Chapter 10 Costs

• Costs in the Short Run

• FC = rK ,
0
VC = wL
Q1 1

TC = FC +VC
• TC = rK + wL
1 0 1

• Note that the curvature of the total

cost curve( fig 10.2) is the opposite of
the curvature of the production
function ( fig 10.1)
• For values of L less than 4, output is
increasing at an increasing rate. Put
differently, a given increase in
output, Q, requires successively
smaller increments of labour, hence
variable costs and thus total costs
increase at a decreasing rate in this
region
• Once diminishing returns set in , the
reverse occurs
• Note that the variable and total cost
curves have the same shape, while

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 the fixed cost curve is constant across
output
• Do example 10.1
• Other Short-run costs
rK 0
AFC Q1 =
Q1
wL1
AVC Q1 =
Q1
• ATC Q1 =
rK 0 + wL1
Q1
∆TC Q1 ∆VC Q1
MC Q1 = =
∆Q ∆Q

• Note in fig 10.5 the average cost

curves and the marginal cost curves
• While the fixed cost curve is
constant, the AFC curve is decreasing
• The AVC curve reaches a minimum
before the ATC curve. Because AFC
declines continuously, ATC
continues decreasing even once AVC
has started increasing
• The distance between ATC and AVC
is AFC

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• The MC curve is the slope of the TC
curve. Diminishing returns set in
when marginal costs start increasing
• The MC curve cuts the AVC and
ATC curves at a minimum. When
MC is below ATC(AVC) ,
ATC(AVC) is decreasing. When MC
is above ATC(AVC),ATC(AVC) is
increasing.
• Note that ATC and AVC are given by
the slope of the rays R1 and R2
respectively.
• Thus, when comparing MC and ATC
we can compare the slope of TC
curve with the slope of the ray R1.
When comparing MC with AVC we
can compare the slope of VC with the
slope of R2.
• Do example 10.3
• Allocating Production between two
processes
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• Suppose there are two production
processes. Total output is Qt. Q1 is
output produced by process 1 and Q2
is output produced by process 2.
• The values of Q1 and Q2 that
minimize costs,will be those output
levels that result in equal marginal
costs for the two processes
• Note that the cost minimization
condition does not require the level of
average costs to be the same in the
two processes, it is simply their
marginal costs that need to be the
same
• Do example 10.4
• The relationship among MP, AP, MC
and AVC
w
MC =
•
MP
w
AVC =
AP

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• We see from these formulae that
when MP is a maximum , MC is a
minimum and visa versa
• Similarly, when AP is a maximum
AVC is a minimum and visa versa

• Costs in the Long Run

• Choosing the Optimal input
combination
• In the long-run all inputs are variable
• An isocost line is a set of input

bundles each of which costs the same

amount
• The isocost line is given by the

equation C = rK + wL with slope = -w/r

• Fig 10.11 shows the maximum output
for a given expenditure/cost. This
occurs where the isocost line is
tangent to an isoquant in the isoquant
map

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• Fig 10.12 shows how we produce a
given output at the lowest possible
cost. Here we have a map of isocost
curves with a single isoquant. The
point of tangency between the
isoquant and an isocost curve is the
optimal input bundle
• The point of tangency occurs where
the slope of the isoquant (MPL/MPK)
= the slope of the isocost line =-w/r
M PL * M kP*
• We thus have = . This means
w r
that, at the cost minimizing input
combination, the extra output we get
from the last rand spent on labour
must equal the extra output we get
from the last rand spent on Capital
• Why is gravel made by hand in Nepal
but by machine in the US?
• It has to do with the relative price of
capital to labour in the two countries
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• See fig 10.13.Since labour is cheaper
in Nepal than in the US and the price
of capital is the same in both
countries, the slope of the isocost line
in the US is steeper than that of the
isocost line in Nepal. The point of
tangency on the isoquant in the US is
at a point with more capital and less
labour than the corresponding point
of tangency for Nepal
• Why do unions support minimum
wage laws so strongly?
• Minimum wage legislation usually
applies to non-skilled labour, yet
labour unions consist predominantly
of skilled labour. So why do labour
unions support minimum wage
legislation?
• See fig 10.14. The higher the ratio of
wages of unskilled workers to that of

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 skilled workers, the more skilled
workers will be employed
• The relationship between Optimal
Input choice and Long-run costs
• Fig 10.15 shows the cost minimixing

input combinations corresponding to

different output levels. It is called the
output expansion path
• S, T and U show the input
combinations corresponding to Q1,
Q2 and Q3 respectively
• The long run total cost curve can be
derived from plotting the output
levels Q1, Q2 etc against their
corresponding long-run total costs
See fig 10.16
• For a constant returns to scale
production function, doubling output
means doubling costs ( since input
must be doubled) See fig 10.17

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• For increasing returns to scale ,
doubling output means costs increase
but by less than double( see fig
10.19)
• For decreasing returns to
scale,doubling total output means
total costs increase by more than
double( see fig 10.18)
• Long run costs and the Structure of
the Industry
• Markets characterized by declining

average costs throughout will be

served by a single firm. This is what
is referred to as natural monopolies
• The output level, Q0, that

corresponds to the minimum point on

the LAC is known as the minimum
efficient scale
• If Q0 constitutes a substantial share
of industry output, the industry is

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 likely to be populated by just a few
firms
• If Q0 is a very small portion of
industry output than the industry will
consist of many small firms
• The relationship between long-run
and short-run cost curves
• The LAC forms an envelope of all
the short-run average cost curves
• Each short run ATC curve
corresponds to a different level of
capital
• At the point of tangency between the
LAC and the respective ATC’s,
short-run marginal cost equals long
run marginal cost
• At the minimum point on the LAC,
LAC=ATC=SMC=LMC

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