of the variable inputs), varies
with inputs

TC FC VC

Depends on the time horizon

Short time horizon most costs are fixed Long time horizon costs become variable

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Average Total Cost (ATC)

Cost per unit of output Total cost has a fixed component in the
SHORT RUN

Also equals average fixed cost (AFC) plus

average variable cost (AVC)

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Marginal Cost
The cost of expanding output by one unit Fixed costs have no impact on marginal cost, so
it can be written as:

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Short Run Costs

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Cost Curves for a Firm

TC
Cost 400
($ per year)

300

Total cost is the vertical sum of FC and VC.

VC

200

Variable cost increases with production and the rate varies with increasing and decreasing returns.

100

Fixed cost does not vary with output

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0 1 2 3 4 5 6 7 8 9 10 11 12 13

FC
Output
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Cost Curves
120 100
Cost ($/unit)
MC

80 60 40 20 0 0 2 4 6 Output (units/yr) 8 10
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ATC AVC AFC

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Cost Curves
Average Marginal relationship

When MC is below AVC, AVC is falling
When MC is above AVC, AVC is rising When MC is below ATC, ATC is falling

When MC is above ATC, ATC is rising

Therefore, MC crosses AVC and ATC at the

minimums
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Determinants of Short Run Costs

Rate at which these costs increase depends on the nature of the production process, i.e. diminishing returns to variable factors
If marginal product of labor decreases significantly as more labor is hired

Costs of production increase rapidly Greater and greater expenditures must be made to
produce more output
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Determinants of Short Run Costs

Assume the wage rate (w) is fixed relative to the number of workers hired
Variable costs is the per unit cost of extra labor times the amount of extra labor: wL

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Long-Run:Economies and Diseconomies of Scale

Economies of Scale Increase in output is greater than the increase in costs Diseconomies of Scale Increase in output is less than the increase in costs U-shaped LAC shows economies of scale for relatively low output levels and diseconomies of scale for higher levels
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Long Run Costs

Increasing Returns to Scale [OUTPUT]

Output more than doubles when the
quantities of all inputs are doubled

Economies of Scale [COSTS]

Doubling of output requires less than a
doubling of cost
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Long Run Costs

Economies of scale are measured in terms of costoutput elasticity, EC

EC is the percentage change in the cost of production resulting from a 1-percent increase in output

C C MC EC Q Q AC
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Cost-output elasticity EC
EC = 1
when MC = AC

EC < 1
when MC < AC

EC > 1
when MC > AC

Costs increase proportionately with output Neither economies nor diseconomies of scale

AC is declining; MC may be declining or rising

Both MC and AC are rising

Economies of scale Diseconomies of scale

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Long Run Average and Marginal Cost

Cost ($ per unit of output

LMC LAC

Output
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Cost Functions & Measurement of Scale Economies

Scale Economy Index (SCI) EC = 1, SCI = 0: no economies or diseconomies of scale EC > 1, SCI is negative: diseconomies of scale EC < 1, SCI is positive: economies of scale

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Measuring Cost: Which Costs Matter?

For a firm to minimize costs, we must clarify what is meant by costs and how to measure them

It is clear that if a firm has to rent equipment or

buildings, the rent they pay is a cost

What if a firm owns its own equipment or

building?

How are costs calculated?

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Measuring Cost: Which Costs Matter?

Accountants = retrospective view of firms costs Economists = forward-looking view Accounting Cost Actual expenses plus depreciation charges for capital equipment Economic Cost Cost to a firm of utilizing economic resources in production, including opportunity cost
E.g. foregone interests on capital stock E.g. manager could work as an employee
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Measuring Cost: Which Costs Matter?

Although opportunity costs are hidden and should be taken into account, sunk costs should not
Sunk Cost

Expenditure that has been made and cannot be

recovered

Should not influence a firms future economic

decisions

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Sunk Cost

Firms expenditure on an RD project

that failed

Decision to fund specific RD might have

been good or bad, but looking forward this is a done deal

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Fixed Cost Versus Sunk Cost

Fixed cost sunk cost

Fixed Cost

Cost paid by a firm for inputs fixed in the short-run

Sunk Cost

Cost that has been incurred and cannot be recovered

Essential difference lies in time perspective

(static versus dynamic decision)
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Summary

Distinction SR and LR costs Economies of Scale Estimation of cost functions

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Required Reading

Pindyck and Rubinfeld, 8th edition, Chapter 7, pp. 229-249, 254-256

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