2 IntroductionThe production technology measures the relationship between input and output.Production technology, together with prices of factor inputs, determine the firm’s cost of productionGiven the production technology, managers must choose how to produce.The optimal, cost minimizing, level of inputs can be determined.
3 MEASURING COST: WHICH COSTS MATTER? ● 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.● opportunity cost Cost associated with opportunities that are forgone when a firm’s resources are not put to their best alternative use.● sunk cost Expenditure that has been made and cannot be recovered.
4 Fixed Costs and Variable Costs total cost (TC or C) Total economic cost of production,consisting of fixed and variable costs.fixed cost (FC) Cost that does not vary with the level of outputand that can be eliminated only by shutting down.variable cost (VC) Cost that varies as output varies.Shutting DownShutting down doesn’t necessarily mean going out of business.By reducing the output of a factory to zero, the company could eliminate the costs of raw materials and much of the labor. The only way to eliminate fixed costs would be to close the doors, turn off the electricity, and perhaps even sell off or scrap the machinery.
5 Marginal and Average Cost marginal cost (MC) Increase in cost resulting from the production of one extra unit of output.Because fixed cost does not change as the firm’s level of output changes, marginal cost is equal to the increase in variable cost or the increase in total cost that results from an extra unit of output.We can therefore write marginal cost as
6 Marginal and Average Cost TABLE A Firm’s CostsRate of Fixed Variable Total Marginal Average Average AverageOutput Cost Cost Cost Cost Fixed Cost Variable Cost Total Cost(Units (Dollars (Dollars (Dollars (Dollars (Dollars (Dollars (Dollarsper Year) per Year) per Year) per Year) per Unit) per Unit) per Unit) per Unit)(FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)(1) (2) (3) (4) (5) (6) (7)
7 Average Total Cost (ATC) Cost per unit of outputAlso equals average fixed cost (AFC) plus average variable cost (AVC).
8 The Determinants of Short-Run Cost The change in variable cost is the per-unit cost of the extra labor w times the amount of extra labor needed to produce the extra output ΔL. Because ΔVC = wΔL, it follows thatThe extra labor needed to obtain an extra unit of output is ΔL/Δq = 1/MPL. As a result,
9 If marginal product of labor decreases significantly as more labor is hired Costs of production increase rapidlyGreater and greater expenditures must be made to produce more output
13 Cost Curves for a Firm12345678910111213OutputP100200300400FCVCTCThe line drawn from the origin to the variable cost curve:Its slope equals AVCThe slope of a point on VC or TC equals MCTherefore, MC = AVC at 7 units of output (point A)
14 COST IN THE LONG RUN● user cost of capital Annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest.We can also express the user cost of capital as a rate per dollar of capital:
15 The Rental Rate of Capital The Price of CapitalThe price of capital is its user cost, given by r = Depreciation rate + Interest rate.The Rental Rate of Capital● rental rate : Cost per year of renting one unit of capital.
16 COST IN THE LONG RUN● isocost line Graph showing all possible combinations of labor and capital that can be purchased for a given total cost.To see what an isocost line looks like, recall that the total cost C of producing any particular output is given by the sum of the firm’s labor cost wL and its capital cost rK:If we rewrite the total cost equation as an equation for a straight line, we getIt follows that the isocost line has a slope of ΔK/ΔL = −(w/r), which is the ratio of the wage rate to the rental cost of capital.
17 Cost Minimizing Input Choice AssumptionsTwo Inputs: Labor (L) & capital (K)Price of labor: wage rate (w)The price of capitalr = depreciation rate + interest rateOr rental rate if not purchasingThese are equal in a competitive capital market
18 Producing a Given Output at Minimum Cost CapitalperyearQ1 is an isoquant for output Q1.There are three isocost lines, of which 2 are possible choices in which to produce Q1C2Q1AK1L1K3L3K2L2C1Isocost C2 shows quantityQ1 can be produced withcombination K2L2 or K3L3.However, both of theseare higher cost combinationsthan K1L1.C0Labor per year
19 C2 Q1 C1 K2 L2 B K1 L1 A Capital per year If the price of labor rises, the isocost curvebecomes steeper due tothe change in the slope -(w/L).Q1C1The new combination of K and L is used to produce Q1.Combination B is used in place of combination A.K2L2BK1L1ALabor per year
20 Cost in the Long RunIt follows that when a firm minimizes the cost of producing a particular output, the following condition holds:We can rewrite this condition slightly as follows:
21 Cost in the Long RunMinimum cost for a given output will occur when each dollarof input added to the production process will add an equivalent amount of output
22 Cost in the Long RunIf w = $10, r = $2, and MPL = MPK, which input would the producer use more of?Labor because it is cheaperIncreasing labor lowers MPLDecreasing capital raises MPKSubstitute labor for capital until
23 Cost in the Long Run Cost minimization with Varying Output Levels For each level of output, there is an isocost curve showing minimum cost for that output levelA firm’s expansion path shows the minimum cost combinations of labor and capital at each level of output.Slope equals K/L
24 A Firm’s Expansion Path Capitalperyear255075100150The expansion path illustratesthe least-cost combinations oflabor and capital that can beused to produce each level ofoutput in the long-run.$3000300 UnitsCExpansion Path$2000200 UnitsBALabor per year100150300200
25 Long-Run Versus Short-Run Cost Curves In the short run some costs are fixedIn the long run firm can change anything including plant sizeCan produce at a lower average cost in long run than in short runCapital and labor are both flexible
26 The Inflexibility of Short-Run Production Q2K2DCCapital is fixed at K1To produce q1, min cost at K1,L1If increase output to Q2, min costis K1 and L3 in short runQ1ABL1K1Long-RunExpansion PathIn LR, can change capital and min costs falls to K2 and L2L3PShort-RunExpansion Path
27 Long-Run Versus Short-Run Cost Curves Long-Run Average Cost (LAC)Most important determinant of the shape of the LR AC and MC curves is relationship between scale of the firm’s operation and inputs required to min costConstant Returns to ScaleIf input is doubled, output will doubleAC cost is constant at all levels of output.Increasing Returns to ScaleIf input is doubled, output will more than doubleAC decreases at all levels of output.Decreasing Returns to ScaleIf input is doubled, output will less than doubleAC increases at all levels of output
28 Economies and Diseconomies of Scale As output increases, the firm’s average cost of producing that output is likely to decline, at least to a point.This can happen for the following reasons:If the firm operates on a larger scale, workers can specialize in the activities at which they are most productive.Scale can provide flexibility. By varying the combination of inputs utilized to produce the firm’s output, managers can organize the production process more effectively.
29 Economies and Diseconomies of Scale ● economies of scale Situation in which output can be doubled for less than a doubling of cost.● diseconomies of scale Situation in which a doubling of output requires more than a doubling of cost.Increasing Returns to Scale: Output more than doubles when the quantities of all inputs are doubled.Economies of Scale: A doubling of output requires less than a doubling of cost.
30 Long Run Costs EC is equal to 1, MC = AC Costs increase proportionately with outputNeither economies nor diseconomies of scaleEC < 1 when MC < ACEconomies of scaleBoth MC and AC are decliningEC > 1 when MC > ACDiseconomies of scaleBoth MC and AC are rising
31 Long-Run Cost with Economies and Diseconomies of Scale
32 Cont’ Advantages Both use capital and labor. The firms share management resources.Both use the same labor skills and type of machineFirms must choose how much of each to produce.The alternative quantities can be illustrated using product transformation curvesCurves showing the various combinations of two different outputs (products) that can be produced with a given set of inputs
33 The learning curve in the figure is based on the relationship:
34 Dynamic Changes in Costs – The Learning Curve If N = 1L equals A + B and this measures labor input to produce the first unit of outputIf = 0Labor input per unit of output remains constant as the cumulative level of output increases, so there is no learningIf > 0 and N increases,L approaches A, and A represents minimum labor input/unit of output after all learning has taken place.The larger ,The more important the learning effect.