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Theory of Cost

Chapter 8

Introduction
Classifications of costs Implicit or explicit fixed or variable Develop family of cost curves long run (all factors variable) short run (all factors except one fixed) Cost minimization problem Use isoquants from production theory, set tangent to isocost line (input price ratio) Cost curves incorporate technology used for producing an output input prices given (supply is perfectly elastic, firms are price takers)

long-run cost curves and returns to scale How do cost curves shift when input prices change or new technologies are introduced.

Explicit And Implicit Costs


Explicit (or expenditure) costs
Costs of employing additional inputs not owned by firm
Includes all cash or out-of-pocket expenses incurred in production
Accounting cost for purchased inputs whether they are fixed or variable

Implicit costs (also called nonexpenditure, imputed, or entrepreneurial costs)


Costs charged to inputs that are owned by firm
An opportunity cost of using an input in production of a commodity
Loss in benefits that could be obtained by using these inputs in another activity

Owners of firm also have an implicit cost associated with time devoted to a particular production activity

Fixed And Variable Costs


Fixed
Costs that do not vary with changes in output

Variable
Costs associated with variable inputs and do vary with output

Note: Explicit and implicit costs may contain both fixed and variable costs
Variable
Explicit: electricity to run machine, cans for beer. Implicit: Opp. cost of time owner spends overseeing workers.

Fixed
Explicit: long term lease on machinery Implicit: Opp. cost of not selling a new technology invented for production

Total cost (TC) = fixed + variable

Profits
Normal
Minimum total return to the inputs necessary to keep a firm in a given production activity
Also called necessary, ordinary, or opportunity-cost profit

Equals implicit cost

Pure
Total return above total cost Also called economic profit In short run, possibility of earning a pure profit exists but firms will only earn a normal profit in long run
In long run, firms have ability to enter or exit an industry
Will not operate at a loss or earn a pure profit

Normal vs. Pure Profits

Cost Minimization
Cost Function: A mathematical relationship showing the lowest economic cost for each possible level of output. Cost minimization is done by constrained optimization:
Identify lowest cost mix of inputs to achieve a given level of output Two inputs are used in production Perfectly competitive input and output markets
Firm takes input and output prices as fixed
Input supply curves are horizontal and perfectly elastic

No barriers to entry or exit Producers have perfect information about prices.

Cost Minimizing Decision Rule


Isoquant: Technological possibilities based on production function (last chapter) Isocost line: Market possibilities for substituting one input for another Least cost combination: Occurs where the firms MRTS (technological possibility for substituting inputs holding output constant) equals the rate at which inputs can be traded in markets.

Cost Minimization

Long-run Costs: Isocost


Isocost equation is
TC = wL + rK
w is wage rate of labor r is per-unit input price of capital (book uses v)

Solving isocost equation for K


K = -w/rL + TC/v
Results in a linear equation with TC/v as the capital (K), intercept -w/r as slope

Example: Find LRTC function


Production Function:

q ! K

1/ 2

L1 / 2
where w0 = fixed wage r0 = fixed cap. cost

Cost Minimization Problem: Min TC = w0L + r0K s.t. Solve:

q0 ! K

1/ 2

L1 / 2

L ! w0L  r0K  P q0  K

1/ 2

L1 / 2

First Order Conditions: (1)

K 1/ 2 K 1/ 2 dL ! w0  P 1/ 2 ! 0 w0 ! P 1/ 2 ! PMPL dL 2L 2L L1/ 2 L1/ 2 dL ! r 0  P 1/ 2 ! 0 r 0 ! P 1/ 2 ! PMPK dK 2K 2K dL ! q 0  K 1/ 2 L1/ 2 ! 0 dP


= dTC/dq is the change in total cost of production when output is increased by one unit. Under our assumption that output prices are fixed, the last unit produced sells for the market price, Pq. Therefore, = Pq Value of the marginal product (VMPL or VMPK) VMPL = w0 = *MPL = Pq*MPL VMPK = r0 = *MPK = Pq*MPK

(2) (3)

Using equations (1) and (2) =>

2w0 L1/ 2 2r 0 K 1/ 2 P! ! 1/ 2 K L1/ 2 w0 L K! 0 Expansion Path r


Substitute this result into equation (3)
1/ 2

w q  0 r
0

L!0
1/ 2

r0 L* ! 0 q 0 w
0 1/ 2 1/ 2

Optimal Level of L, L*

Substitute L* into expansion path to get K*:

w0 w r0 K * ! 0 0 q0 ! 0 q0 r r w

Optimal Level of K, K*

Find LRTC Function


Know: TC* = w0L + r0K and K*,L*. Substitute K* and L* into TC*

r 0 0 w TC ! w 0 q  r 0 w r
0 * 0

1/ 2

q0
0 1/ 2

1/ 2

TC ! w
*

r
0 1/ 2

0 1/ 2

q  w

r
0 1/ 2

q0

TC * ! 2( w0 r 0 )1/ 2 q 0

Example: w0 = 5; r0 = 20; q0 =100


Optimal Levels of L and K

r 20 ) L* ! 0 q0 ! 100! (4)1/ 2 (100 ! 200 w 5


0

1/ 2

1/ 2

5 0 * w ) K ! 0 q ! 100! (1/ 4)1/ 2 (100 ! 50 r 20


6 4 apital

0 1/ 2

1/ 2

Tangency: MRTS = w/r

Tangency
6 4

FK w ! EL r

4 La o

Constructing LRTC
Vary Level of Output and connect tangency points along long-run expansion path
LRTC for CRS Cobb Douglas Example
4

LR C

6 4

Output

LRTC

Long-Run Input Demand Functions Derived Demand Functions


L*, and K* were derived assuming q0 was constant =>

r 0 L ! 0 q w
0 *

1/ 2

w 0 K ! 0 q r
*

0 1/ 2

Can determine L*, K* combinations for any level of output by varying q =>

r L ! 0 q w
0 * 1/ 2

1/ 2

w K ! 0 q r
* 1/ 2

0 1/ 2

Generalized conditional long-run demand functions =>

r L ! q w
*

w K ! q r
*

LR Average and Marginal Cost


LRATC = LRTC/q =>

2( w0 r 0 )1/ 2 q ! 2( w0 r 0 )1/ 2 LRATC ! TC * ! q q


*

LRMC = (d/dq)LRTC =>

d d LRMC ! TC * ! 2( w0 r 0 )1/ 2 q ! 2( w0 r 0 )1/ 2 dq dq


*

In this case LRATC = LRMC

LRATC LRMC

Output

LRATC = LRMC

Costs and Returns to Scale


Constant returns to scale=> LRATC constant
LRATC/q = 0 Long-run average cost does not change for a given change in output

Increasing returns to scale => LRATC is declining


LRATC/q < 0 Increases in total cost are proportionally smaller than an increase in output Implies that inputs less than double for a doubling of output Corresponds to LTC also less than doubling

Decreasing returns to scale => LRATC is increasing


LRATC/q > 0 Increases in total cost are proportionally larger than an increase in output
Implies that inputs more than double for a doubling of output Corresponds to LTC more than doubling for a doubling of output

Constant Returns to Scale


R C LRT

RMC

Output

!$

!"

"

Costs increase at the same rate as output

"

where z =

!"

q( K,

)=

zq(K,

)= q

&

RA C

Output

&

















       


RA C = RMC

Decreasing Returns to Scale


9 7 6 R R 4

O tp t

q( K,

)=

zq(K,

)< q
6 4

where z < osts increase more rapidly than output

10

'0

98 1)
4 R RM RM R 4 O tp t 6 7

7 ') 3 3 ( 1 ( ' 1 '

'''''' '''''' '''''' ''''''

''''''2 ''''''1 ''''''0 '''''') ' ( '''''' 6 5 4

Increasing Returns to Scale


LRTC

Output

q( K,

)=

zq(K,

)> q
R RM

where z > osts increase less rapidly than output

FG

@G

P H I
R

FA

@A

FE

@E

@DE @ E B @CE @AE @@E @D @ B @C @A @


R RM Output

Cost Curves with Constant, Decreasing, and Increasing Returns

LMC LAC

Average and Marginal Cost Relationship


Marginal cost is not cost of producing last unit of output
Cost of producing last unit of output is same as that of producing all other units of output
Average cost of production

Marginal cost is increase in cost of producing an extra increment of output


Equal to average cost plus an adjustment factor
Additional cost to all factors of production caused by increase in output

Marginal cost differs from average cost by per-unit effect on costs of higher output, multiplied by total output
If LAC does not vary with output adjustment factor is zero

Short-run Costs
Short run => One of the inputs is fixed
Example: Upon signing a 5-year lease for their restaurant, owners have committed themselves to paying a fixed amount in costs whether they operate or not Results in a short-run situation where, for short-run profit maximization, owners will determine lowest TC for a given level of output and fixed input
Lowest TC is called short-run total cost (STC)

STC= short-run total variable cost (STVC) + total fixed cost (TFC)
Assuming that capital is fixed at K in short run STC(K) = STVC(K) + TFC(K) = min(wL + vk)
(wL + vk) is isocost equation STVC(K) = wL* and TFC(K) = vk
L* denotes level of labor that minimizes costs for a given level of output

Even if firm were to produce nothing, in short run it must still pay TFC
TFC is a horizontal line, showing that at all output levels, TFC remains the same

Short-run cost curves

Note: SRMC should Pass through the Minimum of SAVC & SATC

Example: Find SRTC function


Production Function:

q ! K

1/ 2

L1 / 2
where w0 = fixed wage r0 = fixed cap. Cost K0 = fixed capital

Cost Minimization Problem: Min TC = w0L + r0K0 s.t. Solve:

! K


0 0

0 1/ 2

L1 / 2

L ! w Lr K
0

P q  K
0

0 1/ 2

L1 / 2

First Order Conditions: (1)


1 1 0 / 2 0 / 2 2 L1/ 2 w0 K K dL 0 0 ! w  P 1/ 2 ! 0 w ! P 1/ 2 P ! 0 1/ 2 2L 2L dL K

(2)

q 0 dL 0 0 1/ 2 1/ 2 K ! q  L ! 0 L ! 0 K dP
2L w
1/ 2 0 0

= dTC/dq SRMC =

K
0 2 0

0 1/ 2

2w K

L K K
0 1/ 2 0 1/ 2
0

1/ 2

0 1/ 2

2 w0 q ! K0
q0 2w* 0 K wq rK 0  0 K q

SRTC = w*L + r*K0 =

q  r K
*

SMC = dSRTC/dq =

SVC =

q
K0

0 2

SATC = SRTC/q =

Example:
5000 0000 35000 30000 SRTC 25000 20000 15000 10000 5000 0 0 100 200 300 Output 00 500 00 00 120 100 0 SRMC 1 0

w0 = 5; r0 = 20; K0 =50
SRTC

Properties of SR Cost Functions SRMC is increasing with Output SRAVC will eventually rise SRATC is U shaped.

0 0 20

SRAC

SRAVC 0 0 100 200 300


Output

00

500

00

00

Some points about AC/MC


AFC is continually declining as output increases
As output tends toward zero (infinity), AFC approaches infinity (zero) SATC and SAVC never intersect Approach each other as output increases

SATC is sum of SAVC and AFC SATC is U-shaped due to Law of Diminishing Marginal Returns Short-run marginal cost (SMC) for a fixed level of capital K is defined as

Due to Law of Diminishing Marginal Returns,


SMC may at first decline, but will ultimately rise.

Relate Costs to Production


Figure .1 Figure 8.

Law of Diminishing Marginal Returns


Law of Diminishing Marginal Returns:
At some point when adding additional variable inputs marginal product of variable inputs will decline

A positively sloping SMC represents diminishing marginal returns A negatively sloping SMC represents increasing marginal returns Shape of SMC is determined by Law of Diminishing Marginal Returns
As output increases SMC curve will have a positive slope at some point

SR vs. LR

In general, there are an infinite number of short-run total cost curves One for every conceivable level of fixed input LRTC = Envelope of all these SR cost-minimizing choices STC curves for alternative levels of fixed input capital completely cover top of LTC curve and will not dip below it STC will only equal LTC at output level where long-run optimal input usage of capital corresponds to fixed capital input level associated with STC

Where STC is tangent to LTC, SATC is also tangent to LAC SATC curves envelop top of LAC curve SATC cannot be less than LAC for a given level of output

Constant Returns to Scale

Price changes?
Increase in wages? w0 -> w Shifts isocost line to left Shifts expansion path to left Raises LTC

Price/Fixed Cost Change

Technology Change?