Chapter 8

Cost

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All Rights Reserved.
 Main Topics

Types of cost
What do economic costs include?
Short-run cost: one variable input
Long-run cost: cost minimization with two
variable inputs
Average and marginal costs
Effects of input price changes
Economies and diseconomies of scale
8-2
 Types of Cost

Firm’s total cost is the expenditure required to

produce a given level of output in the most
economical way
Variable costs are the costs of inputs that vary
with output level
Fixed costs do not vary as the level of output
changes, although might not be incurred if
production level is zero
Avoidable versus sunk costs

8-3
Production Costs: An Example

Table 8.1: Fixed, Variable, and Total Costs of Producing

Garden Benches
Number of
Benches Fixed Costs Variable Cost Total Cost
Produced per (per Week) (per Week) (per Week)
Week
0 $1,000 $0 $1,000
33 $1,000 500 1,500
74 $1,000 1,000 2,000
132 $1,000 2,000 3,000

8-4
 Economic Costs

Some economic costs are hidden, such

as lost opportunities to use inputs in
other ways
Example: Using time to run your own firm
means giving up the chance to earn a salary
in another job
An opportunity cost is the cost
associated with forgoing the opportunity
to employ a resource in its best
alternative use
8-5
 Short Run Cost:
One Variable Input
If a firm uses two inputs in production, one is
fixed in the short run
To determine the short-run cost function with
only one variable input:
Identify the efficient method for producing a given
level of output
This shows how much of the variable input to use
Firm’s variable cost = cost of that amount of input
Firm’s total cost = variable cost + any fixed costs
Can be represented graphically or
mathematically

8-6
Figure 8.1: Variable Cost from
Production Function

8-7
 Figure 8.2: Fixed, Variable, and
Total Cost Curves
Dark red curve is
variable cost
Green curve is fixed
cost
Light red curve is
total cost, vertical
sum of VC and FC

8-8
Long-Run Cost: Cost Minimization
with Two Variable Inputs
In the long run, all inputs are variable
Firm will have many efficient ways to
produce a given amount of output, using
different input combinations
Which efficient combination is cheapest?
Consider a firm with two variable inputs K
and L, and inputs and outputs that are
finely divisible

8-9
 Isocost Lines
 An isocost line connects all input combinations with the
same cost
 If W is the cost of a unit of labor and R is the cost of a
unit of capital, the isocost line for total cost C is:

WL  RK  C
 Rearranged,
 C  W 
K      L
R  R 
 Thus the slope of an isocost line is –(W/R), the
negative of the ratio of input prices

8-10
 Isocost Lines, continued

Isocost lines closer to the origin represent

lower total cost
A family of isocost lines contains, for given
input prices, the isocost lines for all possible
cost levels of the firm
Note the close relationship between isocost
lines and consumer budget lines
Lines show bundles that have same cost
Slope is negative of the price ratio

8-11
 Sample Problem 1:

Plot the isocost line for a total cost of

$20,000 when the wage rate is $10 and the
rental rate is $40.

How does the isocost line change if the

wage rises to $20?
 Least-Cost Production

How do we find the least-cost input

combination for a given level of output?
Find the lowest isocost line that touches the
isoquant for producing that level of output
No-Overlap Rule: The area below the isocost
line that runs through the firm’s least-cost input
combination does not overlap with the area
above the Q-unit isoquant
Again, note the similarities to the consumer’s
problem

8-13
 Garden Bench Example,
Continued
In the long run, Naomi and Noah can
vary the amount of garage space they
rent and the number of workers they hire
An assembly worker earns $500 per
week
Garage space rents for $1 per square
foot per week
Inputs are finely divisible

8-14
 Figure 8.7: Least-Cost Method,
No-Overlap Rule Example
Square Feet
of Space, K

A
2500

2000

D
1500

B Q = 140
1000

500 C = $3500

C = $3000
1 2 3 4 5 6
Number of Assembly
Workers, L
8-15
 Interior Solutions

A least-cost input combination that uses at

least a little bit of every input is an interior
solution
Interior solutions always satisfy the tangency
condition: the isocost line is tangent to the
isoquant there
Otherwise, the isocost line would cross the isoquant
Create an area of overlap between the area under
the isocost line and the area above the isoquant
This would not minimize the cost of production

8-16
 Least-Cost Production and MRTS

 Restate the tangency condition in terms of marginal

products and input prices:
 Slope of isoquant = -(MRTSLK)
 MRTS = ratio of marginal products
 Slope of isocost lines = -(W/R)
 Thus the tangency condition says:
MPL W MPL MPK
 or 
MPK R W R
 Marginal product per dollar spent must be equal
across inputs when the firm is using a least-cost input
combination
8-17
 Least-Cost Input Combination
 How can we find a firm’s least-cost input combination?
 If isoquant for desired level of output has declining
MRTS:
 Find an interior solution for which the tangency condition
formula holds
 That input combination satisfies the no-overlap rule and must
be the least-cost combination
 If isoquant does not have declining MRTS:
 First identify interior combinations that satisfy the tangency
condition, if any
 Compare the costs of these combinations to the costs of any
boundary solutions

8-18
 Sample Problem 2:

Suppose the production function for

Gadget World is Q = 5L0.5K0.5. The wage
rate is $25 and the rental rate is $50.
What is the least-cost combination of
producing 100 gadgets? 200?
 The Firm’s Cost Function

To determine the firm’s cost function need to

find least-cost input combination for every
output level
Firm’s output expansion path shows the
least-cost input combinations at all levels of
output for fixed input prices
Firm’s total cost curve shows how total cost
changes with output level, given fixed input
prices

8-20
Figure 8.10: Output Expansion
Path and Total Cost Curve

8-21
 Average and Marginal Cost
 A firm’s average cost, AC=C/Q, is its cost per unit of
output produced
 Marginal cost measures now much extra cost the
firm incurs to produce the marginal units of output, per
unit of output added
C C Q   C Q  Q 
MC  
Q Q
 As output increases:
 Marginal cost first falls and then rises
 Average cost follows the same pattern

8-22
 Cost, Average Cost, and
Marginal Cost
Table 8.3: Cost, Average Cost, and Marginal Cost for a
Hypothetical Firm

Output (Q) Total Cost (C) Marginal Cost Average Cost

Tons per day (per day) (per day) (per day)

0 $0 $0 $0
1 1,000 1,000 1,000
2 1,800 800 900
3 2,100 300 700
4 2,500 400 625
5 3,000 500 600
6 3,600 600 600
7 4,300 700 614
8 5,600 1,300 700

8-23
 AC and MC Curves
When output is finely divisible, can represent
AC and MC as curves
Average cost:
Pick any point on the total cost curve and draw a
straight line connecting it to the origin
Slope of that line equals average cost
Efficient scale of production is the output level at
which AC is lowest
Marginal cost:
Firm’s marginal cost of producing Q units of output
is equal to the slope of its cost function at output
level Q

8-24
 Figure 8.16: Relationship
Between AC and MC
AC slopes downward
where it lies above
the MC curve
AC slopes upward
where it lies below
the MC curve
Where AC and MC
cross, AC is neither
rising nor falling

8-25
Marginal Cost, Marginal Products,
and Input Prices
Intuitively, a firm’s costs should be lower the
more productive it is and the lower the input
prices it faces
Formalize relationship between marginal cost,
marginal products, and input prices using the
tangency condition:
R W
MC  
MPK MPL

8-26
 More Average Costs: Definitions

Apply idea of average cost to firm’s variable

and fixed costs to find average variable cost
and average fixed cost:
VC FC
AVC  AFC 
Q Q

Since total cost is the sum of variable and

fixed costs, average cost is the sum of AVC
and AFC:
C VC  FC VC FC
AC      AVC  AFC
Q Q Q Q
8-27
 Average Cost Curves

Fixed costs are constant so AFC is

always downward sloping
At each level of output the AC curve is
the vertical sum of the AVC and AFC
curves
Average cost curve lies above both AVC and
AFC at every output level
Efficient scale of production exceeds output
level where AVC is lowest

8-28
Figure 8.18: AC, AVC, and
AFC Curves

8-29
Figure 8.20: AC, AVC, and
MC Curves

8-30
Effects of Input Price Changes

Changes in input prices usually lead to

changes in a firm’s least-cost production
method
Responses to a Change in an Input Price:
When the price of an input decreases, a firm’s least-
cost production method never uses less of that input
and usually employs more
For a price increase, a firm’s least-cost input
production method never uses more of that input
and usually employs less

8-31
 Figure 8.21: Effect of an Input
Price Change
Point A is optimal
input mix when price
of labor is four times
more than the price
of capital
Point B is optimal
when labor and
capital are equally
costly

8-32
 Short-run vs. Long-run Costs
 In the long run a firm can vary all inputs
 Will choose least-cost input combination for each output level
 In the short run a firm has at least one fixed input
 Produce some level of output at least-cost input combination
 Can vary output from that in short run but will have higher
costs than could achieve if all inputs were variable
 Long-run average variable cost curve is the lower
envelope of the short-run average cost curves
 One short-run curve for each possible level of output

8-33
Figure 8.24: Input Response over
the Long and Short Run

8-34
Figure 8.25: Long-run and Short-
run Costs

8-35
Figure 8.26: Long-run and Short-
run Average Cost Curves

8-36
 Economies and Diseconomies of
Scale
What are the implications of returns to scale?
A firm experiences economies of scale when
its average cost falls as it produces more
Cost rises less, proportionately, than the increase in
output
Production technology has increasing returns to
scale
Diseconomies of scale occur when average
cost rises with production

8-37
Figure 8.28: Returns to Scale and
Economies of Scale

8-38
 Sample Problem 3 (8.12):

Noah and Naomi want to produce 100 garden

benches per week in two production plants. The
cost functions at the two plants are
C1  600Q1  3Q 1
2
C2  650Q2  2Q 2
2
and ,
and the corresponding marginal costs are MC1 =
600 – 6Q1 and MC2 = 650 – 4Q2. What is the best
output assignment between the two plants?