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ANALYSIS OF COSTS. SHORT-RUN COST FUNCTION TOTAL COST TC = FC + VC FIXED COST - stays constant no matter what level of output VARIABLE COST - vary with.

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Presentation on theme: "ANALYSIS OF COSTS. SHORT-RUN COST FUNCTION TOTAL COST TC = FC + VC FIXED COST - stays constant no matter what level of output VARIABLE COST - vary with."— Presentation transcript:

1 ANALYSIS OF COSTS

2 SHORT-RUN COST FUNCTION TOTAL COST TC = FC + VC FIXED COST - stays constant no matter what level of output VARIABLE COST - vary with the level of output

3 COST CONCEPTS Marginal cost = the extra or additional cost of producing 1 extra unit of output Average cost (unit costs) – concept that enables a firm to dicern whether or not it is making a profit (compared with price or average revenue)

4 AC can be broken down into two components – AFC and AVC Average Fixed Cost since total fixed cost is a constant, dividing it by an increasing output gives a steadily falling Average Variable Cost VC divided by output

5 Relationship between AC and MC if MC is below AC, AC must be falling (the last unit produced costs less than the average of all the earlier units produced  AC including the last unit must be less than the old AC), if MC is above AC, AC must be rising (the last unit costs more than the average of the earlier units, the AC including the last unit must be higher than the old AC), if MC is just equal to AC  the last unit costs exactly the same as the average cost of all earlier units (the AC curve is flat).

6 Short-run cost curves

7 THE LINK BETWEEN PRODUCTION AND COSTS the shape of cost curves is affected strictly by the shape of production function, which reflects the form of returns  the U-shaped cost curves are grounded in the law of diminishing returns the essence of the link between costs and production is simple – for each level of output, firms must choose the least costly combination of inputs

8 THE LONG-RUN COST CURVE the long-run cost curves depends on production function also – therefore, depends on the returns to scale the long-run average cost (LAC) curve is called „envelope curve“, because it wraps around the outside of all the short-run curves LMC can be derived from the LAC – also goes through the minimum point of the LAC and has a gentler slope than the short-run SMC at the minimum point

9 The Least-cost Rule whatever the level of output, the firm should strive to produce that output at the lowest possible cost and thereby have the maximum amount of revenue left over for profits MP L / w = MP K /r  technological optimum = the level of output with the lowest average cost

10 Other cost concepts difference between economic and accounting approach to cost OPPORTUNITY COST (implicit cost) = implicit return to labor supplied by the owner of a firm

11 1. Decide, what is the optimal level of output regarding to the technology knowing: 2. Calculate and graphically depict the course of AC, AVC and AFC curves. 3. Calculate and graphically depict the course of FC, VC, MC, AC curves. 4. Explain mistakes in thinking: a) While the total cost are constantly growing, the average cost must be growing also, b) It is optimal to produce the amount of production for firm, which corresponds to the intersection of MC an AC from economic point of view, c) AC tends to decline, as long as the MC are declining. Q MC Q TC Q AVC211814,615,52231,3 AFC1053,32,521,6


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