Cost and Supply

Dr. Gong Jie

Where are we?

Demand
• Preference
• Budget
constraint

Market
Equilibrium

Supply?
How does a firm maximize profit?

What is profit?
♦ Economic profit instead of accounting profit
♦ Profit = Sales revenue-Economic (opportunity) cost
How to maximize profit?
♦ Step 1: How many units of the product to produce (Q*)
♦ Step 2: How to minimize production cost
How to efficiently employ productive resources to
produce Q* units of the product?
Agenda

Production Process
♦ Measures of Productivity
♦ Input Choice: Isoquants and Isocosts
Cost of Production
♦ Concepts of Costs
♦ Short-run and Long-run Cost Function
♦ Economies of Scale
Part I: Production Function
What is production?
Production of goods and services involves transforming
resources (inputs) into finished products (output).

Input: Productive resources, such as labor and capital

equipment, that firms use to manufacture goods and services

Output: the amount of goods and services produced

Technology determines the quantity of output that is feasible

to attain for a given set of inputs.
Production in Short Run and Long Run

Firm makes production decisions in two different

time frames: short run and long run.

In the short run, at least one input is fixed in quantity.

♦ Fixed inputs and variable inputs

In the long run, all inputs are variable.

Production Function

Production Function defines the maximum amount of

output that can be produced with a given set of inputs
(K units of capital, L units of labor, etc.)

Q = F(K,L)
In the short run, the amount of capital K may be fixed
at K0.
The short run production function is then given by Q
= F(K0,L). The output is simply a function of labor.
Example: Cobb-Douglas Function

Cobb-Douglas Production Function

F ( K , L) = KL
Numerical example:
♦ Assume K is fixed at 16 units in short run.
♦ Short run production function is Q = 4 L
♦ What’s the quantity of output when 100 units of
labor are used?
Q = 4 ×10 = 40
Q Example: The Short-run Production Function

Not feasible

A
• Technically efficient
Q = F(L)
D
•
C •
• B Technically inefficient

L1 L2 L
Marginal Productivity
ΔQ
Marginal Product of Labor: MPL =
ΔL
♦ Measures the output produced by the last worker.

ΔQ
Marginal Product of Capital: MP K =
ΔK
♦ Measures the output produced by the last unit of
capital.

The Law of Diminishing Marginal Return states

that marginal products (eventually) decline as the
quantity used of a single input increases.
Average Productivity

Average Product of Labor: APL = Q/L.

♦ Measures the output of an “average” worker.

Average Product of Capital: APK = Q/K.

♦ Measures the output of an “average” unit of capital.

Example: Q = F(K,L)= KL
♦ If the inputs are K = 16 and L = 16, then the average
product of labor is
APL = 256 / 16 =16 / 16 =1
Production with Two Inputs: Isoquant

We can describe production technology by isoquants.

Suppose the firm needs both capital and labor in the
production process: Q=F(K,L)
An isoquant is a curve that connects all combinations
of inputs (K, L) that generate the same level of output.
The shape of an isoquant reflects the ease with which
a producer can substitute among inputs while
maintaining the same level of output.
Example: Isoquant of Cobb-Douglas Function

Production Function Q = F(K,L) = KL

What is the algebraic form of the isoquant for an

output level of Q=20?

20 = 𝐾𝐿
⇒ 400 = 𝐾𝐿
⇒ 𝐾 = 400/𝐿
K Example: Isoquants for Q= KL

All combinations of (L,K) along the

isoquant produce 20 units of output.

A
•
Q = 20

Slope=ΔK/ΔL
• B
Q = 10

L
0
Substitutability Among Inputs

Marginal Rate of Technical Substitution

♦ The rate at which the firm can reduce quantity of input
Y for one additional unit of X, holding the output level
constant
Δy MPX
MRTSYX = - =
Δx MPY
Why is the isoquant getting flatter as x increases?
♦ Diminishing marginal rate of technical substitution
Analogy to Consumer Theory
Production Function
Marginal product
Diminishing marginal returns
Isoquant (all possible
combinations of inputs that just
suffice to produce a given amount
of output)
Marginal rate of technical
substitution (MRTS)
Diminishing MRTS
Utility Function
Marginal utility
Diminishing marginal utility
Indifference curve (all bundles
that yield the same level of
satisfaction to the consumer)
Marginal rate of substitution
(MRS)
Diminishing MRS
Part II: Cost Minimization
Cost Minimization

Among all the input combinations that can produce a

given amount of output (Q), a firm that maximizes
profit should choose the one that minimizes its costs
of production.
Let the desired output be Q0 and technology be
Q = f(L,K)
Firm’s problem:
min TC = wL + rK
K,L

s.t.Q0 = f (L, K)
Multi-input Choice: Isocost
K New Isocost Line
associated with higher
C1/r costs (C0 < C1).
The combinations of inputs
that yield the same total cost: C0/r
wL + rK = C
Rearranging, C0 C1
C0/w C1/w L
K= (1/r)C - (w/r)L
K
For given input prices, isocosts New Isocost Line for
further from the origin are C/r a decrease in the
associated with higher costs. wage (price of labor:
w0 > w1).
Changes in input prices change
the slope of the isocost line.

L
C/w0 C/w1
 K Which combination is cost minimizing?

TC2/r Higher isocost, higher total cost

TC1/r

TC0/r
•
A

Isoquant Q = Q0

• B

L
TC0/w TC1/w TC2/w
Solution to Cost Minimization Problem

At the cost-minimizing input mix, the slope of the

isoquant is equal to the slope of the isocost line.
MPL w
=
MPK r
It means that marginal product per dollar spent should
be equal for all inputs.
MPL w MPL MPK
= ⇔ =
MPK r w r
Comparative Statics: Changes in Input Price

A firm initially produces Q0 using

input mix A at a cost of C0. K
Suppose labor becomes cheaper:
w0 falls to w1.
♦ The isocost curve rotates
counterclockwise; which
represents the same cost level
prior to the wage change (C0). A
K0
♦ The slope of the new isocost line
represents the lower wage relative
to the price of capital. B
K1
♦ To produce the same level of
output, Q0, the firm will produce Q0
using point B on a lower isocost
line (C1)
L1 C0/w0 C1/w1 C0/w1 L
0 L0
Comparative Statics: Changes in Input Price

When labor becomes cheaper,

point B is the new cost- K
minimizing input mix for
producing Q0 units of output.
The total cost of production is
C1.

A’ is not optimal: it produces A

K0 B’
Q0 but costs C0 (>C1)
B Q1
B’ is not optimal either: it K1
produces Q1 (>Q0) at cost C0
(>C1). Q0
A’

L1 C0/w0 C1/w1 C0/w1 L

0 L0
Part III: Concepts of Costs & Cost
in The Short Run and Long Run
Review: Opportunity Cost

Opportunity cost: the value of a resource in its best

alternative use
♦ Suppose the firm can use its capital in A or B.
♦ If the firm chooses A, the opportunity cost is the value
(payoff) the firm could have earned had it chosen B.
Accounting cost
♦ Cost appeared in accounting books
Economic Cost = Opportunity Cost
Example of Opportunity Cost

An aluminum smelter purchased electricity to manufacture

aluminum at 2 cents per kilowatt-hour. Since then, the price of
electricity in the spot market rose to 2.5 cents.
What is the cost of manufacturing aluminum?
♦ 2.5 cents per unit, not 2 cents!
In 2000, some aluminum producers in the Pacific Northwest
who had contracted to purchase electricity at low prices,
temporarily shut down their smelters to re-sell the electricity in
the spot market, as spot prices rose as a result of tight supply
conditions in western electricity markets.
Sunk Cost

Sunk cost is the cost that can never be recovered no

matter what the decision maker does.
♦ Costs resulted from past decisions and cannot be
avoided
♦ No future decisions can change sunk costs.
♦ Sunk costs are irrelevant for future decisions.
Example: R&D Expenditure

A manager in a pharmaceutical company is thinking

about spending $50 million on R&D to develop a new
drug.
♦ At this point, the $50 million is not sunk.
If the manager decided to develop the new drug and paid
$50 million R&D expenditure:
♦ Now the $50 million is sunk.
♦ Nothing can be done to reverse the $50 million.
♦ None of future decisions, e.g., “how to price the drug”,
“which market to launch the new drug” should take the $50
million into account.
Fixed Cost and Variable Cost

In the short run, the manager is free to alter the use of

variable inputs but is “stuck” with existing levels of
fixed inputs.
Fixed costs (FC): costs that do not vary with output Q
♦ When Q = 0, FC > 0
Variable costs (VC): costs that change when output Q
is changed.
♦ When Q = 0, VC = 0
Short-run Total Cost = Fixed Costs + Variable Costs
Fixed Cost and Sunk Cost

Fixed costs do not change as the firm produces

different volumes of output, including Q=0.
♦ In the short run, FC>0 even if it produces nothing.
♦ But in the long run, fixed costs can be eliminated by
closing the factory (shut-down decision).
Sunk costs are not recoverable once incurred.
♦ Irrelevant to decision making: cannot be avoided by
any decisions.
Fixed Cost, Variable Cost, and Sunk Cost

Suppose your tuition has the following components

♦ Admin fee $500: due at the time you accept the offer,
non-refundable
♦ Cost per course $1000: due at the beginning of each
semester, refundable if you drop the course
Fixed cost
♦ $500 admin fee
Variable cost
♦ Cost of taking courses
Fixed Cost, Variable Cost, and Sunk Cost

Sunk cost?
♦ Depends on the time point!
When you are deciding whether to accept the offer
♦ No sunk cost
At the beginning of your first semester
♦ Admin fee is sunk.
After your first semester
♦ Admin fee + course cost in that semester is sunk.
The Cost Function

Cost function C(Q) summarizes the relationship

between Q and the total cost of producing Q in the
cost-minimizing fashion.
Short-run vs long-run cost function:
♦ In the short-run, at least one input is fixed.
♦ In the long-run, a firm is free to adjust both inputs.
TC Short-Run Total Cost = Total
Variable Cost + Total Fixed Cost

STC(Q, K0)

rK0 TVC(Q, K0)

TFC

rK0

Q
Average Cost and Marginal Cost

Average Cost
♦ AC(Q)=TC(Q)/Q

Marginal Cost
♦ Discrete Q: MC(Q)=TC(Q) – TC(Q-1)
♦ Continuous Q: the slope of TC curve
ΔTC (Q)
MC (Q) =
ΔQ
AC, MC ($)

Average and Marginal Cost Curves

MC AC

•
AC at minimum when AC(Q)=MC(Q)

0 Q
The link between the marginal value and
the average value
When an average magnitude is falling, the
corresponding marginal magnitude must be pulling
down the average, that is, MC<AC.
When an average magnitude is rising, the
corresponding marginal magnitude must be pulling
up the average, that is, MC>AC.
Example: your average grade is B. You take this
course and make A. Your average grade tends to
increase.
 Relations among Costs

Average Total Cost

ATC = C(Q)/Q $
MC ATC
ATC = AVC + AFC AVC
Minimum
Average Variable Cost of ATC
AVC = VC(Q)/Q

Average Fixed Cost

AFC = FC/Q
Minimum
Marginal Cost of AVC
AFC
MC = ΔC/ ΔQ
Q
Example: Different Categories of Costs

• Sunk costs: license fee, sanitation

approval, “WESTERN FOOD”
lampbox, the menu board, etc.
• Fixed costs: rent
• Variable costs: utilities, food
ingredients, etc.
• Marginal costs for a fish n’ chips: the
fish, the chips, the tartar sauce, the gas
for cooking the dish, etc.
• Average costs: divide the relevant
costs by the total number of dishes
sold.
Long-Run Cost Function

In the long run, all costs are variable.

The long run cost function relates minimized total
cost to output Q, for given factor prices.

Every point on the curve represents the firm’s

minimized total cost for a given level of output, Q,
holding input prices constant.
When Q=0, LTC=0
♦ No fixed cost in the long run.
 K Deriving Long-Run Total Cost Curve
Q1

Q0
K1
• TC = TC0
K0
• TC = TC1

0 L0 L1 L

TC ($/yr)

LR Total Cost Curve

TC1=wL1+rK1

TC0 =wL0+rK0

0 Q0 Q1 Q
Economies and Diseconomies of Scale

If average cost decreases as output rises, all else equal,

the cost function exhibits economies of scale.
If the average cost increases as output rises, all else
equal, the cost function exhibits diseconomies of
scale.
The smallest quantity at which the long run average
cost curve attains its minimum point is called the
minimum efficient scale.
AC ($)

Economies No Economies Diseconomies

of scale of scale of scale

A: Minimum
efficient scale

A B

0
Q (units)
Sources of Economy of Scale

Indivisibilities and the spreading of fixed cost

♦ An input cannot be scaled down below a minimum size,
even when the level of output is very small: Fixed cost
arises.
Specialization and division of labor
Inventories
♦ Firms have to keep inventories to avoid potential “stock-
out”. Mass-merchandising firms such as Carrefour can
maintain a lower ratio of inventory to sales than smaller
retailers while achieving the same level of “stock-out”.
Sources of Diseconomies of Scale

Managing large firms may become complex and

inefficient.
The advantage of buying in bulk may disappear.
♦ At some point, available suppliers of key inputs may
be limited, pushing their costs up.
 Takeaway: Categorizing Costs
(Short-run) Total Cost
Is the cost recoverable in the short run?

No! Yes!
Fixed Cost Variable cost
Is it recoverable in the
longer run? Can I only
recover it by
producing
No! Yes! nothing?

Sunk cost Non-sunk cost Yes!

This is the economic (or non-sunk) cost