Lecture Outline

Cost in the Short Run

The relationship among MP, AP, MC and AVC

Allocating production between two processes

Cost in the Long Run
Choosing optimal input combination
The relationship between optimal input choice and the

long-run costs

The relationship between long-run & short-run

cost curves

The calculus approach to cost minimization

Introduction
Production technology, together with prices of factor

inputs, determine the firms cost of production.

The optimal, cost minimizing, level of inputs can be

determined.

A firms costs depend on the rate of output and will

change over time.

The characteristics of the firms production technology

can affect costs in the long run and short run.

Definitions of Costs
It is important to differentiate between accounting

cost and economic cost

Accountants: out-of-pocket expenses, historical costs,

depreciation, and other bookkeeping entries

Economists focus more on opportunity cost

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part, except for use as permitted in a license

COST THEORY
BASIC CONCEPTS OF 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 (both explicit and
implicit costs).

OPPORTUNITY COST

-Cost associated with opportunities that are foregone

when a firms resources are not put to their highest
value use.
Sunk Cost
-Expenditure that has been made and cannot be
recovered.

a) Explicit costs

- are those costs that involve an actual payment to

other parties.
b) Implicit cost
- represent the value off foregone opportunities but
do not involve an actual cash payment.
eg.: a manager who runs his bussiness foregoes
the salary that could have been earned working for
someone else.
value of the input owned and used by the
firm in its own production processes.

Examples:
1. Inventory valuation

- Firm purchases raw materials for $100 but its price

subsequently fell to $60
Accounting cost : $100
Economic cost : $60
Sunk cost
: $40

2. Measurement of depreciation cost.

-Firm purchased a machine for $100. Its estimated life

of the machine is 10 year. An accountant uses a
straight-line depreciation method. Suppose the
machine can still be sold for $120 at the end of 10 th
year.
Accounting cost : $0
Economic cost : $120

COST COMPONENTS
Total Fixed Costs (TFC)

-Those costs that do not vary with output.

Total Variable Cost (TVC)

-Those costs that vary with levels of output.

TC = TFC + TVC
Note: Fixed cost only exists in the short run as one
of the inputs has to be fixed!.

PRODUCTION AND SHORT-RUN COST FUNCTION

A cost function relates cost to the rate of output.
The basis for a cost function is the production function

and prices of input.

Re. : Q= (L)
TC = wL + r
TVC

TFC

Q
Q = (K0, L)

84
81
72

58
43
27
14
4
1

VC = wL

80

70

60

50

40

30

20
10

VC

14

27

VC growss at a
Decreasing rate

43

58

72

81

84

VC grows at
An increasing

TC
TC, FC, VC ($/HR)
VC

80

FC = 30

70
60

50

FC = 30

40

30

FC

20
10

14

27

43

58

72

81

84

Q
(bags/hr)

Re:

TC = TFC + TVC

1. Average Variable Cost (AVC)

AVC = TVC/Q

2. Average Fixed Cost (AFC)

AFC = TFC/Q

3.Average Total Cost (ATC)

ATC = TC/Q

But from (1),

TC = TFC + TVC
ATC = TC/Q = TFC/Q + TVC/Q

ATC = AFC + AVC

(1)
(2)
(3)
(4)

4. Marginal Cost (MC)

TC/ Q
Suppose : TC = (Q)
MC = dTC/dQ = (Q)
MC is the slope of the total cost function
But,
TC = TVC + TFC
MC = dTC/dQ = dTVC/dQ + dTFC/dQ
= 0 since TFC =

TC TVC
MC

Q
Q
b

$
A
30

0
$
15

TFC

AFC = TFC/Q

7.5

AFC
Q

$/hr

R1

TC
VC

TC

R2

Q
SRTC(Q)

C F

FC

0
Q1
$/Unit of output

Q2

Q3

MC

A
B

Q1

ATC
AVC
AFC

Q2

Q3

Note: At point A, SRATC is minimum and we know that

the slope of point A on SRTC curve is SRMC.

as shown at A , SRATC = SRMC when SRATC

is minimum.

Proof:
SRATC minimum slope of SRTC = 0
or
d(SRATC)/dQ = d(SRTC/Q)/dQ
=0
Take a derivative of d(SRTC/Q)/dQ using quotient
rule:
Q d(SRTC)/dQ - SRTCdQ/dQ set
d(SRTC/Q)

dQ

Q2

= 0

Q SRMC - SRTC1
Q2

= 0

Cross multiply:

Q/Q SRMC - SRTC/Q = 0

SRMC - SRATC = 0

SRMC

= SRATC

When SRTAC min.

Q.E.D

COST CURVES FOR A FIRM

MP, AP
Max MP

Max AP, MP=AP

30

APL
L1

MC, AVC

L2
MC

MPL

AVC
Min MC

L1
Q1

L2
Q2

Min AVC, MC=AVC

L
Q

RELATIONSHIPS BETWEEN AVC, MC WITH

AP
&input
MP case production function
Re: 1
Q= (LK)
(SR) TC = wL + b
*** wL = variable Cost
b = fixed Cost (Constant)
i. MC = dTC/dQ

= d(wL + b)/dQ

= w dL
dQ
= w 1
MPL
w
MC =
MPL

dQ
MPL =
dL

ii. AVC = TVC/Q

= wL/Q
= w L
Q
= w1
APL

w
AVC =
APL

APL =

Q
L

Economic Cost
Economic cost of any input
The payment required to keep that input in its present

employment
The remuneration the input would receive in its best
alternative employment

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Simplifying Assumptions
There are only two inputs
Homogeneous labor (l), measured in labor-hours
Homogeneous capital (k), measured in machinehours

Entrepreneurial costs - included in capital costs

Inputs are hired in perfectly competitive markets

24

Firms are price takers in input markets

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Economic Profits
Total costs for the firm:

total costs = C = wl + rk
Total revenue for the firm:

total revenue = pq = pf(k,l)

Economic profits ():

= total revenue - total cost

= pq - wl - rk
= pf(k,l) - wl - rk
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Economic Profits
Economic profits
Are a function of the amount of k and l
employed
We could examine how a firm would choose k
and l to maximize profit

Derived demand theory of labor and capital inputs

Assume that the firm has already chosen its

output level (q0) and wants to minimize its costs

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COST IN THE LONG RUN

The User Cost of Capital
user cost of capital Annual cost of
owning and using a capital asset, equal
to economic depreciation plus forgone
interest.
The user cost of capital is given by the sum of the economic
depreciation and the interest (i.e., the financial return) that could
have been earned had the money been invested elsewhere.
Formally,

We can also express the user cost of capital as a rate per dollar of
capital:

COST IN THE LONG RUN

The Cost-Minimizing Input Choice
We now turn to a fundamental problem that all firms face: how to
select inputs to produce a given output at minimum cost.
For simplicity, we will work with two variable inputs: labor (measured in
hours of work per year) and capital (measured in hours of use of
machinery per year).

The Price of Capital

The Rental Rate of Capital

rental rate

Cost per year of renting one unit of capital.

If the capital market is competitive, the rental rate should be equal to the user
cost, r. Why? Firms that own capital expect to earn a competitive return when
they rent it. This competitive return is the user cost of capital.
Capital that is purchased can be treated as though it were rented at a rental rate
equal to the user cost of capital.

COST IN THE LONG RUN

The Isocost Line
isocost line Graph showing
all possible combinations of
labor and capital that can be
purchased for a given total cost.
To see what an isocost line looks like, recall that the total cost C of
producing any particular output is given by the sum of the firms labor
cost wL and its capital cost rK:
(7.2)

If we rewrite the total cost equation as an equation for a straight line,

we get

It follows that the isocost line has a slope of K/L = (w/r), which is
the ratio of the wage rate to the rental cost of capital.

COST IN THE LONG RUN

The Isocost Line
Figure 7.3
Producing a Given Output at
Minimum Cost

Isocost curves describe the

combination of inputs to
production that cost the
same amount to the firm.
Isocost curve C1 is tangent
to isoquant q1 at A and
shows that output q1 can be
produced at minimum cost
with labor input L1 and
capital input K1.
Other input combinations
L2, K2 and L3, K3yield the
same output but at higher
cost.

COST IN THE LONG RUN

Choosing Inputs
Figure 7.4
Input Substitution When an
Input Price Changes

Facing an isocost curve

C1, the firm produces
output q1 at point A using
L1 units of labor and K1
units of capital.
When the price of labor
increases, the isocost
curves become steeper.
Output q1 is now
produced at point B on
isocost curve C2 by using
L2 units of labor and K2
units of capital.

COST IN THE LONG RUN

Choosing Inputs
Recall that in our analysis of production technology, we showed
that the marginal rate of technical substitution of labor for
capital (MRTS) is the negative of the slope of the isoquant and
is equal to the ratio of the marginal products of labor and
capital:
(7.3)

It follows that when a firm minimizes the cost of producing a particular

output, the following condition holds:

We can rewrite this condition slightly as follows:

(7.4)

Cost-Minimizing Input
Choices
Minimum cost
Occurs where the RTS = w/r
The rate at which k can be traded for l in the
production process = the rate at which they
can be traded in the marketplace

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Cost-Minimizing Input
Choices
Minimize total costs given q = f(k,l) = q
Setting up the Lagrangian:

= wl + rk + [q0 - f(k,l)]
First-order conditions:

/l = w - (f/l) = 0
/k = r - (f/k) = 0
/ = q0 - f(k,l) = 0

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Cost-Minimizing Input
Choices
Dividing the first two conditions we get
w f / l

RTS (l for k )
v f / k
The cost-minimizing firm should equate
the RTS for the two inputs to the ratio of
their prices

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Cost-Minimizing Input
Choices
Cross-multiplying, we get
fk
fl

v
w
For costs to be minimized, the marginal
productivity per dollar spent should be
the same for all inputs

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Cost-Minimizing Input
Choices
The inverse of this equation is also of interest

w v

fl f k
The Lagrangian multiplier shows how
the extra costs that would be incurred
by increasing the output constraint
slightly
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10.1

Minimization of Costs Given q = q0

k per period
C3
C2
kc
q0
C1
lc

l per period

A firm is assumed to choose k and l to minimize total costs. The condition for this minimization is
that the rate at which k and l can be traded technically (while keeping q = q0) should be equal to the
rate at which these inputs can be traded in the market. In other words, the RTS (of l for k) should be
set equal to the price ratio w/v.
ThisCengage
tangency
is shown
the figure; costs are minimized at C1 by
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choosing inputs kc and lc.
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COST IN THE LONG RUN

Cost Minimization with Varying Output
Levels

expansion path Curve passing

through points of tangency
between a firms isocost lines
and its isoquants.

The Expansion Path and Long-Run Costs

To move from the expansion path to the cost curve, we follow three
steps:
1. Choose an output level represented by an isoquant. Then find
the point of tangency of that isoquant with an isocost line.
2. From the chosen isocost line determine the minimum cost of
producing the output level that has been selected.
3. Graph the output-cost combination.

COST IN THE LONG RUN

Cost Minimization with Varying Output
Figure
7.6
Levels
A Firms 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 longrun total cost curve (from the
origin through points D, E, and
F) measures the least cost of
producing each level of
output.

Eg.: Cost Minimization

Cobb-Douglas production function: q = k l
The Lagrangian expression for cost minimization of
producing q0 is

= rk + wl + (q0 - k l )
First-order conditions for a minimum

/k = r - k -1l = 0
/l = w - k l -1 = 0
/ = q0 - k l = 0

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for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
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41

Eg. : Cost Minimization

Dividing the first equation by the second gives us
1

w k l
k
1 RTS
v k l
l
This production function is homothetic
The RTS depends only on the ratio of the two
inputs
The expansion path is a straight line

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for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected
website for classroom use.
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Properties of Cost
Functions
Homogeneity
Cost functions are all homogeneous of degree

one in the input prices

A doubling of all input prices will not change the
levels of inputs purchased
Inflation will shift the cost curves up

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Properties of Cost
Functions
Nondecreasing in q, v, and w
Cost functions are derived from a costminimization process
Any decline in costs from an increase in one of
the functions arguments would lead to a
contradiction

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Properties of Cost
Functions
Concave in input prices
Costs will be lower
When a firm faces input prices that fluctuate around
a given level
Than when they remain constant at that level

The firm can adapt its input mix to take

advantage of such fluctuations

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10.6

Cost Functions Are Concave in Input Prices

Costs

Cpseudo
C(v,w,q0)

C(v,w,q0)

With input prices w and v , total costs of producing q 0 are C (v, w, q0).

If the firm does not change its input mix, costs of producing q 0 would
follow the straight line C PSEUDO. With input substitution, actual costs C (v,
w, q0) will fall below this line, and hence the cost function is concave in w.
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46

Properties of Cost
Functions
Some of these properties carry over to

average and marginal costs

Homogeneity
Effects of v, w, and q are ambiguous

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INPUT INFLEXIBILITY AND COST

MINIMIZATION

Re : 1) In the short-run, by definition, one input must be fixed.

2) We also know that in the long run when all inputs can
be varied, firms will minimize its cost of production
by producing on the expansion path
ie. MRTSLK = MPL/MPK = w/r (optimal condition)
The SRTC derived so far are not the minimal costs
for producing the various level of output
ie. firms do not have the flexibility in input choice
to operate on the expansion path (LR)

To vary its output level in the short-run, the firm

will be forced to use non optimal input
combinations.

Capital
Per Year

150
100

$3000
Isocost Line
$2000
Isocost Line

75

(A)

Cost
(Dollars
3000
Per Year)

300 Unit
Isocquant

50
25

Expansion Path

A
50

200 Unit
Isocquant

100

150

200

300

Labor per Year

F
Long-Run Total Cost

2000

(B)
1000

100

200

300

Output, Unit per Year

THE INFLEXIBILITY OF SHORT-RUN PRODUCTION

Capital
Per Year E
C
Long-Run
Expansion Path

A
K2
K1

L1

Short-Run
Expansion Path

L2

L3

Labor per Year

SRTC2

SRTC1

SRTC0

q2

q1
q0

L0

L1

L2

Non Optimal Choice made in the SR

Re : in the LR, firm will be operating on the Expansion Path

K
SRTC2

SRTC1

Exxpension Path
(Least-Cost)

SRTC0

q2

q1
q0
L

SRTC2

SRTC1

SRTC0

q2

q1
q0
L

SRTC2

$
SRTC1

SRTC0

LRTC

TFC0
0

q0

q1

Non-Optimal (Choice in the SR)

q2

Relationship between SRTC and LRTC

Curves
SRTC(K3)

LRTC

SRTC(K1)

SRTC(K0)

a
0

q0

q1

q2

a, b and c are least-cost or the most efficient production level for a

given amount of a fixed capital, K

The locus of all these cost-minimizing choices is called the LRTC
curve because it summarizes the relationship between costs and
output when input are variable

Long-Run Average and Marginal Cost

COST
(Dollars per
Unit of
output

LMC

LAC

OUTPUT

COST
(Dollars per
Unit of
output

LRMC

LRAC
Economies
Of
scale

Min LRAC

Q*

i.

ii.

Economies of scale:
LRAC is declining
LRMC < LRAC
Due to specialozation

Diseconomies of scale
LRAC is increasing
LRMC > LRAC
Due to mismanagement

Diseconomies
Of
scale

OUTPUT

LONG RUN AVERAGE AND MC CURVES

LRTC curve summarizes the relationship between

quantity produced and TC when long run adjustments in

capital input are permitted.
LRATC = LRTC/Q
LRMC = LRTC/Q
$

SRAC3

SRAC1
SRMC1

SRAC2

SRMC3

SRMC2

Envelope
Curve
(LRATC)
Q

LRMC

$
SRAC1
SRMC1

SRAC3

SRMC2
SRAC2

LRATC

SRMC3

Q0

Q1

At a minimum point of LRATC (b):

LRATC = LRMC = SRATC = SRMC

Q2