Cost Concepts in

Economics
Chapter 9: Kay and Edwards

Agenda

Opportunity Cost
Long Versus Short-Run
Cost Concepts
Revenue Concepts
Production Rules in Short and
Long-Run
Size in Long-Run
2

Opportunity Costs

The value of the product not

produced because an input was
used for another purpose.
The income that would have been
received if the input had been used
in its most profitable alternative use.
It denotes the real cost of using an
input.
3

Short Versus Long Run

The short run is a period of time

sufficiently short that only some of
the variables can be changed.
The long run is a period of time
that all variables can be changed.

Types of Costs

Variable Costs

These costs exist only if production occurs.

E.g., fuel for tractor, seed, etc.

Fixed Costs

These cost exist whether production occurs or

not.
In the long-run there are no fixed costs.
Can be both cash and non-cash expenses.
E.g., depreciation on tractors and buildings, etc.

Types of Costs Cont.

Sunk Costs

Is an expenditure that cannot be

recovered.
In essence, it becomes part of fixed
costs.
E.g., pre-harvest costs.

Cost Concepts

Total Fixed Costs (TFC)

Total Variable Costs (TVC)

The summation of all fixed and sunk costs to

production.
The summation of all variable costs to
production.

Total Costs (TC)

The summation of total fixed and total variable

costs.
TC=TFC+TVC

Cost Concepts Cont.

Average Fixed Costs (AFC)

Average Variable Costs (AVC)

The total fixed costs divided by output.

The total variable costs divided by output.

Average Total Costs (ATC)

The total costs divided by output.

The summation of average fixed costs and
average variable costs, i.e., ATC=AFC+AVC.
8

Cost Concepts Cont.

Marginal Costs

The change in total costs divided by

the change in output.

TC/Y

The change in total variable costs

divided by the change in output.

TVC/Y

Side Note on Marginal Cost

How can marginal cost equal both

the change in total cost divided by
the change in output and the change
in total variable cost divided by the
change in output when variable
costs are not equal to total costs?

Short answer: fixed costs do not

change.
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Side Note on Marginal Cost

Cont.

We want to show that MC = TVC/Y when

TVC TC.
We know that TC = TFC + TVC
This implies that TC = (TFC + TVC)
This implies that TC = TFC + TVC
We know that TFC = 0
Hence, TC = TVC
Divide the previous by Y, we obtain
TC/Y = TVC/Y
MC = TVC/Y
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Graphical Representation
of Cost Concepts
$
TC
TVC

TFC

12

Graphical Representation
of Cost Concepts Cont.
$
MC

ATC
AVC

AFC

13

Notes on Costs

MC will meet AVC and ATC from

below at the corresponding
minimum point of each.

Why?

As output increases AFC goes to

zero.
As output increases, AVC and ATC
get closer to each other.
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Example of Cost Concepts

X

TFC

TVC

TC

10

10

1000

2000

16

30

100
0

1600

20

48

22

65

26

81

32

96

40

108

50

116

62

120

76

117

100
0
100
0
100
0
100
0
100
0

AFC

AVC

ATC

MC

100

100

200

2600

33.33

53.33

86.67

30

2000

3000

20.83

41.67

62.50

22.22

2200

3200

15.38

33.85

49.23

11.76

2600

3600

12.35

32.10

45.45

25

3200

4200

10.42

33.33

43.75

40

4000

5000

9.26

37.04

46.30

66.67

5000

6000

8.62

43.10

51.72

125

6200

7200

8.33

51.67

60.00

300

7600

8600

8.55

64.96

73.51

-466.67

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Revenue Concepts

Revenue (TR) is defined as the

output price (py) multiplied by the
quantity (Y).
Average revenue (AR) equals total
revenue divided by output (Y), i.e.,
TR/Y, which equals py.
Marginal Revenue is the change in
total revenue divided by the change
in output, i.e., TR/Y.
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Short-Run Decision Making

In the short-run, there are many

ways to choose how to produce.

Maximize output.
Utility maximization of the manager.
Profit maximization.

Profit () is defined as total revenue

minus total cost, i.e., = TR TC.

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Short-Run Decision Making

Cont.

When examining output, we want to

set our production level where MR =
MC when MR > AVC in the short-run.

If MR AVC, we would want to shut down.

Why?

If we can not set MR exactly equal to MC,

we want to produce at a level where MR
is as close as possible to MC, where MR >
MC.
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Intuition for Setting MR =

MC

Suppose MR < MC.

This implies that by producing
more output, you have a greater
addition of cost than you do
revenue.

Hence you would not make the

change.
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Intuition for Setting MR =

MC

Suppose MR > MC.

This implies that by producing
more output, you have a greater
addition of revenue than you do
cost.

Hence you would make the change.

You would stop increasing output

at the point where the trade-off in
additional revenue is just equal to
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Why Shutdown When

MR < AVC

If MR < AVC, this implies that you

are not bringing in enough revenue
from each unit produced to cover
your variable costs.
Hence you could minimize your
loss if you were to shutdown.

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Why Produce When

ATC > MR > AVC

When MR < ATC, the company is

making a loss.

Why would it produce?

Since the firm is making something

above and beyond its variable cost, it
can put some of that revenue towards
fixed cost.

This implies that it minimizes its loss by

producing.
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Profit Scenario Graphically

$

Profi
t

MC

MR = py
ATC
ATC

AVC

AFC
Yprofit

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Loss Minimizing
Graphically
$
MC
Loss
ATC
ATC

AVC

MR =
py
AFC
Yloss

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Shutdown Decision
Graphically
$

If we did not
produce: loss = B

MC

Loss = A + B
ATC

ATC
B

MR =
py

AVC

AFC
Yloss

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Production Rules for the

Long-Run

To maximize profits, the farmer

should produce when selling price
is greater than ATC at the
production level where MC = MR.
To minimize losses, the farmer
should not produce when selling
price is less than ATC, i.e.,
shutdown the business.
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Note on Cost Concepts

The producers supply curve is the

part of the MC curve that is above
the shutdown point.

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Long-Run Average Costs

The long run average cost (LRAC) curve

is the envelope of the short run average
cost curves when the size of the
operation is allowed to increase or
decrease.
Note that a short run average cost
curve exists for every possible farm
size, as defined by the amount of fixed
input available.
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Long-Run Average Costs

Cont.

In a competitive market, the long

run optimal production will occur
at the lowest point on the LRAC,
i.e., economic profits are driven to
zero.

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Size in the Long-Run

A measure of size in the long run

between output and costs as farm
size increases (EOS) is the
following:

EOS = percent change in costs

divided by percent change in output
value

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Size in the Long-Run Cont.

If this ratio of EOS is less than one, then

there are decreasing costs to expanding
production, i.e., increasing returns to size.
If this ratio is equal to one, then there are
constant costs to expanding production,
i.e., constant returns to size.
If this ratio is greater than one, then there
are increasing costs to expanding
production, i.e., decreasing returns to size.
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Economies of Size

This exists when the LRAC is decreasing.

Also known as increasing returns to size.
Usually occurs because of full utilization
of capital (tractors and buildings) and
labor.
Also occurs because of discount pricing
for buying in bulk and selling price
benefits for selling large quantities.
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