MEASURING COST: WHICH COSTS MATTER?

Accounting Cost versus Economic 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.

opportunity cost Cost of the things that

must be forgone to acquire that item.

𝐸𝑐𝑜𝑛𝑜𝑚𝑖𝑐 𝐶𝑜𝑠𝑡 = 𝐴𝑐𝑐𝑜𝑢𝑛𝑡𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 + 𝑂𝑝𝑝𝑜𝑟𝑡𝑢𝑛𝑖𝑡𝑦 𝐶𝑜𝑠𝑡

MEASURING COST: WHICH COSTS MATTER?
Accounting Profit versus Economic Profit

● accounting profit The difference ● economic profit The difference

between the total revenue and the between total revenue and total
total cost, where total cost equals cost, including both implicit and
explicit cost. explicit cost.

Economic
Profit
Accounting
Profit
Implicit
Revenue Revenue Costs Total
Economic
Costs
Explicit Explicit
Costs Costs
MEASURING COST: WHICH COSTS MATTER?
Sunk Cost

● sunk cost Expenditure that has been made and cannot

be recovered.

Because a sunk cost cannot be recovered, it should not

influence the firm’s decisions.

For example, consider the purchase of specialized equipment

for a plant. Suppose the equipment can be used to do only what
it was originally designed for and cannot be converted for
alternative use. The expenditure on this equipment is a sunk
cost. Because it has no alternative use, its opportunity cost is
zero. Thus it should not be included as part of the firm’s
economic costs.
MEASURING COST: WHICH COSTS MATTER?
Fixed Costs and Variable Costs

● fixed cost (FC) Cost that does not

vary with the level of output

● variable cost (VC) Cost that

varies as output varies.

Total Cost Total economic cost of production,

consisting of fixed and variable costs.

𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 𝑇𝐶 = 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡 𝐹𝐶 + 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝐶𝑜𝑠𝑡 (𝑉𝐶)

MEASURING COST: WHICH COSTS MATTER?

Cost Curves for a Firm

MEASURING COST: WHICH COSTS MATTER?
Marginal Cost and Average Cost
● marginal cost (MC) Increase in cost resulting
from the production of one extra unit of output.

● average total cost (AC) Firm’s per-unit cost of

production.
MEASURING COST: WHICH COSTS MATTER?
Marginal Cost and Average Cost
● average fixed cost (AFC) Firm’s fixed cost per
unit of output produced.

● average variable cost (AVC) Firm’s variable

cost per unit of output produced.
MEASURING COST: WHICH COSTS MATTER?

A Firm’s Costs
Quantity of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Cost Variable Cost Total Cost

q (FC) (VC) (TC) (MC) (AFC) (AVC) (ATC)

(1) (2) (3) (4) (5) (6) (7)

0 50 0 50 -- -- -- --
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
MEASURING COST: WHICH COSTS MATTER?
The Shapes of the Cost Curves
Costs

Cost Curves for a Firm

MC

AC
AVC

AFC

Output (q)
MARGINAL REVENUE, MARGINAL COST, AND
PROFIT MAXIMIZATION

● profit (𝜋) Difference ● marginal revenue (MR) Change in

between total revenue and revenue resulting from a one-unit
total cost increase in output.
∆𝑅
𝜋 𝑞 = 𝑅 𝑞 − 𝐶(𝑞) 𝑀𝑅 =
∆𝑞
Profit Maximization in the Short
Run
A firm chooses output q*, so that
profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope of
the cost curve).
∆𝜋 𝑞 = ∆𝑅 𝑞 − ∆𝐶 𝑞 = 0
CHOOSING OUTPUT IN THE SHORT-RUN
The Short-Run Profit of a Competitive Firm (Assume P=40)
q FC VC TC MC AFC AVC AC TR MR PROFIT
0 50 0 50 - - - -
1 50 50 100 50 50.0 50.0 100.0
2 50 78 128 28 25.0 39.0 64.0
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28.0 40.5
5 50 130 180 18 10.0 26.0 36.0
6 50 150 200 20 8.3 25.0 33.3
7 50 175 225 25 7.1 25.0 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5.0 30.0 35.0
11 50 385 435 85 4.5 35.0 39.5
CHOOSING OUTPUT IN THE SHORT-RUN
The Short-Run Loss of a Competitive Firm (Assume P=30)
q FC VC TC MC AFC AVC AC TR MR PROFIT
0 50 0 50 - - - -
1 50 50 100 50 50.0 50.0 100.0
2 50 78 128 28 25.0 39.0 64.0
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28.0 40.5
5 50 130 180 18 10.0 26.0 36.0
6 50 150 200 20 8.3 25.0 33.3
7 50 175 225 25 7.1 25.0 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5.0 30.0 35.0
11 50 385 435 85 4.5 35.0 39.5
CHOOSING OUTPUT IN THE SHORT-RUN
The Short-Run Loss of a Competitive Firm

A Competitive Firm
Incurring Losses
If the competitive firm
will produce q*, it will
minimize its losses
(since P < ATC).

The firm may produce

in the short run if price
is greater than average
variable cost at q*.
CHOOSING OUTPUT IN THE SHORT-RUN
EXAMPLE Assume price is 131, what is 𝑞∗ ?

Q FC VC TC MC AFC AVC AC TR MR PROFIT

0 100 0
1 100 90
2 100 170
3 100 240
4 100 300
5 100 370
6 100 450
7 100 540
8 100 650
9 100 780
10 100 930
CHOOSING OUTPUT IN THE SHORT-RUN
EXAMPLE Assume price is 81, what is 𝑞∗ ?

Q FC VC TC MC AFC AVC AC TR MR PROFIT

0 100 0
1 100 90
2 100 170
3 100 240
4 100 300
5 100 370
6 100 450
7 100 540
8 100 650
9 100 780
10 100 930
CHOOSING OUTPUT IN THE SHORT-RUN
EXAMPLE Assume price is 60, what is 𝑞∗ ?

Q FC VC TC MC AFC AVC AC TR MR PROFIT

0 100 0
1 100 90
2 100 170
3 100 240
4 100 300
5 100 370
6 100 450
7 100 540
8 100 650
9 100 780
10 100 930