Cost Function In Economics we usually talk about two different types of costs, explicit and implicit.

Implicit costs incorporate all opportunity costs and rate of returns into your cost function. We have already covered these types of costs in Macroeconomics. We will come back to them later in this course, but for now we are going to focus on Explicit Costs. These are costs that must be paid; anything that you actually receive a bill for is an explicit cost. Explicit costs are broken down into two categories; all costs are either Fixed or Variable. Fixed costs are costs that must be paid regardless of production or output. These can be leases on cars, salaried employees, buildings, cell phones, copy machines etc. More times than not these costs are contractual obligations (which is what makes them unavoidable). Variable costs are costs that change with the level of production, these are usually costs that are in some way directly associated with output, such as electricity, paper, steal, packaging etc. Adding together Fixed Costs and Variable Costs will give you Total Costs. Fixed + Variable = Total Costs We also want to find the Average costs; they are Average Fixed Cost, Average Variable Cost and Average Total Cost. To find the average costs, you divide Total by the quantity produced at that point. Average Variable Cost = Total Variable Cost / Quantity Average Fixed Cost = Total Fixed Cost / Quantity Average Total Cost = Total Cost / Quantity EMPHASIS: The average costs can also be found by adding AVC and AFC to equal ATC. This is nice for checking work. Beware not to round off your answers too much though, or they wont add correctly. I recommend rounding to 2 decimal places, or cents.

Quantity 0 1 2 3 4 5 6 7 8 9 10

Fixed 100 100 100 100 100 100 100 100 100 100 100

Variable 0 30 55 105 185 305 475 705 1005 1385 1855

Total 100 130 155 205 285 405 575 805 1105 1485 1955

MC x 30 25 50 80 120 170 230 300 380 470

AFC x 100 50 33.3 25 20 16.7 14.3 12.5 11.1 10

AVC x 30 27.5 35 46.25 61 79.2 100.7 125.6 153.9 185.5

ATC x 130 77.5 68.3 71.25 81 95.8 115 138.1 165 195.5

Microeconomics is the study of individual people, businesses, and markets. So it is very important in Micro to discuss and analyze individual changes. To do this we need to reintroduce the concept called Marginal. We can apply the word/concept to any numeric definition. The term Marginal simply means one additional. Marginal Cost means the additional cost of producing the next unit of output, or the cost incurred of producing one additional item. The Marginal Cost of output #2 would be the difference in cost of output #2 and output #1; it is the cost of producing that extra unit. The final categorization of costs we need to address are Sunk Costs. Sunk Costs can be any type of cost, the distinction is that these are expenses that have already been paid or obligated to. Sunk Costs are most important in the decision making process, if you have already spent money you generally dont want to consider that when deciding on future action. If you cant unspend it, we usually consider it irrelevant in future decisions. Economies to Scale In the Long Run, the decision making process with respect to expansion or contraction occurs using Economies of Scale. Economies of scale tell you how much return you gain from expansion. Increasing Returns to Scale occurs when you expand production (increase output) and a lower average cost occurs. Constant Returns to Scale results when you have expansion and the average costs follows by the exact same percentage. Decreasing Returns to Scale happens when you expand and your average cost per unit increases by more than production. Negative Returns to Scale occurs when you expand production and output decreases.

To calculate the percentages we would use our elasticity set up. This is going to give us the Elasticity of Supply. Instead of measuring the Percent Change in Quantity, we can measure the Percent Change in Output. This doesnt change the way we measure elasticity, it is still a quantity measurement in the top half of our equation. The bottom half of the equation is still a monetary measurement, only know we are changing our costs instead of prices or incomes. The only difference we need to consider is that we now must look at the answer for each half of the equation, as opposed to using our final E= answer. This is important because we may find significant information that would be missed with a single numeric answer. Types of Economies to Scale: When % change in Q > % change in Cost is a Increasing Return to Scale (its becoming relatively cheaper to produce our product with each expansion) When % change in Q < % change in Cost is a Decreasing Return to Scale (its becoming relatively more expensive to produce our product with expansion) If the % change in Q is a negative number and the % change in Cost is a Positive number we have a Negative Return to Scale (we are spending more money but getting less output) If the % change in Q is a positive number and the % change in Cost is a Negative number we have Increasing Returns to Scale (we somehow found a way to cut costs AND produce more of our product at the same time Id argue this is very rare but if you can find a way to do it you will make a LOT of money) Example:
Quantity 3 4 Fixed 100 100 Variable 105 185 Total 205 285 MC 50 80 AFC 33.3 25 AVC 35 46.25 ATC 68.3 71.25

The Returns to Scale from increasing output from 3 units to 4 units is .29 (or 29%) versus a 55% increase in expenses (185 from 105). This gives us Decreasing Returns to Scale, because the change in cost was greater than the increases in output that resulted. If we finished our elasticity equation, this would give us a number between 0 and 1, or in this case an Elasticity of Supply of 0.53.

If a firm decides to employ a new piece of machinery that will increase costs by 25%, but output only increases 35% this is Increasing Returns to Scale. Our Elasticity of Supply would be greater than 1, in this case 1.4. If a firm decides to employ a new production method increasing costs by 8%, but output decreases by 3%, this is Negative Returns to Scale. The decision resulted in a net loss in output. Your measurements are moving in opposite directions. How do you use this? It is important to understand that this is an area of business where there is no rule for when you should or should not expand. Like with utility, Economies to Scale is a comparative measurement tool. In a real world application you would ideally have a variety of options available and would select the most profitable option. Even Negative Returns to Scale could be the best option, especially if the product you are producing is an Inelastic good.