chapter 8 Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-2 Learning Objectives Describe various types of cost and the characteristics of each. Identify a firm’s least-cost input choice, and the firm’s cost function, in the short-and long-run. Understand the concepts of average and marginal cost. Describe the effect of an input price change on the firm’s least-cost input combination. Explain the relationship between short-run and long-run cost. Define economies and diseconomies of scale and explain their relationship to the concept of returns to scale. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-3 Overview There are several types of cost: fixed vs. variable; avoidable vs. sunk; out-of-pocket vs. opportunity costs. We will start with the simpler case of one variable input, then expand to cost minimization with two variable inputs. Along the way, we will learn several new tools, such as isocost lines, and average and marginal cost curves. Compared to the short run, costs can be lower in the long run. As firms grow and increase the use of all inputs, average costs may increase or decrease – economies of scale. A similar phenomenon may happen when new lines of products are introduced – economies of scope. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-4 Types of Cost Total cost Variable cost: costs of inputs that vary with the firm’s output level Fixed cost: costs of inputs whose use does not vary with the firm’s output level Avoidable: the firm does not incur the cost (or recoups it) if it produces no output Sunk: cost that is incurred even if the firm decides not to operate Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-5 Types of Cost Opportunity Cost: the cost associated with forgoing the opportunity to employ a resource in its best alternative use A firm’s true economic costs of production consists of both out of pocket expenditures and opportunity costs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-6 Types of Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-7 Types of Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-8 Cost with One Variable Input Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-9 Deriving Variable Cost from Production Function Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Fixed, Variable, and Total Cost Cost curve is equal to the variable cost plus the fixed cost curves Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 8-10

8-11 Isocost Lines To find the cheapest combination of inputs to produce a given output, we will need a new tool. Isocost line: contains all the input combinations with the same cost Isocost lines in combination with isoquants will allow the firm to pick the least-cost combination of inputs to produce a certain level of output (or the largest possible output given a certain cost). Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-12 Isocost Lines Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-13 Isocost Lines Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-14 Least-Cost Method To find the least-cost input combination for an output of 140, we look for the point in that isoquant that lies on the lowest isocost line (point D) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-15 Cost Minimization with Fixed Proportions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-16 Interior Solutions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-17 Interior Solutions Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-18 Boundary Solutions Boundary solution: the least-cost input combination excludes some inputs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-19 Output Expansion Path and Total Cost Curve Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-20 Output Expansion Path with a Lumpy Input and Avoidable Fixed Costs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-21 Average and Marginal Costs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-22 Cost, Average Cost, and Marginal Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-23 From Total Cost to Average Cost Efficient scale of production Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-24 From Total Cost to Marginal Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-25 Relationship between Average and Marginal Cost When output is finely divisible, the AC curve is upward sloping at Q if MC > AC, downward sloping if MC < AC, and neither rising nor falling if MC = AC Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-26 Three Kinds of Average Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-27 Three Kinds of Average Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-28 Effects of Input Price Changes After an increase in the price of an input, a cost-minimizing firm never uses more of that input to produce a given amount of output, and usually employs less. Point B reflects a higher cost of capital than in point A Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-29 Effects of Input Price Changes When capital costs R, the least-cost combination is A. When the price of capital increases to R’, the new least-cost combination B must lie in the green region, because it must be no less costly than A when the price is R, and no more costly when the price is R’ Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-30 Short-Run Versus Long-Run Costs In the short run, capital is fixed (points B, E, F). In the long run, all inputs are variable, usually allowing the firm to produce at a lower cost (compare A to E, and D to F) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-31 Short-Run Versus Long-Run Costs Keeping capital fixed Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-32 Short-Run Versus Long-Run Average Costs Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-33 Short-Run Versus Long-Run Marginal Costs Marginal Costs rise more rapidly when we can only vary one input Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-34 Economies and Diseconomies of Scale Economies of scale: average cost falls as firm produces more Diseconomies of scale: average cost rises as firm produces more Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Economies and Diseconomies of Scale twice the cost of A more than twice the cost of D less than twice the cost of A Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 8-35

8-36 Economies and Diseconomies of Scope Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-37 Review Costs can be either variable or fixed. Fixed costs can be either avoidable or sunk. Economic costs include not only out-of-pocket expenditures, but also opportunity costs. Firms minimize costs. The marginal cost curve crosses the average cost curve from below at the efficient scale of production. If a firm cannot adjust one of its inputs in the short run but can do so over the long run, its costs when its output level changes will be higher in the short run than in the long run. A firm enjoys economies of scale if its average cost decreases as the quantity produced increases. It suffers diseconomies of scale if its average cost increases as the quantity produced increases. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

8-38 Looking Forward Until now, we have focused on production and costs. Next, we will incorporate sales and revenue into our analysis, and we will analyze how firms maximize profits. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.