• Explicit Costs

– Accounting Costs
• Economic Costs
– Implicit Costs
– Alternative or Opportunity Costs
• Relevant Costs
– Incremental Costs
– Sunk Costs are Irrelevant
Quantity Total M arginal Quantity Total M arginal
Cost Cost Cost Cost
0 $ 3 .0 0 —
1 3 .3 0 $ 0 .3 0 6 $ 7 .8 0 $ 1 .3 0
2 3 .8 0 0 .5 0 7 9 .3 0 1 .5 0
3 4 .5 0 0 .7 0 8 1 1 .0 0 1 .7 0
4 5 .4 0 0 .9 0 9 1 2 .9 0 1 .9 0
5 6 .5 0 1 .1 0 10 1 5 .0 0 2 .1 0
Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25 AVC
1.00
0.75
0.50
AFC
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
If MC > ATC, then ATC is rising
If MC = ATC, then ATC is at its minimum
If MC < ATC, then ATC is falling

If MC > AVC, then AVC is rising

If MC = AVC, then AVC is at its minimum
If MC < AVC, then AVC is falling
 Cost Curves and Their Shapes
• The average total-cost curve is U-shaped.
• At very low levels of output average total cost is
high because fixed cost is spread over only a few
units.
• Average total cost declines as output increases.
• Average total cost starts rising because average
variable cost rises substantially.
• The bottom of the U-shaped ATC curve occurs at
the quantity that minimizes average total cost.
This quantity is sometimes called the efficient
scale of the firm.
Figure 5 Thirsty Thelma’s Average-Cost and Marginal-Cost Curves

Costs
$3.50
3.25
3.00
2.75
2.50
2.25
MC
2.00
1.75
1.50 ATC

1.25
1.00
0.75
0.50
0.25

0 1 2 3 4 5 6 7 8 9 10 Quantity
of Output
(glasses of lemonade per hour)
Copyright © 2004 South-Western
COSTS IN THE SHORT RUN AND IN THE
LONG RUN
– In the short run, some costs are fixed.
– In the long run, fixed costs become variable costs.
• Because many costs are fixed in the short run
but variable in the long run, a firm’s long-run
cost curves differ from its short-run cost
curves.
Graphical Presentation

9
 Long-Run Cost Curves
• The long run is the period of time during which:
 Technology is constant
 All inputs and costs are variable
 The firm faces no fixed inputs or costs
 The long run period is a series of short run
periods. [For each short run period there is a
set of TP, AP, MP, MC, AFC, AVC, ATC, TC,
TVC & TFC for each possible scale of plant].
• Long-Run Total Cost = The minimum total costs of
producing various levels of output when the firm
can build any desired scale of plant: LTC = f(Q)
• Long-Run Average Cost = The minimum per-unit
cost of producing any level of output when the firm
can build any desire scale of plant: LAC = LTC/Q
• Long-Run Marginal Cost = The change in long-run
total costs per unit change in output: LMC =
LTC/ Q
Minimizing cost for a given level of
output

12
 Expansion Path
• Locus of points where isoquant curve and isocost
line are tangent is called expansion path
• It describes the combinations of labor and capital
that the firm will choose to minimize costs at
each level of output.

• Generally, an expansion path has a positive slope

– An increase in LTC, required for producing a higher
level of output, results in both inputs increasing
Expansion path
7
. COST IN THE LONG RUN
3 Cost Minimization with Varying Output Levels

A Firm’s Expansion Path and

Long-Run Total Cost Curve

In (a), the expansion path

(from the origin through
points A, B, and C)
illustrates the lowest-cost
combinations of labor and
capital that can be used
to produce each level of
output in the long run—
i.e., when both inputs to
production can be varied.
In (b), the corresponding
long-run total cost curve
(from the origin through
points D, E, and F)
measures the least cost
of producing each level of
output.
 Shape of the long run cost surve
• The LTC curve is a straight line in the previous slide because of
constant returns to scale
• LTC can also be U shaped depending on the returns to scal and
• If the firm has increasing returns to scale , average cost of production
falls with output . When there are decreasing returns to scale, the
average cost of production increases with output.
• The typical LAC curve is a U shaped due to increasing and decreasing
returns to scale.
• LMC lies below the LAC curve when LAC is falling and above it when
LAC is rising. The two curves intersect at A, where the LAC curve
achieves its minimum.
• E=When LAC is constant, LAC and LMC are equal.

•
Long-run cost curves
 The Relationship Between Short-
Run and Long-Run Cost
Long-Run Cost with
Economies and
Diseconomies of Scale

The long-run average cost

curve LAC is the envelope
of the short-run average
cost curves
SAC1, SAC2, and SAC3.

With economies and

diseconomies of scale, the
minimum points of the short-
run average cost curves do
not lie on the long-run
average cost curve.
LMC is not the envelope of
the SMCs. Each point on
the LMC is the SMC cost
associated with the cost-
efficient plant.
Possible Shapes of the LAC Curve

The left panel shows a U-shaped LAC curve which

indicates first decreasing and then increasing
returns to scale. The middle panel shows a nearly L-
shaped LAC curve which shows that economies of
scale quickly give way to constant returns to scale or
gently rising LAC. The right panel shows an LAC
curve that declines continuously, as in the case of
natural monopolies.
19
Economies and Diseconomies of Scale

• As output increases, the firm’s average cost of producing that output is likely to
decline, at least to a point.

• This can happen for the following reasons:

1. If the firm operates on a larger scale, workers can specialize in the activities at
which they are most productive.

2. Scale can provide flexibility. By varying the combination of inputs utilized to

produce the firm’s output, managers can organize the production process more
effectively.

3. The firm may be able to acquire some production inputs at lower cost because it
is buying them in large quantities and can therefore negotiate better prices. The
mix of inputs might change with the scale of the firm’s operation if managers
take advantage of lower-cost inputs.
 Economies of scale
• Real Economies- which arise due to labour
economies, technical
economies(mechanisation), inventory
economies, selling economies (advertising, dealer
tie-ups etc.), managerial
economies(decentralisation), transport
economies etc.
• Pecuniary economies- lower prices of raw
material, external
finance, advertising., transport, workers die to
better prestige.
• economies of scale Situation in which
output can be doubled for less than a
doubling of cost.
• diseconomies of scale Situation in which
a doubling of output requires more than a
doubling of cost.
• Economies of scale are often measured in
terms of a cost-output elasticity, EC. EC is the
percentage change in the cost of production
resulting from a 1-percent increase in output:
 Economies of Scope
• Situation in which joint output of a single firm
is greater than output that could be achieved
by two different firms when each produces a
single product.
• The joint use of inputs or production
facilities, joint marketing programs, or
common administration. Eg: sheet metal
manufacturers produce scrap metal and
shavings that they can sell
• diseconomies of scope Situation in which
joint output of a single firm is less than could
be achieved by separate firms when each
produces a single product.
 Learning Curves

The learning curve shows the decline in the

average input cost of production with rising
cumulative total outputs over time. The learning
curve also shows that the average cost is about $
250 for producing the 100th unit at point F etc..
24
 Returns to Scale
• Returns to scale can be directly related to long-run
cost curves
• A cost curve may exhibit
increasing, decreasing, and/or constant returns to
scale
– Increasing returns to scale (also called economies of scale)
is where LAC is declining
• ∂LAC/∂q < 0
• Increases in total cost are proportionally smaller than an increase
in output
– Corresponds to concave area of LTC curve
• Implies that inputs less than double for a doubling of output
– Corresponds to LTC also less than doubling
• Decreasing returns to scale (also called diseconomies of scale)
is where LAC is increasing
– ∂LAC/∂q > 0
– Increases in total cost are proportionally larger than an increase in
output
• Corresponds to convex area of LTC curve
– Implies that inputs more than double for a doubling of output
• Corresponds to LTC more than doubling for a doubling of output
• Constant returns to scale (also called constant economies of
scale) corresponds to where ∂LAC/∂q = 0
– Long-run average cost does not change for a given change in output
• If LTC curve is linear, then constant returns to scale exists for all levels of
output