MICROECONOMICS: Theory & Applications Chapter 8 The Cost of Production By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 9th Edition, copyright 2006 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Delineate the nature of a firm’s cost – explicit as well as implicit. Outline how cost is likely to vary with output in the short run and various measures of short-run cost. Detail the typical shapes of a firm’s short-run cost curves. See how a firm will choose to combine inputs in its production process in the long run when all inputs are variable. Show how input price changes affect a firm’s cost curves. (Continued) John Wiley & Sons, Inc. Copyright 2006

Learning Objectives (continued) Differentiate between a firm’s long-run and short-run cost curves. Understand how the minimum efficient scale of production is related to market structure. Cover economies of scope – is it cheaper for one firm to produce products jointly than it is for separate firms to produce the same products independently? Overview how cost functions can be empirically estimated through surveys and regression analysis. John Wiley & Sons, Inc. Copyright 2006

The Nature of Cost Recall: Explicit costs – arise from transactions in which the firm purchases inputs or the services of inputs from other parties Implicit costs – costs associated with the use of the firm’s own resources and reflect the fact that these resources could be employed elsewhere Opportunity cost reflects both explicit and implicit costs. John Wiley & Sons, Inc. Copyright 2006

Measures of Short-Run Cost Total fixed cost (TFC) – the cost incurred by the firm that does not depend on how much output it produces Total variable cost (TVC) – the cost incurred by the firm that depends on how much output it produces John Wiley & Sons, Inc. Copyright 2006

Five Other Measure of Short-Run Cost Total cost (TC) – the sum of total fixed and total variable cost at each output level Marginal cost (MC) – the change in total cost that results from a one-unit change in output Average fixed cost (AFC) – total fixed cost divided by the amount of output Average variable cost (AVC) – total variable cost divided by the amount of output Average total cost (ATC) – total cost divided by the output John Wiley & Sons, Inc. Copyright 2006

Example of Short-Run Costs ($) [Table 8.1] John Wiley & Sons, Inc. Copyright 2006

Behind Cost Relationships The shape of the TVC curve is determined by the shape of the TP curve, which in turn reflects diminishing marginal returns. Figure 8.1 John Wiley & Sons, Inc. Copyright 2006

Short-Run Cost Curves [Figure 8.2] John Wiley & Sons, Inc. Copyright 2006

Marginal Cost The marginal product curve of the variable input generally rises and then falls, attributable to the law of diminishing marginal returns. As a result, the MC curve will first fall and then rise. John Wiley & Sons, Inc. Copyright 2006

Average Cost The average product curve rises, reaches a maximum, and then falls, due to the law of diminishing marginal productivity. As a result, the AVC curve will fall and then rise. The AFC curve declines over the entire range of output as the amount of total fixed cost is spread over ever-larger rates of output. The ATC curve is the sum of AFC and AVC. It measures the average unit cost of all inputs, both fixed and variable, and must also be U-shaped. John Wiley & Sons, Inc. Copyright 2006

Marginal-Average Relationships When marginal cost is below average (total or variable) cost, average cost will decline. When marginal cost is above average cost, average cost rises. When average cost is at a minimum, marginal cost is equal to average cost. John Wiley & Sons, Inc. Copyright 2006

Geometry of Cost Curves [Figure 8.3] John Wiley & Sons, Inc. Copyright 2006

Isocost Lines An isocost line is a line that identifies all the combinations of capital and labor, two factor inputs, that can be purchased at a given total cost. The line intersects each axis at the quantity of that input that the firm could purchase if only that input were purchased. The slope of an isocost line is (minus) the ratio of input prices, w/r, indicating the relative prices of inputs. John Wiley & Sons, Inc. Copyright 2006

Least Costly Input Combination A point of tangency between an isocost line and an isoquant show the least costly way of producing a given output level. Alternatively, a point of tangency shows the maximum output attainable at a given cost as well as the minimum cost necessary to produce that output. John Wiley & Sons, Inc. Copyright 2006

Interpreting the Tangency Points Golden rule of cost minimization: a rule that says that to minimize cost, the firm should employ inputs in such a way that the marginal product per dollar spent is equal across all inputs MPL/w = MPK/r John Wiley & Sons, Inc. Copyright 2006

If the firm is not producing at a tangency point… Whenever MPL/w > MPK/r, a firm can increase output without increasing production cost by shifting outlays from capital to labor. Whenever MPL/w < MPK/r, a firm can increase output without increasing production cost by shifting outlays from labor to capital. John Wiley & Sons, Inc. Copyright 2006

The Expansion Path The expansion path is a curve formed by connecting the points of tangency between isocost lines and the highest respective attainable isoquants. John Wiley & Sons, Inc. Copyright 2006

Isocost Lines and the Expansion Path [Figure 8.4] John Wiley & Sons, Inc. Copyright 2006

Input Price Changes and Cost Curves [Figure 8.5] John Wiley & Sons, Inc. Copyright 2006

Long-Run Cost Curves [Figure 8.7] John Wiley & Sons, Inc. Copyright 2006

Economies of Scale and Diseconomies of Scale Economies of scale – a situation in which a firm can increase its output more than proportionally to its total input cost Diseconomies of scale – a situation in which a firm’s output increases less than proportionally to its total input cost John Wiley & Sons, Inc. Copyright 2006

Learning by Doing Learning by doing – improvements in productivity resulting from a firm’s cumulative output experience Figure 8.8 John Wiley & Sons, Inc. Copyright 2006

Importance of Cost Curves to Market Structure Minimum efficient scale – the scale of operations at which average cost per unit reaches a minimum Table 8.2 John Wiley & Sons, Inc. Copyright 2006

Economies of Scope and Diseconomies of Scope Economies of scope – a case where it is cheaper for one firm to produce products jointly than it is for separate firms to produce the same products independently Diseconomies of scope – a case where it is cheaper for separate products to be produced independently than for one firm to produce the same products jointly John Wiley & Sons, Inc. Copyright 2006

Estimating Cost Functions Techniques: Surveys Econometric specification New entrant/survivor technique – method for determining the minimum efficient scale of production in an industry based on investigating the plant sizes either being built or used by firms in the industry John Wiley & Sons, Inc. Copyright 2006

Copyright 2006 John Wiley & Sons, Inc. All rights reserved Copyright 2006 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in section 117 of the 1976 United States Copyright Act without express permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages caused by the use of these programs or from the use of the information herein. John Wiley & Sons, Inc. Copyright 2006