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Economics
MBAFT 6103
Today
Costs and Cost Minimization
Overview
1. Introduction: Bestar
2. Opportunity Cost
3. Long Run Cost Minimization
The constrained minimization problem
Comparative statics
Input demands
Motivation
Bestar
2003
2004
2005
44,300
43,700
38,700
Restructuring costs
(C$ 000)
n.a.
1,400
n.a.
254
-442
174
Bestar
How do changes in wood prices affect furniture
industry?
Should Bestar shut down?
Also, check the case of DND Flyover
http://www.docstoc.com/docs/33337793/NOIDATOLL-BRIDGE
Opportunity Cost
One relevant concept of cost is opportunity cost:
based the value of a resource in its best alternative
use.
The only alternative we consider is the best
alternative which is not chosen
Opportunity cost includes all explicit and implicit
costs.
Opportunity Cost
Example
Opportunity Cost of using Steel to produce Cars
Purchase steel for Rs. 10 lakhs. Since then, price has
gone up so that it is worth Rs. 12 lakhs.
Two alternatives:
i) making cars, or ii) reselling the steel.
What is the opportunity cost of using the steel to
produce cars?
Explicit cost of producing cars + Rs. 12 lakhs
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Opportunity Cost
Opportunity cost is forward looking. What does the
decision-maker give up at the time the decision is
being made?
Opportunity costs have an implicit component
Accounting costs (total explicit cost incurred in the
past) different from economic (opportunity) costs.
Explicit Costs
Common Misconceptions
Capital Expenditure = Fixed cost
Labor = Variable cost
Fixed cost and Sunk cost are the same
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Sunk Costs
Sunk Costs are costs that have been already incurred and
cannot be recovered. These costs are not part of
opportunity costs. Depends on the stage of decision
making.
Example: Bowling Ball Factory
Costs Rs. 50 lakh to build and has no alternative uses
Rs. 50 lakh is not sunk cost for the decision of whether or
not to build the factory
After the factory is built, Rs. 50 lakh is sunk cost for the
decision of whether to operate or shut down the factory
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TC1/r
TC0/r
TC2/r
Slope = -w/r
L
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Isoquant Q = Q0 is given
L
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Cost Minimization:
Tangency Condition
Cost minimization subject to satisfaction of the
isoquant equation: Q0 = f(L,K)
Note: analogous to expenditure minimization for the
consumer
Tangency Condition:
MRTSL,K = MPL/MPK = w/r ---- (1)
(w = price of labor, r = price of capital)
Constraint:
Q0 = f(K,L) ---- (2)
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Comparative Statics
A change in the relative price of inputs changes the
slope of the isocost line.
All else equal, an increase in w must decrease the
cost minimizing quantity of labor and increase the
cost minimizing quantity of capital with diminishing
MRTSL,K.
All else equal, an increase in r must decrease the
cost minimizing quantity of capital and increase the
cost minimizing quantity of labor.
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An Example
Isoquant Q = Q0
L
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Example
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Short-run Cost
Minimization
Minimize wL + mM + rK*
(L,M)
Subject to Q0 = f(L,M,K*)
Note: L,M are the variable inputs and:
wL+mM is the total variable cost
K* is the fixed input and
rK* is the total fixed cost
To solve: Tangency condition: MPL/w = MPM/m
Constraint: Q0 = f(L,K*,M)
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Tangency Condition:
Long Run
What is the solution to the firms long run cost minimization
problem given that the manager wants to produce Q0 units of output?
MPL/MPM = w/m
MPL/MPK = w/r
Constraint: Q0 = f(L,K,M)
Three equations and three unknowns. Combining these, we get the
long run demand functions for labor, capital and materials.
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Next
Cost Curves
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