1. COST ANALYSIS Chapter 6 slide 1 General Principles: - Only Differential Costs Matter. Ignore Costs that are fixed across Options. Examples MBA Degree City-Owned Land Surplus Factory Space Starting a Business Cost of Capital $100 K at 15% Revenues $200 K Expenses -$110 K Your Wage -$65 K -$15 K Economic Profit $10 K - Opportunity Costs Should Not be Ignored.

2. ORDERING A BEST SELLER Demand: P = 24 - Q MC = $12 per book A. Find optimal Q and P. MR = 24 - 2Q = 12 Q = 6 hundred, P = $18 Cont. = (18 - 12)(600) = $3,600. B. Suppose average book earns $4 and shelf space is limited. MC = 12 + 4 (Opp Cost) Q = 4 hundred, P = $20. Cont. = (20 - 16)(400) = $1,600. C. Suppose demand falls to P = 18 - 2Q. How many of the 400 books should the store sell and how many should it return for $6 each? MC = 4 + 6 (Opp Cost) MR = 18 - 4Q = 10, Q = 2 hundred, P = $14. Cont. = (14 -16)(200) + (6 - 12)(200) = -$1,600. 6.2

3. COST ANALYSIS MC Short-Run Cost Behavior Diminishing Marginal Productivity leads to Increasing MC. Example: MC = Wage/MP L W = $12/Hr, MP L = 4/Hr then MC = $3/unit AC 6.3

4. LONG-RUN COST 6.4 The shape of LR average cost depends upon returns to scale. Constant LAC reflects Constant Returns to Scale. SAC 1 SAC 2 SAC 3 Flat LAC reflects Constant Returns to Scale. With plant fixed, SAC is U-shaped and lies above LAC.

5. OPTIMAL OUTPUT MC Q* P* Demand MR Q* Low Demand versus High Demand AC 6.5 In either case, the firm ’ s Optimal output occurs where: MR = MC

6. THE SHUT-DOWN RULE MC P* Demand MR 1. In the long run, the firm should shut down when: P < AC. AVC 6.6 AC 2. In the short run, the firm should produce Q* because: P > AVC. Q*