AAEC 3315 Agricultural Price Theory

CHAPTER 6 Cost Relationships The Case of One Variable Input in the Short-Run

Objectives
To gain understanding of: Cost Relationships

Fixed Costs, Variable Costs,& Total Costs Average and Marginal Costs

Cost Functions Relationships between product and cost curves

Cost Relationships

A managers goal is to determine how much to produce to maximize profits. We established earlier that Stage II is the rational stage of production, but realized that cost and revenue information are necessary to determine at which point in Stage II to produce. Now, lets introduce cost relationships into production.

Cost Definitions
Costs of Production or Economic Costs: The payments that a firm must make to attract inputs and keep them from being used to produce other products.

A firms cost functions show various relationships between its costs and output rate. Thus, the firms cost functions are determined by the firms production function and input prices. Since the production function can pertain to the short run or the long run, it follows that the cost functions can also pertain to the short run or the long run.

Cost Functions in the Short Run

Fixed Costs: Costs which do not vary with the level of production - These costs are associated with the fixed factors of production. Incurred regardless whether any output is produced

Variable Costs: Costs that vary as the output level changes - These costs are associated with variable factors of production.

Short-Run Cost Relationships The Case of One Variable Input

Costs Based on Total Output

Total Fixed Costs (TFC): costs of inputs that are fixed in the SR & do not change as the output level changes.

Total Variable Costs (TVC): costs of inputs that are variable in the Short Run, and change as output level changes, i.e., TVC = PXX
Total Costs (TC): TFC + TVC

Total Cost Curves

(Assume TFC = $80 and Px = $25
X
0 1 2 3 4 5 6 7 8 9 10

Y
0 10 25 50 70 85 95 100 101 95 85

TFC
$80 $80

TOTAL FIXED COSTS

$80
350

$80
300

$80 $80 $80 $80

250 200 150 100 50

Cost

TFC

$80 $80 $80

0

0 0 20 40 60 Output 80 100 120

Total Cost Curves

(Assume TFC = $80 and Px = $25
X
0 1 2 3 4 5 6 7 8 9 10

Y
0 10 25 50 70 85 95 100 101 95 85

TFC
$80 $80 $80 $80 $80 $80 $80 $80 $80 $80 $80
0

TVC = PXX
$0 $25
TOTAL VARIABLE COSTS

$50
300

$75 $100
Costs

250 200 150 100

TVC

$125 $150

50

TFC
0 20 40 60 Output 80 100 120

$175 $200 $225 $250

Total Cost Curves

(Assume TFC = $80 and Px = $25
X
0 1 2 3 4 5 6 7 8 9 10

Y
0 10 25 50 70 85 95 100 101 95 85

TFC
$80 $80 $80 $80 $80 $80 $80 $80 $80 $80 $80
0

TVC
$0 $25 $50 $75 $100 $125 $150 $175 $200 $225 $250

TC = TFC+TVC
80 105 130
350

TOTAL COSTS

155 180
Costs

300 250 200 150 100

TC TVC TFC
0 20 40 60 Output 80 100 120

205 230 255 280 305 330

50 0

Total Cost Curves

TOTAL COSTS
350 300 250

TC

Costs

200 150 100 50 0 0 20 40 60 Output 80 100

TVC

TFC
120

Total Cost Curve Functions

TFC = 100 TVC = 6Q 0.4Q2 + 0.02Q3 TC = TFC + TVC = 100 + 6Q 0.4Q2 + 0.02Q3

Short-Run Cost Relationships

Costs Based on Per Unit of Output

Average Fixed Costs (AFC): Total fixed costs per unit of output, i.e., AFC = TFC / Q
Average Variable Costs (ATC): Total variable cost per unit of output, i.e., AVC = TVC/Q Average Total Costs (ATC): Average total cost per unit of output, i.e., ATC = TC / Y = AFC + AVC Marginal Cost (MC): The increase in cost necessary to increase output by one more unit, i.e., MC = TC/Q MC = (TVC + TFC) / Q MC = TVC / Q MC = TC/ Q = TVC/ Q

Costs Based on Per-Unit Output

Average Fixed Costs (AFC): Average cost of fixed inputs per unit of output, i.e., AFC = TFC / Q
Y TFC AFC

Average Fixed Costs

9.00 8.00 7.00

80

6.00

10
25 50 70 85 95 100 101 95 85

80
80 80 80 80 80 80 80 80 80

8.00
3.20 1.60 1.14 0.94 0.84
1.00 5.00 4.00 3.00 2.00

AFC

0.80 0.79 0.84 0.94

0.00 0 20 40 60 80 100 120

Costs Based on Per-Unit Output

Average Variable Costs (ATC): Total Variable cost per unit of output, i.e., AVC = TVC / Q
Y TVC AVC
9 8

Average Variable Cost

0 10 25 50 70 85 95 100 101 95 85

0 25 50 75 100 125 150 175 200 225 250 2.50 2.00

7 6 5

AVC

1.50 1.43 1.47 1.58 1.75 1.98 2.37 2.94

4 3 2 1 0 0 20 40 60 80 100 120

AFC

Costs Based on Per-Unit Output

Average Total Costs (ATC): Average total cost per unit of output, i.e., ATC = TC / Q = AFC + AVC
Y TC ATC
12

Average Total Cost

10

0 10 25 50 70 85 95 100

80 105 130 155 180 205 230 255 10.50 5.20 3.10 2.57
4 6 8

ATC

2.41 2.42 2.55

2

AVC AFC
0 20 40 60 80 100 120

101
95 85

280
305 330

2.77
3.21 3.88

Costs Based on Per-Unit Output

Marginal Cost (MC): The increase in cost necessary to increase output by one more unit, i.e., MC = TC/Q= TVC / Q = TC/ Q = TVC/ Q
Y TC MC

Marginal Cost
15 13 11 9

MC

0 10 25

80 105 130 2.50 1.67

7 5

50
70 85 95 100 101 95 85

155
180 205 230 255 280 305 330

1.00
1.25 1.67 2.50 5.00 25.00 -4.17 -2.50
-10 -1 10 30 50 70 3 1

ATC AVC AFC

90 110

Summary of Relationships Between Short-Run Cost Curves

AFC is a continuously decreasing function AVC & ATC curves are Ushaped The vertical distance between ATC & AVC at each output level is equal to AFC MC crosses both AVC & ATC from below at their respective minimums MC is not affected by fixed costs

Relationship Among Cost Curves

TOTAL COSTS
350 300 250

TC TVC
Inflection Point

Costs

200 150 100 50 0 0

.
60 Output 80

.
TFC
100 120

20

40

MC

ATC AVC

Costs/unit

AFC
Output

Changes in Input Price

Price of Variable Input Increases

The cost of producing each output level increases

VC & TC shift upward & left; TFC remains unchanged AVC, AC, & MC shift upward & left

Price of variable Input Decreases

The cost of producing each output level decreases

TVC & TC shift downward & right; TFC remains unchanged AVC, ATC, & MC shift downward & right

Working With Cost Functions

TOTAL COSTS

Given the total cost functions:

TC = 100 + 6Q 0.4Q2 + 0.02Q3, TFC = 100, TVC = 6Q 0.4Q2 + 0.02Q3,
Costs

TC TVC
Inflection Point

Average and Marginal costs functions can be derived.

ATC = TC/Q = 100/Q + 6 0.4Q + 0.02Q2, AFC = TFC/Q = 1000/Q, AVC = TVC/Q = 6 0.4Q + 0.02Q2, and MC = = TC/ Q = TVC/ Q = 6 0.8Q + 0.06Q2

TFC

Output

MC ATC
Costs/unit

With these given: Can you calculate the level of output at the minimum of AVC, and MC?

AVC

AFC
Output

Working With Cost Functions

TOTAL COSTS

Given the cost functions:

TC = 100 + 6Q 0.4Q2 + 0.02Q3, TFC = 100, TVC = 6Q 0.4Q2 + 0.02Q3, ATC = TC/Q = 100/Q + 6 0.4Q + 0.02Q2, AFC = TFC/Q = 100/Q, AVC = TVC/Q = 6 0.4Q + 0.02Q2, and MC = = TC/ Q = TVC/ Q = 6 0.8Q + 0.06Q2
Costs

TC TVC
Inflection Point

TFC

Output

MC ATC
Costs/unit

Level of output at the minimum of AVC:

AVC/ Q = -0.4 + 0.04Q = 0 Q = 10

AVC

AFC
Output

10

Working With Cost Functions

TOTAL COSTS

Given the cost functions:

TC = 100 + 6Q 0.4Q2 + 0.02Q3, TFC = 100, TVC = 6Q 0.4Q2 + 0.02Q3, ATC = TC/Q = 100/Q + 6 0.4Q + 0.02Q2, AFC = TFC/Q = 100/Q, AVC = TVC/Q = 6 0.4Q + 0.02Q2, and MC = = TC/ Q = TVC/ Q = 6 0.8Q + 0.06Q2
Costs

TC TVC
Inflection Point

TFC

Output

MC ATC
Costs/unit

Level of output at the minimum of MC:

MC/ Q = -0.8 + 0.12Q = 0 Q = 6.67

AVC

AFC 6.67
Output

10

Relationships among Product Curves and Cost Curves

The cost curves are derived directly from the production process. TPP & TVC, APP & AVC and MPP & MC are mirror images of each other

Therefore, the production function can be transferred directly to the cost curves The three stages of a production function can be transferred directly to the cost curves

Relationship Between TPP and TVC

TPP 120.00
300.00 TVC

100.00

250.00

80.00

B
TPP

200.00

60.00

150.00

B* A*

TVC

40.00

100.00

20.00

25

A
50.00 0.00 0.00

0.00 0.00

2.00

4.00

6.00

8.00

10.00

12.00

20.00

40.00

60.00

80.00

100.00

120.00

The TVC is derived from the TPP: At A on TPP, 25 units of the output is being produced with 2 units of the input. The corresponding point A* on the TVC shows that the variable cost of producing 25 units of output is $50 (PX:$25 * 2 units of input =$50). Note similar linkage between point B on TPP and point B * on TVC. Similar relationships can be derived between AVC & APP and between MPP & MC.