Cost & Production Theory Firms seek to produce any given quantity of output (Q) at lowest cost. Firms are cost minimizers.

Costs C = rK + wL r is the price of capital, w is the wage Cost is the sum of each input quantity multiplied by its price when input prices reflect all costs including opportunity costs

Economic Costs are Opportunity Costs Economic Cost includes both implicit and explicit costs Explicit Costs – payment to others Implicit Costs – cost of owned inputs, or other costs that do not generate explicit payments

Costs and Output Long-Run Total Cost or LTC Combinations of Cost and Output Q (C1,Q1), (C2,Q2), (C3,Q3) Long-run average cost LAC = (LTC/Q) Long-run marginal cost LMC = ΔLTC/ΔQ

Short-run vs. Long-run Long-run: all inputs variable Short-run: one or more inputs fixed Total Product: Q = f(K 0,L) Average Product of Labor: AP L = Q/L Marginal Product of Labor: MP L = ΔQ/ΔL Law of diminishing marginal product As more labor is employed with a fixed amount of capital, labor’s marginal product (MP L ) eventually declines

Watch the video Microeconomics The Law of Diminishing Returns: Econ Concepts in 60 Seconds

Short-run Costs Total Cost = rK 0 + wL = TC Total Fixed Cost = rK 0 = TFC Total Variable Cost = wL = TVC TC = TFC + TVC Average Fixed Cost: AFC = TFC/Q Average Variable Cost: AVC = TVC/Q Average Total Cost: ATC = TC/Q

Short-run Marginal Cost SMC = ΔTC/ΔQ ΔTFC/ΔQ = 0 SMC = ΔTVC/ΔQ = ΔTC/ΔQ SMC = AVC at its minimum SMC = ATC at its minimum

Watch the videos Episode 23: Cost Curves Cost Curves MC, ATC, AVC, and AFC: Econ Concepts in 60 Seconds

Short-run Cost & Product AVC and MC are inversely related to AP L and MP L MP L > AP L implies MC < AVC Max MP L corresponds to Min MC MP L = AP L implies MC = AVC MP L AVC

Short-run and Long-run Cost Short-run and long-run costs are equal ONLY at a long-run optimum The quantity where short-run fixed K 0 minimizes long run cost ATC = LAC Only at the minimum of LAC are all average and marginal costs equal LAC = LMC = ATC = SMC

Watch the video Long-Run Cost Structure

Economies of Scale Economies of scale: LAC is decreasing Costs increase less than proportionately with output Diseconomies of scale: LAC increasing Costs increase more than proportionately with output Constant returns to scale: LAC = LMC Costs increase exactly in proportion to output Minimum Efficient Scale or MES The quantity at which economies of scale end and constant returns begin

Watch the video Economies and Diseconomies of Scale.mp4

Economies of Scope A firm can produce two products together more cheaply than producing each product separately, or C(X,Y) < C(X) + C(Y)