The Cost of Production

Chapter 7
The Cost of Production
Topics to be Discussed

Measuring Cost: Which Costs Matter? Cost in the Short Run Cost in the Long Run Long-Run Versus Short-Run Cost Curves
Chapter 7
Slide 2
Introduction
The production technology measures the relationship between input and output. Given the production technology, managers must choose how to produce.
Chapter 7
Slide 3
Introduction
To determine the optimal level of output and the input combinations, we must convert from the unit measurements of the production technology to dollar measurements or costs.
Chapter 7
Slide 4
Measuring Cost: Which Costs Matter?

Economic Cost vs. Accounting Cost
Accounting Cost
Actual expenses plus depreciation charges for capital equipment
Economic Cost
Cost to a firm of utilizing economic resources in production, including opportunity cost
Chapter 7
Slide 5
Opportunity cost.
Cost associated with opportunities that are foregone when a firms resources are not put to their highest-value use.
Chapter 7
Slide 6
An Example
A
firm owns its own building and pays no rent for office space this mean the cost of office space is zero?
Does
Chapter 7
Slide 7
Sunk Cost
Expenditure that has been made and cannot be recovered Should not influence a firms decisions.
Chapter 7
Slide 8

Fixed and Variable Costs
Total output is a function of variable inputs and fixed inputs. Therefore, the total cost of production equals the fixed cost (the cost of the fixed inputs) plus the variable cost (the cost of the variable inputs), or
TC FC VC
Chapter 7 Slide 10

Fixed and Variable Costs
Fixed Cost
Does
not vary with the level of output
Variable Cost
Cost
that varies as output varies
Chapter 7
Slide 11
Fixed Cost
Cost
paid by a firm that is in business regardless of the level of output
Sunk Cost
Cost
that have been incurred and cannot be recovered
Chapter 7
Slide 12

Personal
Computers: most costs are variable

Components,
labor
Software:
Cost
most costs are sunk
of developing the software
Chapter 7
Slide 13
A Firms Short-Run Costs ($)

Rate of Fixed Output Cost (FC) Variable Cost (VC) Total Cost (TC) Marginal Cost (MC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC)
0 1 2 3 4 5 6 7 8 9 10 11
50 50 50 50 50 50 50 50 50 50 50 50
0 50 78 98 112 130 150 175 204 242 300 385
50 100 128 148 162 180 200 225 254 292 350 435
--50 28 20 14 18 20 25 29 38 58 85
--50 25 16.7 12.5 10 8.3 7.1 6.3 5.6 5 4.5
--50 39 32.7 28 26 25 25 25.5 26.9 30 35
--100 64 49.3 40.5 36 33.3 32.1 31.8 32.4 35 39.5
Cost in the Short Run
Marginal Cost (MC) is the cost of expanding output by one unit. Since fixed cost have no impact on marginal cost, it can be written as:
VC TC MC Q Q
Chapter 7 Slide 16
Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC). This can be written:
TFC TVC ATC Q Q

Chapter 7 Slide 17
Average Total Cost (ATC) is the cost per unit of output, or average fixed cost (AFC) plus average variable cost (AVC). This can be written:
TC ATC AFC AVC or Q

Chapter 7 Slide 18
The Determinants of Short-Run Cost
The relationship between the production function and cost can be exemplified by either increasing returns and cost or decreasing returns and cost.
Chapter 7
Slide 19
The Determinants of Short-Run Cost
Increasing returns and cost

With
increasing returns, output is increasing relative to input and variable cost and total cost will fall relative to output.
decreasing returns, output is decreasing relative to input and variable cost and total cost will rise relative to output.
Decreasing returns and cost

With
Chapter 7
Slide 20
A Firms Short-Run Costs ($)

Rate of Fixed Output Cost (FC) Variable Cost (VC) Total Cost (TC) Marginal Cost (MC) Average Fixed Cost (AFC) Average Variable Cost (AVC) Average Total Cost (ATC)
0 1 2 3 4 5 6 7 8 9 10 11
50 50 50 50 50 50 50 50 50 50 50 50
0 50 78 98 112 130 150 175 204 242 300 385
50 100 128 148 162 180 200 225 254 292 350 435
--50 28 20 14 18 20 25 29 38 58 85
--50 25 16.7 12.5 10 8.3 7.1 6.3 5.6 5 4.5
--50 39 32.7 28 26 25 25 25.5 26.9 30 35
--100 64 49.3 40.5 36 33.3 32.1 31.8 32.4 35 39.5
Cost Curves for a Firm

Cost 400
($ per year)
Total cost is the vertical sum of FC and VC.
TC VC
Variable cost increases with production and the rate varies with increasing & decreasing returns.
300
200
100
Fixed cost does not vary with output
50
0 Chapter 7 1 2 3 4 5 6 7 8 9 10 11 12 13
FC
Output
Slide 27

Cost
($ per unit)
100
MC
75
50
ATC AVC
25
AFC
0 Chapter 7 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.) Slide 28
The line drawn from the origin to the tangent of the variable cost curve:
P
400
TC VC
Its slope equals AVC
300
The slope of a point on VC equals MC

Therefore, MC = AVC at 7 units of output (point A)
200
A
100
FC
1 2 3 4 5 6 7 8 9 10 11 12
13 Output
Chapter 7
Slide 29
Unit Costs
Cost
($ per unit)
AFC falls continuously

When MC < AVC or MC < ATC, AVC & ATC decrease When MC > AVC or MC > ATC, AVC & ATC increase
100
MC
75
50
ATC
AVC
25
AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)
Chapter 7
Slide 30
Unit Costs
Cost
($ per unit)
MC = AVC and ATC at minimum AVC and ATC

Minimum AVC occurs at a lower output than minimum ATC due to FC
100
MC
75
50
ATC
AVC
25
AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)
Chapter 7
Slide 31
Cost in the Long Run

The User Cost of Capital
User Cost of Capital = Economic Depreciation + (Interest Rate)(Value of Capital)
Chapter 7
Slide 32

Example
Delta
buys a Boeing 737 for $150 million with an expected life of 30 years
Annual economic depreciation = $150 million/30 = $5 million

Interest rate = 10%
Slide 33
Chapter 7

Example
User
Cost of Capital = $5 million + (.10)($150 million depreciation)
Year 1 = $5 million + (.10)($150 million) = $20 million Year 10 = $5 million + (.10)($100 million) = $15 million
Slide 34
Chapter 7

Rate per dollar of capital

r
= Depreciation Rate + Interest Rate
Chapter 7
Slide 35

Airline Example
Depreciation Rate
Rate = 1/30 = 3.33/yr
of Return = 10%/yr
User Cost of Capital

r
= 3.33 + 10 = 13.33%/yr
Slide 36
Chapter 7

The Cost Minimizing Input Choice
Assumptions

Two Inputs: Labor (L) & capital (K) Price of labor: wage rate (w) The price of capital
R = depreciation rate + interest rate
Chapter 7
Slide 37

The Cost Minimizing Input Choice The User Cost of Capital
Question
If capital was rented, would it change the value of r ?
Chapter 7
Slide 38

The Cost Minimizing Input Choice The User Cost of Capital
The Isocost Line

C = wL + rK Isocost: A line showing all combinations of L & K that can be purchased for the same cost
Chapter 7
Slide 39

The Isocost Line
Rewriting C as linear:
K = C/r - (w/r)L
Slope of the isocost: K L w r
is the ratio of the wage rate to rental cost of capital. This shows the rate at which capital can be substituted for labor with no change in cost.
Chapter 7
Slide 40
Choosing Inputs
We will address how to minimize cost for a given level of output.
We will do so by combining isocosts with isoquants
Chapter 7
Slide 41
Producing a Given Output at Minimum Cost

Capital per year
Q1 is an isoquant for output Q1. Isocost curve C0 shows all combinations of K and L that can produce Q1 at this cost level.
K2
CO C1 C2 are three isocost lines
A K1 K3 C0 L2
Chapter 7
Isocost C2 shows quantity Q1 can be produced with combination K2L2 or K3L3. However, both of these are higher cost combinations than K1L1.
Q1
C1 L3 C2
Labor per year Slide 42
L1
Input Substitution When an Input Price Change

Capital per year
If the price of labor changes, the isocost curve becomes steeper due to the change in the slope -(w/L).
B K2 A K1
This yields a new combination of K and L to produce Q1. Combination B is used in place of combination A. The new combination represents the higher cost of labor relative to capital and therefore capital is substituted for labor.
Q1
C2 L2
Chapter 7
C1
L1
Isoquants and Isocosts and the Production Function
MRTS - K
MP L
MP K
w r
Slope of isocost line K

and MPL
Chapter 7
MPK
r
Slide 44
The minimum cost combination can then be written as:
MPL
MPK
Minimum cost for a given output will occur when each dollar of input added to the production process will add an equivalent amount of output.
Slide 45
Chapter 7
Cost minimization with Varying Output Levels
A firms expansion path shows the minimum cost combinations of labor and capital at each level of output.
Chapter 7
Slide 53
A Firms Expansion Path

Capital per year
The expansion path illustrates the least-cost combinations of labor and capital that can be used to produce each level of output in the long-run.
150 $3000 Isocost Line
$2000 Isocost Line
Expansion Path C
100 75 B 50 A 25
200 Unit Isoquant 300 Unit Isoquant
50 Chapter 7
100
150
200
300
A Firms Long-Run Total Cost Curve

Cost per Year Expansion Path F 3000
E
2000
D 1000
100 Chapter 7
200
300
Output, Units/yr Slide 55
Long-Run Versus Short-Run Cost Curves
What happens to average costs when both inputs are variable (long run) versus only having one input that is variable (short run)?
Chapter 7
Slide 56
The Inflexibility of Short-Run Production

Capital per year
E C
The long-run expansion path is drawn as before..
Long-Run Expansion Path
A
K2 P K1 Q1
L1 Chapter 7 L2 B L3 D F Short-Run Expansion Path
Q2
Labor per year
Slide 57
Long-Run Average Cost (LAC)
Constant Returns to Scale
If input is doubled, output will double and average cost is constant at all levels of output.
Chapter 7
Slide 58
Increasing Returns to Scale
If input is doubled, output will more than double and average cost decreases at all levels of output.
Chapter 7
Slide 59
Decreasing Returns to Scale
If input is doubled, the increase in output is less than twice as large and average cost increases with output.
Chapter 7
Slide 60
In the long-run:
Firms experience increasing and decreasing returns to scale and therefore long-run average cost is U shaped.
Chapter 7
Slide 61
Long-run marginal cost leads long-run average cost:

If LMC < LAC, LAC will fall If LMC > LAC, LAC will rise Therefore, LMC = LAC at the minimum of LAC
Chapter 7
Slide 62
Long-Run Average and Marginal Cost

Cost ($ per unit of output
LMC LAC
Output
Chapter 7 Slide 63
Question
What is the relationship between longrun average cost and long-run marginal cost when long-run average cost is constant?
Chapter 7
Slide 64
Economies and Diseconomies of Scale
Economies of Scale
Increase in output is greater than the increase in inputs. Increase in output is less than the increase in inputs.
Diseconomies of Scale
Chapter 7
Slide 65
Measuring Economies of Scale
Ec Cost output elasticity % in cost from a 1% increase in output
Chapter 7
Slide 66
Measuring Economies of Scale
Ec ( C / C ) /( Q / Q ) Ec ( C / Q ) /(C / Q ) MC/AC
Chapter 7
Slide 67
Therefore, the following is true:
EC < 1: MC < AC
Average cost indicate decreasing economies of scale
EC = 1: MC = AC Average cost indicate constant economies of scale EC > 1: MC > AC Average cost indicate increasing diseconomies of scale
Slide 68
Chapter 7
The Relationship Between Short-Run and Long-Run Cost
We will use short and long-run cost to determine the optimal plant size
Chapter 7
Slide 69
Long-Run Cost with Constant Returns to Scale

Cost ($ per unit of output SAC1
SMC1 SMC2 With many plant sizes with SAC = $10 the LAC = LMC and is a straight line
SAC2
SMC3
SAC3
LAC = LMC
Q1
Chapter 7
Q2
Q3
Output
Slide 70
Observation

The optimal plant size will depend on the anticipated output (e.g. Q1 choose SAC1,etc). The long-run average cost curve is the envelope of the firms short-run average cost curves.
Question
What would happen to average cost if an output level other than that shown is chosen?
Chapter 7
Slide 71
Long-Run Cost with Economies and Diseconomies of Scale

Cost ($ per unit of output $10 $8 B SAC1 SAC2 SAC3
LAC
SMC1
SMC3 SMC2
LMC
If the output is Q1 a manager would chose the small plant SAC1 and SAC $8. Point B is on the LAC because it is a least cost plant for a given output.
Q1
Chapter 7
Output Slide 72
What is the firms long-run cost curve?
Firms can change scale to change output in the long-run.

The long-run cost curve is the dark blue portion of the SAC curve which represents the minimum cost for any level of output.
Chapter 7
Slide 73
Observations
The LAC does not include the minimum points of small and large size plants? Why not? LMC is not the envelope of the short-run marginal cost. Why not?
Chapter 7
Slide 74
Product Transformation Curve

Number of tractors
Each curve shows combinations of output with a given combination of L & K.
O2
O1
O1 illustrates a low level of output. O2 illustrates a higher level of output with two times as much labor and capital.
Number of cars Chapter 7 Slide 75
Cost Functions for Electric Power

Scale Economies in the Electric Power Industry
Output (million kwh) Value of SCI, 1955
43 .41
338 .26
1109 .16
2226 .10
5819 .04
Chapter 7
Slide 76
Average Cost of Production in the Electric Power Industry

Average Cost (dollar/1000 kwh)
6.5
6.0
A
5.5
1955
5.0
1970
6 Chapter 7
12
18
24
30
36
Output (billions of kwh)
Slide 77
Cost Functions for Electric Power
Findings
Decline
in cost
Not due to economies of scale

Was caused by:

Lower input cost (coal & oil) Improvements in technology
Chapter 7
Slide 78
Summary
Managers, investors, and economists must take into account the opportunity cost associated with the use of the firms resources. Firms are faced with both fixed and variable costs in the short-run.
Chapter 7
Slide 79
Summary
When there is a single variable input, as in the short run, the presence of diminishing returns determines the shape of the cost curves. In the long run, all inputs to the production process are variable.
Chapter 7
Slide 80
Summary
The firms expansion path describes how its cost-minimizing input choices vary as the scale or output of its operation increases. The long-run average cost curve is the envelope of the short-run average cost curves.
Chapter 7
Slide 81
Summary
A firm enjoys economies of scale when it can double its output at less than twice the cost.
Chapter 7
Slide 82
End of Chapter 7
The Cost of Production

The Cost of Production

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The Cost of Production

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Chapter 7

The Cost of Production

Measuring Cost: Which Costs Matter?

Actual expenses plus depreciation charges for capital equipment

Cost to a firm of utilizing economic resources in production, including opportunity cost

Measuring Cost: Which Costs Matter?

Measuring Cost: Which Costs Matter?

Measuring Cost: Which Costs Matter?

Measuring Cost: Which Costs Matter?

Measuring Cost: Which Costs Matter?

not vary with the level of output

that varies as output varies

Measuring Cost: Which Costs Matter?

paid by a firm that is in business regardless of the level of output

that have been incurred and cannot be recovered

Measuring Cost: Which Costs Matter?

Computers: most costs are variable

most costs are sunk

of developing the software

A Firms Short-Run Costs ($)

0 50 78 98 112 130 150 175 204 242 300 385

--50 25 16.7 12.5 10 8.3 7.1 6.3 5.6 5 4.5

--50 39 32.7 28 26 25 25 25.5 26.9 30 35

--100 64 49.3 40.5 36 33.3 32.1 31.8 32.4 35 39.5

Cost in the Short Run

Cost in the Short Run

TFC TVC ATC Q Q

Cost in the Short Run

TC ATC AFC AVC or Q

Cost in the Short Run

The Determinants of Short-Run Cost

Cost in the Short Run

The Determinants of Short-Run Cost

Increasing returns and cost

Decreasing returns and cost

A Firms Short-Run Costs ($)

0 50 78 98 112 130 150 175 204 242 300 385

--50 25 16.7 12.5 10 8.3 7.1 6.3 5.6 5 4.5

--50 39 32.7 28 26 25 25 25.5 26.9 30 35

--100 64 49.3 40.5 36 33.3 32.1 31.8 32.4 35 39.5

Cost Curves for a Firm

Total cost is the vertical sum of FC and VC.

Fixed cost does not vary with output

Cost Curves for a Firm

Cost Curves for a Firm

Its slope equals AVC

The slope of a point on VC equals MC

Cost Curves for a Firm

AFC falls continuously

Cost Curves for a Firm

MC = AVC and ATC at minimum AVC and ATC

Cost in the Long Run

User Cost of Capital = Economic Depreciation + (Interest Rate)(Value of Capital)

Cost in the Long Run

Annual economic depreciation = $150 million/30 = $5 million

Cost in the Long Run

Cost of Capital = $5 million + (.10)($150 million depreciation)

Cost in the Long Run

Rate per dollar of capital

= Depreciation Rate + Interest Rate

Cost in the Long Run

Rate = 1/30 = 3.33/yr