1 Prof. Dr. Mohamed I. Migdad Professor in Economics Chapter six Analysis of Costs Prof. Dr. Mohamed I. Migdad Professor in Economics

2 Short run cost Short run cost and revenue Decision in Perfect competition

3 Costs in the Short Run The short run is a period of time for which two conditions hold: 1. The firm is operating under a fixed scale (fixed factor) of production, and 2. Firms can neither enter nor exit an industry.

Accounting & Economic Costs, & Opportunity Costs Accounting CostAccounting cost is also known as explicit cost; cost that is explicitly paid for factors of production such as salary, maintenance, prices of raw material, electricity and water bills in addition to the cost of transportation, advertisement, and other payments such as insurance and taxes 4

Opportunity Costs Opportunity cost is also known as implicit cost; cost that is not actually paid for factors of production, but is sacrificed for the sake of using the existing factors of production available at the work place. For example, if a company owns a warehouse and uses it to store products, the company will not pay rent for the usage of this warehouse because the company owns it. The opportunity cost of using the warehouse is renting it, and benefiting from the rent. 5

Economic Costs Economic cost is comprised of both explicit costs and implicit costs. It is also the cost the company pays or sacrifices to guarantee the contribution of all available factors of production. Economic costs could be either explicit, when factors of production are not owned by companies, or implicit, when factors of production are owned by companies. In this case, costs are calculated on the basis of opportunity cost. 6

Normal and Economic Profit As a result of differentiating between economic and accounting costs, we must differentiate between normal and economic profit. Normal (accounting) profit = total revenue – explicit (accounting) costs. Economic profit = total revenue – economic implicit and explicit costs. If total revenue > economic costs, the company gains economic profit. 7

Cont. If total revenue < economic costs, the company gains economic loss, and if total revenue = the economic cost, economic profit = 0, and the company gains only normal profit. This normal profit is in fact an implicit cost. At this point, it is important to say that any company's ultimate goal is to maximize the economic profit, however, the accounting (normal) profit is higher than or equals the economic profit. 8

9 Costs in the Short Run Fixed cost is any cost that does not depend on the firm’s level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run. Variable cost is a cost that depends on the level of production chosen.

10 Costs in the Short Run Total Cost = Total Fixed + Total Variable Cost Cost

11 Total Fixed Cost (TFC) Total fixed costs (TFC) or overhead refers to the total of all costs that do not change with output, even if output is zero. Another name for fixed costs in the short run is sunk costs is because firms have no choice but to pay for them.

12 Average Fixed Cost (AFC) Average fixed cost (AFC) is the total fixed cost (TFC) divided by the number of units of output (q):

13 Average Fixed Cost (AFC) Spreading overhead is the process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises.

14 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm (1) q (2) TFC (3) AFC (TFC/q) 0$1,000 $  11, , , ,000200

15

16 Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm As output increases, total fixed cost remains constant and average fixed cost declines.

17 Variable Costs The total variable cost curve is a graph that shows the relationship between total variable cost and the level of a firm’s output. The total variable cost is derived from production requirements and input prices.

18 Variable Costs

19 Derivation of Total Variable Cost Schedule from Technology and Factor Prices The total variable cost curve shows the cost of production using the best available technique at each output level, given current factor prices.

20 PRODUCT USING TECHNIQU E UNITS OF INPUT REQUIRED (PRODUCTION FUNCTION) TOTAL VARIABLE COST ASSUMING P K = $2, P L = $1 TVC = (K x P K ) + (L x P L ) KL 1Units ofA44(4 x $2) + (4 x $1) =$12 outputB26(2 x $2) + (6 x $1) = 2Units ofA76(7 x $2) + (6 x $1) =$20 outputB410(4 x $2) + (10 x $1) = 3Units ofA96(9 x $2) + (6 x $1) = outputB614(6 x $2) + (14 x $1) =$26 $10 $18 $24

21 Marginal Cost (MC) Marginal cost (MC) is the increase in total cost that results from producing one more unit of output. Marginal cost reflects changes in variable costs. UNITS OF OUTPUT TOTAL VARIABLE COSTS ($) MARGINAL COSTS ($)

22 The Shape of the Marginal Cost Curve in the Short Run In the short run every firm is constrained by some fixed input that: 1. leads to diminishing returns to variable inputs, and 2. limits its capacity to produce.

23

24 Graphing Total Variable Costs and Marginal Costs Total variable cost always increases with output. The marginal cost curve shows how total variable cost changes.

25

26 Average Variable Cost (AVC) Average variable cost (AVC) is the total variable cost divided by the number of units of output.

27 Average Variable Cost (AVC) Marginal cost is the cost of one additional unit, while average variable cost is the variable cost per unit of all the units being produced.

28 Short-Run Costs of a Hypothetical Firm

29 (1) q (2) TVC (3) MC (  TVC) (4) AVC (TVC/q) (5) TFC (6) TC (TVC + TFC) (7) AFC (TFC/q) (8) ATC (TC/q or AFC + AVC) 0$0$  $  $1,00 0 $ $  $  110 1,00 0 1,0101,0001, ,00 0 1, ,00 0 1, ,00 0 1, ,00 0 1,    5008, ,00 0 9,

30 Graphing Average Variable Costs and Marginal Costs When marginal cost is below average cost, average cost is declining. When marginal cost is above average cost, average cost is increasing. Marginal cost intersects average variable cost at the lowest, or minimum, point of AVC.

31 At 200 units of output, AVC is minimum and equal to MC.

32 Total Costs Adding the same amount of total fixed cost to every level of total variable cost yields total cost. For this reason, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC.

33 Average Total Cost Average total cost (ATC) is total cost divided by the number of units of output (q). Because AFC falls with output, an ever-declining amount is added to AVC.

34 Average Total Cost

35 The Relationship Between Average Total Cost and Marginal Cost If MC is below ATC, then ATC will decline toward marginal cost. If MC is above ATC, ATC will increase. MC intersects the ATC and AVC curves at their minimum points.

36 The Relationship Between Average Total Cost and Marginal Cost