Chapter 7

The Cost of
Production
Topics to be Discussed

 Measuring Cost: Which Costs Matter?

 Cost in the Short Run
 Cost in the Long Run
 Long-Run Versus Short-Run Cost Curves
 Production with Two Outputs--Economies
of Scope

Chapter 7 Slide 2
Introduction

 The production technology measures

the relationship between input and
output.
 Given the production technology,
managers must choose how to
produce.

Chapter 7 Slide 3
Introduction

 To determine the optimal level of

output and the input combinations, we
must convert from the unit
measurements of the production
technology to dollar measurements or
costs.

Chapter 7 Slide 4
Measuring Cost:
Which Costs Matter?
Economic
Economic Cost
Cost vs.
vs. Accounting
Accounting Cost
Cost
 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

Chapter 7 Slide 5
Measuring Cost:
Which Costs Matter?

 Opportunity cost.
 Cost associated with opportunities that
are foregone when a firm’s resources
are not put to their highest-value use.

 Sunk Cost
 Expenditure that has been made and
cannot be recovered
 Should not influence a firm’s decisions.

Chapter 7 Slide 6
Measuring Cost:
Which Costs Matter?
Fixed
Fixed and
and Variable
Variable Costs
Costs
 Total output is a function of variable
inputs and fixed inputs.
TC  FC  VC TC=ATC*Output

TC
ATC  AFC  AVC or
Q

Chapter 7 Slide 7
Measuring Cost:
Which Costs Matter?
Fixed
Fixed and
and Variable
Variable Costs
Costs
 Fixed Cost
 Does not vary with the level of output
 Cost paid by a firm that is in business regardless of the level
of output
 TFC=AFC*Output
 TFC=TC-TVC
 Average Fixed Cost:
 Defined as total fixed cost per unit of output.
 AFC=TFC/Output
 AFC=ATC-AVC

Chapter 7 Slide 8
 Variable Cost
Cost that varies as output varies
Total Variable Cost
 As output increase, TVC will
increase and when output is
0, TVC is also 0.
 TVC=AVC*Output
 TVC=TC-TFC
 TVC increases in stages:
Stage 1: Decreasing Rate
Stage 2: Increasing Rate

 Sunk Cost
 Cost that have been incurred
and cannot be recovered

Chapter 7 Slide 9
  Average Variable Cost
Defined as the total variable cost per unit of
output.
AVC=TVC/Output
AVC=ATC-AFC

Marginal Cost
Defined as the addition to total cost as a result of
producing as additional to total cost as a result of
producing as additional unit of output.
MC= TC/ Q= TVC/ Q

Chapter 7 Slide 10
Cost in the Short Run

 The Determinants of Short-Run Cost

 The relationship between the production
function and cost can be exemplified by
either increasing returns and cost or
decreasing returns and cost.

Chapter 7 Slide 11
Cost in the Short Run

 The Determinants of Short-Run Cost

 Increasing returns and cost
With increasing returns, output is increasing
relative to input and variable cost and total
cost will fall relative to output.
 Decreasing returns and cost
With decreasing returns, output is
decreasing relative to input and variable cost
and total cost will rise relative to output.

Chapter 7 Slide 12
Cost in the Short Run

 For Example: Assume the wage rate

(w) is fixed relative to the number of
workers hired. Then:

VC
MC 
Q
VC  wL
Chapter 7 Slide 13
Cost in the Short Run
VC  wL
 Continuing:
w L
MC 
Q
Q
MPL 
L
L 1
L for a 1 unit Q  
Q MPL
Chapter 7 Slide 14
Cost in the Short Run

 In conclusion:

w
MC 
MPL
 …and a low marginal product (MP)
leads to a high marginal cost (MC)
and vise versa.

Chapter 7 Slide 15
Cost in the Short Run

 Consequently (from the table):

 MC decreases initially with increasing
returns
 0 through 4 units of output
 MC increases with decreasing returns
 5 through 11 units of output

Chapter 7 Slide 16
 A Firm’s Short-Run Costs ($)
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)

050 0 50--- ------ ---

150 50 10050 5050 100
250 78 12828 2539 64
350 98 14820 16.732.7 49.3
450 112 16214 12.528 40.5
550 130 18018 1026 36
650 150 20020 8.325 33.3
750 175 22525 7.125 32.1
850 204 25429 6.325.5 31.8
950 242 29238 5.626.9 32.4
1050 300 35058 530 35
1150 385 43585 4.535 39.5
Cost Curves for a Firm
Total cost
is the vertical TC
Cost 400 sum of FC
($ per and VC.
year) VC
Variable cost
increases with
300 production and
the rate varies with
increasing &
decreasing returns.

200

Fixed cost does not

100 vary with output
50 FC

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

Chapter 7 Slide 18
Cost Curves for a Firm
Cost
($ per
100
unit)
MC

75

50 ATC
AVC

25

AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)

Chapter 7 Slide 19
Cost Curves for a Firm

 The line drawn from

P TC
the origin to the
400
tangent of the VC

variable cost curve:

300
 Its slope equals AVC
 The slope of a point 200
on VC equals MC
A
 Therefore, MC = AVC 100
at 7 units of output FC
(point A)
0 1 2 3 4 5 6 7 8 9 10 11 12 13
Output

Chapter 7 Slide 20
Cost Curves for a Firm

 Unit Costs Cost

($ per
unit)
100
 AFC falls
MC
continuously 75

 When MC < AVC or

MC < ATC, AVC & 50
ATC
ATC decrease AVC
25
 When MC > AVC or
AFC
MC > ATC, AVC & 0 1 2 3 4 5 6 7 8 9 10 11

ATC increase Output (units/yr.)

Chapter 7 Slide 21
Cost Curves for a Firm

 Unit Costs Cost

($ per
unit)
100
 MC = AVC and ATC
MC
at minimum AVC and 75
ATC
 Minimum AVC 50
ATC
occurs at a lower AVC

output than minimum 25

ATC due to FC AFC

0 1 2 3 4 5 6 7 8 9 10 11
Output (units/yr.)

Chapter 7 Slide 22
 Cost in the Long Run
The
The Cost
Cost Minimizing
Minimizing Input
Input Choice
Choice

 Assumptions
 Two Inputs: Labor (L) & capital (K)
 Price of labor: wage rate (w)
 The price of capital
 R = depreciation rate + interest rate

Chapter 7 Slide 23
 Cost in the Long Run
The
The
TheCost
The User
UserMinimizing
Cost Cost
Cost of
of Capital
Minimizing Input
Input Choice
Capital Choice

 The Isocost Line

C = wL + rK
 Isocost: A line showing all combinations
of L & K that can be purchased for the
same cost

Chapter 7 Slide 24
Cost in the Long Run
The
The Isocost
Isocost Line
Line
 Rewriting C as linear:
 K = C/r - (w/r)L
  
Slope of the isocost: K L   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.

Chapter 7 Slide 25
Choosing Inputs

 We will address how to minimize cost

for a given level of output.
 We will do so by combining isocosts with
isoquants

Chapter 7 Slide 26
 Producing a Given
Output at Minimum Cost
Capital Q1 is an isoquant
per for output Q1.
year Isocost curve C0 shows
all combinations of K and L
that can produce Q1 at this
K2 cost level.

Isocost C2 shows quantity

CO C1 C2 are
Q1 can be produced with
three combination K2L2 or K3L3.
isocost lines However, both of these
A are higher cost combinations
K1 than K1L1.

Q1
K3

C0 C1 C2
L2 L1 L3 Labor per year

Chapter 7 Slide 27
Input Substitution When
an Input Price Change
Capital If the price of labor
per changes, the isocost curve
year becomes steeper due to
the change in the slope -(w/L).

This yields a new combination

of K and L to produce Q1.
B Combination B is used in place
of combination A.
K2
The new combination represents
the higher cost of labor relative
A to capital and therefore capital
K1 is substituted for labor.

Q1

C2 C1

L2 L1 Labor per year

Chapter 7 Slide 28
Cost in the Long Run

 Isoquants and Isocosts and the

Production Function

MRTS  - K  MP L
L MP K

Slope of isocost line  K  w

L r
MPL
and  w
MPK r

Chapter 7 Slide 29
Cost in the Long Run

 The minimum cost combination can

then be written as:

MP L  MP K
w r
 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.

Chapter 7 Slide 30
Cost in the Long Run

 Cost minimization with Varying Output

Levels
A firm’s expansion path shows the
minimum cost combinations of labor and
capital at each level of output.

Chapter 7 Slide 31
A Firm’s Expansion Path
Capital
per The expansion path illustrates
year the least-cost combinations of
labor and capital that can be
used to produce each level of
150 $3000 Isocost Line output in the long-run.

$2000 Expansion Path

Isocost Line
100
C
75
B
50
300 Unit Isoquant
A
25
200 Unit
Isoquant
Labor per year
50 100 150 200 300

Chapter 7 Slide 32
A Firm’s Long-Run Total Cost Curve
Cost
per
Year
Expansion Path
F
3000

E
2000

D
1000

Output, Units/yr
100 200 300

Chapter 7 Slide 33
Long-Run Versus
Short-Run Cost Curves

 Long-Run Average Cost (LAC)

 Constant Returns to Scale
 If input is doubled, output will double
and average cost is constant at all
levels of output.

Chapter 7 Slide 34
Long-Run Versus
Short-Run Cost Curves

 Long-Run Average Cost (LAC)

 Increasing Returns to Scale
 If input is doubled, output will more
than double and average cost
decreases at all levels of output.

Chapter 7 Slide 35
Long-Run Versus
Short-Run Cost Curves

 Long-Run Average Cost (LAC)

 Decreasing Returns to Scale
 If input is doubled, the increase in
output is less than twice as large and
average cost increases with output.

Chapter 7 Slide 36
Long-Run Versus
Short-Run Cost Curves

 Long-Run Average Cost (LAC)

 In the long-run:
 Firms experience increasing and
decreasing returns to scale and
therefore long-run average cost is “U”
shaped.

Chapter 7 Slide 37
Long-Run Versus
Short-Run Cost Curves

 Long-Run Average Cost (LAC)

 Long-run marginal cost leads long-run
average cost:
 If LMC < LAC, LAC will fall
 If LMC > LAC, LAC will rise
 Therefore, LMC = LAC at the
minimum of LAC

Chapter 7 Slide 38
Long-Run Average
and Marginal Cost

Cost
($ per unit
of output LMC

LAC

Output

Chapter 7 Slide 39
Long-Run Versus
Short-Run Cost Curves

 Question
 What is the relationship between long-
run average cost and long-run marginal
cost when long-run average cost is
constant?

Chapter 7 Slide 40
Long-Run Versus
Short-Run Cost Curves

 Economies and Diseconomies of

Scale
 Economies of Scale
 Increase in output is greater than the
increase in inputs.
 Diseconomies of Scale
 Increase in output is less than the
increase in inputs.

Chapter 7 Slide 41
Long-Run Versus
Short-Run Cost Curves

 Measuring Economies of Scale

Ec  Cost  output elasticity

 %Δ in cost from a 1% increase
in output

Chapter 7 Slide 42
Long-Run Versus
Short-Run Cost Curves

 Measuring Economies of Scale

Ec  ( C / C ) /( Q / Q )

Ec  ( C / Q ) /(C / Q )  MC/AC

Chapter 7 Slide 43
Long-Run Versus
Short-Run Cost Curves

 Therefore, the following is true:

 EC < 1: MC < AC
 Average cost indicate decreasing economies
of scale
 EC = 1: MC = AC
 Average cost indicate constant economies of
scale
 EC > 1: MC > AC
 Average cost indicate increasing
diseconomies of scale

Chapter 7 Slide 44
Long-Run Versus
Short-Run Cost Curves

 The Relationship Between Short-Run

and Long-Run Cost
 We will use short and long-run cost to
determine the optimal plant size

Chapter 7 Slide 45
Long-Run Cost with
Constant Returns to Scale

Cost With many plant sizes with SAC = $10

($ per unit the LAC = LMC and is a straight line
of output
SAC1 SAC2 SAC3

SMC1 SMC2 SMC3

LAC =
LMC

Q1 Q2 Q3 Output

Chapter 7 Slide 46
Long-Run Cost with
Constant Returns to Scale

 Observation
 The optimal plant size will depend on the
anticipated output (e.g. Q1 choose SAC1,etc).
 The long-run average cost curve is the
envelope of the firm’s short-run average cost
curves.

 Question
 What would happen to average cost if an output
level other than that shown is chosen?

Chapter 7 Slide 47
Long-Run Cost with Economies
and Diseconomies of Scale

Cost
($ per unit SAC1 SAC3 LAC
of output
SAC2
A
$10
$8
B

SMC1 If the output is Q1 a manager

SMC3
would chose the small plant
SAC1 and SAC $8.
LMC SMC2 Point B is on the LAC because
it is a least cost plant for a
given output.

Q1 Output

Chapter 7 Slide 48
Long-Run Cost with
Constant Returns to Scale

 What is the firms’ long-run cost

curve?
 Firms can change scale to change
output in the long-run.
 The long-run cost curve is the dark blue
portion of the SAC curve which
represents the minimum cost for any
level of output.

Chapter 7 Slide 49
Long-Run Cost with
Constant Returns to Scale

 Observations
 The LAC does not include the minimum
points of small and large size plants?
Why not?
 LMC is not the envelope of the short-run
marginal cost. Why not?

Chapter 7 Slide 50
Production with Two
Outputs--Economies of Scope

 Economies of scope exist when the joint

output of a single firm is greater than the
output that could be achieved by two
different firms each producing a single
output.
 What are the advantages of joint
production?
 Consider an automobile company producing
cars and tractors

Chapter 7 Slide 51
Production with Two
Outputs--Economies of Scope

 Advantages
1) Both use capital and labor.
2) The firms share management
resources.
3) Both use the same labor skills and
type of machinery.

Chapter 7 Slide 52
Production with Two
Outputs--Economies of Scope

 Production:
 Firms must choose how much of each to
produce.
 The alternative quantities can be
illustrated using product transformation
curves.

Chapter 7 Slide 53
Product Transformation Curve
Each curve shows
Number combinations of output
of tractors with a given combination
of L & K.

O2 O1 illustrates a low level

of output. O2 illustrates
a higher level of output with
two times as much labor
O1 and capital.

Number of cars

Chapter 7 Slide 54
Production with Two
Outputs--Economies of Scope

 Observations
 Product transformation curves are
negatively sloped
 Constant returns exist in this example
 Since the production transformation
curve is concave is joint production
desirable?

Chapter 7 Slide 55
Production with Two
Outputs--Economies of Scope

 Observations
 There is no direct relationship between
economies of scope and economies of
scale.
 May experience economies of scope
and diseconomies of scale
 May have economies of scale and not
have economies of scope

Chapter 7 Slide 56
Production with Two
Outputs--Economies of Scope

 The degree of economies of scope measures

the savings in cost and can be written:

C(Q1)  C (Q 2)  C (Q1, Q 2)
SC 
C (Q1, Q 2)
 C(Q1) is the cost of producing Q1
 C(Q2) is the cost of producing Q2
 C(Q1Q2) is the joint cost of producing both
products

Chapter 7 Slide 57
Production with Two
Outputs--Economies of Scope

 Interpretation:
 If SC > 0 -- Economies of scope
 If SC < 0 -- Diseconomies of scope

Chapter 7 Slide 58
Estimating and Predicting Cost

 Difficulties in Measuring Cost

1) Output data may represent an
aggregate of different type of products.
2) Cost data may not include opportunity
cost.
3) Allocating cost to a particular product
may be difficult when there is more than
one product line.

Chapter 7 Slide 59
Summary

 Managers, investors, and economists

must take into account the opportunity
cost associated with the use of the
firm’s resources.
 Firms are faced with both fixed and
variable costs in the short-run.

Chapter 7 Slide 60
Summary

 When there is a single variable input,

as in the short run, the presence of
diminishing returns determines the
shape of the cost curves.
 In the long run, all inputs to the
production process are variable.

Chapter 7 Slide 61
Summary

 The firm’s expansion path describes

how its cost-minimizing input choices
vary as the scale or output of its
operation increases.
 The long-run average cost curve is
the envelope of the short-run average
cost curves.

Chapter 7 Slide 62
Summary

 A firm enjoys economies of scale

when it can double its output at less
than twice the cost.
 Economies of scope arise when the
firm can produce any combination of
the two outputs more cheaply than
could two independent firms that each
produced a single product.

Chapter 7 Slide 63
Summary

 A firm’s average cost of production

can fall over time if the firm “learns”
how to produce more effectively.
 Cost functions relate the cost of
production to the level of output of the
firm.

Chapter 7 Slide 64