Executive Summary of Cost Concepts

I. Key Terms Used in Class

 Variable costs: costs whose level changes as the firm varies its output.
 Fixed costs: costs whose level remains the same as the firm varies its output, even when
it produces an output of zero
 Marginal cost: the change in total cost that, results from changing output by one unit.
Equivalently: the unit cost of the last unit produced.
 Average cost: the cost per unit on average, across all units produced.
 Sunk costs: costs that have been incurred as a result of past decisions
 Other terms:
o “All-in” cost: the sum total of the firm’s on-going variable and fixed costs (but
excluding capital charge on the firm’s assets)
o Full-Reinvestment cost: the firm’s “all-in” costs plus a capital charge on the
firm’s assets

II. Example
Firm has …
1. Variable costs of $15 per ton up to full capacity output of 1,000,000 tons per year
2. Fixed cost of $2,000,000 per year
3. Incurred a one-time entry cost of $50,000,000 to come into this market. Its discount
rate is 10 percent.
4. For simplicity, we assume firm’s assets have no salvage value

Totals
 Total Variable Cost (denoted by TVC) = 15Q
 Total Fixed Cost (denoted by TFC) = $2,000,000 per year
 Total Cost (denoted by TC) = 15Q + 2,000,000
 Annual capital charge: 0.10*$50,000,000 = $5,000,000 per year
 THUS: Full-reinvestment total cost (denoted by FR TC) = 15Q + 7,000,000

Notice the “build-up” relationship here:

 TC = TVC + TFC
 FR-TC = TC + annual capital charge

Question: Why do we use a “capital charge”? Answer: a capital charge, in effect, converts
“one-time” entry or investment costs into an annualized cost flow. It allows an “apples-to-
apples” comparison of all of the costs of doing business (those incurred on a year-in, year-out
basis, as well as one-time costs) that the firm would have to cover in the long run before in
invests in its assets (See “Notes on the Microeconomics of Cost” in case pack for more
information.)

Averages
 AVC = Total variable cost/quantity = TVC/Q = 15
  ATC = Total cost/quantity = TC/Q = 15 + 2,000,000/Q
 FR-ATC = Full-reinvestment cost/quantity = FR TC/Q = 15 + 7,000,000/Q

Marginals
 MC = dTC/dQ = 15

III. Complication: Salvage Value or Direct One-Time Cost of Exit

 What if, upon exit, we could receive a one-time salvage value for our assets of
$30,000,000?
 Then, in defining total cost and average total cost we would want to include this.
 Again, to achieve an “apples-to-apples” comparison, we want to convert the one-time
salvage value into an annualized cost flow, since the need to cover the salvage value is an
opportunity cost of staying in business. Using our discount rate of 10 percent, we have an
annualized salvage value of $3,00,000 per year
 We included this annualized value in defining total cost
 Thus, with a salvage value: TC = TVC + TFC + annualized salvage (or redeployment)
value.
 A direct cost of exit (firm has to pay a one-time fee to exit the industry; think of an
environmental clean-up cost) acts as a negative salvage value. Thus, with a direct one-
time cost of exit: TC = TVC + TFC + annualized direct cost of exit.

IV. Relevant Costs: What Decisions Do We Use These Concepts For?

 Output optimization: In choosing how much output to produce, a price-taking firm
maximizes profit by comparing price to marginal cost, i.e., P  MC.
 Long-run withdrawal of capacity: As a condition of keeping its capacity in the
industry, as opposed to permanently closing it down and exiting from the industry, the
firm must expect to cover the minimum level of its average total cost, i.e., P  min ATC
 Entry or reinvestment: As a condition of entering the industry in the first-place, or
reinvesting in worn-out assets, the firm must expect to cover the minimum level of its
full-reinvestment average total cost, i.e., P  min FR-ATC

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 Executive Summary of Demand Concepts
Shifts in Demand Curves versus Movements Along Demand Curves
 Demand curve: answers question --- “How much will be purchased at different possible
market prices?”
 Shifts versus movements along the demand curve:

Shifts in the demand

Movements along curve tell us how
a given demand curve quantity demanded
tell us how quantity changes with respect to
demanded changes changes in demand drivers
P0 with respect to P0 other than good’s price
changes in the (e.g, income, prices of
Price ($ per unit)

good’s price other goods)

P1

D0 D1
D
X0 X1 X0 X2 Quantity
Quantity
(units per period) (units per period)

Elasticities
 Price elasticity of demand (often denoted ): rate of percentage change in quantity
demanded per one percent change in price.
o  = (dX/dP)(P/X)
o Elasticity  slope! If demand curve is linear, X = a – bP, the coefficient b is
not the price elasticity of demand
o If the demand curve is constant elasticity form: log X = a – b log P, then b is
the price elasticity of demand.
 Other elasticities. Suppose quantity demanded depends on some other demand driver
whose level is Z (Z could be income, prices of a substitute good, advertising, and so
on). The “Z” elasticity of demand (e.g., income elasticity of demand) is given by
(dX/dZ)(Z/X).

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 Reverse Engineering a Linear Demand Curve
 If we know the price, quantity, and price elasticity of demand, we can reverse
engineer the equation of a demand and supply curve.
 Example:
o Given: X = 100, P = 5,  = - 2. Find the a and b terms in the linear demand
curve equation, X = a – bP.
o Step 1: Find b:  = -b(P/X), so – 2 = -b(5/100),  b = 40.
o Step 2: Find a: we know 100 = a – 40(5)  a = 300.
o The demand curve equation consistent with this price and quantity
information is X = 300 – 40P.
 We can apply the same logic to reverse engineer a linear supply curve.
 We could also apply this same logic to reverse engineer other coefficients in a linear
demand equation. For example, if you knew price, quantity, the level of income,
price elasticity of demand and income elasticity of demand, you could infer the
values of a, b, and c in the demand equation, X = a – bP + cY, where Y is income.

Executive Summary of Perfect Competition

I. The “Runs”
 Short run: period of time in which price dynamics determined by output adjustments by
active or near-active firms.
 Long run: period of time in which price dynamics determined by output adjustments by
active or near-active firms as well as entry of new capacity and withdrawal and attrition
of existing capacity

II. Short-Run Equilibrium

 A short-run equilibrium is defined by the condition:

 Market price is such that Quantity Supplied = Quantity Demanded, i.e., S(P) = D(P).
 Provided that market demand and firms’ costs do not change, this is a stable situation
in the short run in that there are no forces at work for price to change.

VI. Long-Run Supply Curves and Prediction of Long-Run Trends

 The long-run market supply curve tells us the how much output would be forthcoming at
various possible market prices in the long

.
 Constructing long-run supply curve the “Blocky Way”: Take the ATC of incumbent firms
(calculated at full capacity operation), arrange in “merit order” from lowest to highest and
graft onto to this, the FR ATC of a typical entrant (calculated at full capacity operation).

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 The question if a long-run price is sustainable boils down to finding a short run
equilibrium price, where we don’t have additional entry and exit in the market. That is
looking at the short-run equilibrium price, now we ask the question: is there going to be
entry or exit. If the answer is yes then the prices move in the direction suggested by entry
or exit (expansion or contraction of supply). If the answer is no, we have found a song-
run sustainable price.

 If all firms have comparable cost structures then prices between ATC and FR-ATC are
potentially sustainable, since there is no exit and no entry in that range. If demand is
expanding over the Long-Run we will end up at price equal to FR-ATC (assuming
nothing else changes). By the same argument, if demand is contracting over the Long-
Run we will end up at ATC (assuming again nothing else changes).

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 Executive Summary of Surplus Analysis and
Government Interventions

I. Surpluses:
 Consumer surplus, individual consumer buying one unit: difference between buyer value
and market price consumer pays. Net “utility” gain to consumer. Like “B – P” from
Strategy.
 Consumer surplus, market (CS): aggregate consumer surplus of all consumers.
 Producer surplus, individual producer producing one unit: difference between marker
price seller receives and marginal seller cost of producing the unit. Like “P – C” from
Strategy.
 Producer surplus, market (PS): aggregate producer surplus of all sellers. Also equals sum
total across all producers of difference between total revenue and total variable cost.
 Total surplus (TS): sum of consumer and producer surplus. TS = CS + PS

II. Deadweight Loss Due to Government Intervention

 Government interventions in perfectly competitive markets (in the absence of
externalities, market power and asymmetric information) create a deadweight loss
 Deadweight loss = Losses to losers – Gains to winners.
 Equivalently: Deadweight loss = CS + CS + (Tax Revenue if any)