Chapter 7

The Cost of
Production
Topics to be Discussed
• Measuring Cost: Which Costs Matter?
• Cost in the Short Run
• Cost in the Long Run
• Long-Run Versus Short-Run Cost
Curves

Chapter 1 2
Topics to be Discussed
• Production with Two Outputs--
Economies of Scope

• Dynamic Changes in Costs--The

Learning Curve

• Estimating and Predicting Cost

Chapter 1 3
Introduction
• The production technology measures
the relationship between input and
output.

• Given the production technology,

managers must choose how to
produce.

Chapter 1 4
Introduction
• To determine the optimal level of
output and the input combinations,
we must convert from the unit
measurements of the production
technology to dollar measurements
or costs.

Chapter 1 5
Measuring Cost:
Which Costs Matter?
Economic Cost vs. Accounting 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

Chapter 1 6
Measuring Cost:
Which Costs Matter?

• Opportunity cost.
– Cost associated with opportunities that
are foregone when a firm’s resources
are not put to their highest-value use.

Chapter 1 7
Measuring Cost:
Which Costs Matter?

• An Example
– A firm owns its own building and pays
no rent for office space

– Does this mean the cost of office space

is zero?

Chapter 1 8
Measuring Cost:
Which Costs Matter?

• Sunk Cost
– Expenditure that has been made and
cannot be recovered
– Should not influence a firm’s decisions.

Chapter 1 9
Measuring Cost:
Which Costs Matter?

• An Example
– A firm pays $500,000 for an option to buy a
building.

– The cost of the building is $5 million or a total

of $5.5 million.

– The firm finds another building for $5.25

million.

– Which building should the firm buy?

Chapter 1 10
Measuring Cost:
Which Costs Matter?
Fixed and Variable Costs

• Total output is a function of variable

inputs and fixed inputs.
• Therefore, the total cost of
production equals the fixed cost (the
cost of the fixed inputs) plus the
variable cost (the cost of the variable
TC = FC + VC
inputs), or…

Chapter 1 11
Measuring Cost:
Which Costs Matter?
Fixed and Variable Costs

• Fixed Cost
– Does not vary with the level of output

• Variable Cost
– Cost that varies as output varies

Chapter 1 12
Measuring Cost:
Which Costs Matter?

• Fixed Cost
– Cost paid by a firm that is in
business regardless of the level of
output

• Sunk Cost
– Cost that have been incurred and
cannot be recovered

Chapter 1 13
Measuring Cost:
Which Costs Matter?

• Personal Computers: most

costs are variable
– Components, labor

• Software: most costs are

sunk
– Cost of developing the
software
Chapter 1 14
 A Firm’s Short-Run Costs ($)
Rate of Fixed Variable Total Marginal Average Average Average
Output Cost Cost Cost Cost Fixed Variable Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)

0 50 0 50 --- --- --- ---

1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Cost in the Short Run
• Marginal Cost (MC) is the cost of
expanding output by one unit. Since
fixed cost have no impact on
marginal cost, it can be written as:

∆VC ∆TC
MC = =
∆Q ∆Q

Chapter 1 16
Cost in the Short Run
• Average Total Cost (ATC) is the cost
per unit of output, or average fixed
cost (AFC) plus average variable cost
(AVC). This can be written:

TFC TVC
ATC = +
Q Q

Chapter 1 17
Cost in the Short Run
• Average Total Cost (ATC) is the cost
per unit of output, or average fixed
cost (AFC) plus average variable cost
(AVC). This can be written:

TC
ATC = AFC + AVC or
Q

Chapter 1 18
Cost in the Short Run
• The Determinants of Short-Run Cost
– The relationship between the production
function and cost can be exemplified by
either increasing returns and cost or
decreasing returns and cost.

Chapter 1 19
Cost in the Short Run
• The Determinants of Short-Run Cost
– Increasing returns and cost
• With increasing returns, output is increasing relative
to input and variable cost and total cost will fall
relative to output.
– Decreasing returns and cost
• With decreasing returns, output is decreasing relative
to input and variable cost and total cost will rise
relative to output.

Chapter 1 20
Cost in the Short Run
• For Example: Assume the wage rate
(w) is fixed relative to the number of
workers hired. Then:
∆VC
MC =
∆Q
VC = wL
Chapter 1 21
Cost in the Short Run
• Continuing:
∆VC = w∆L
w ∆L
MC =
∆Q

Chapter 1 22
Cost in the Short Run
• Continuing:
∆Q
∆MPL =
∆L
∆L 1
∆L for a 1 unit ∆Q = =
∆Q ∆MPL

Chapter 1 23
Cost in the Short Run
• In conclusion:
w
MC =
MPL
• …and a low marginal product (MP)
leads to a high marginal cost (MC)
and vise versa.
Chapter 1 24
Cost in the Short Run
• Consequently (from the table):
– MC decreases initially with increasing
returns
• 0 through 4 units of output
– MC increases with decreasing returns
• 5 through 11 units of output

Chapter 1 25
 A Firm’s Short-Run Costs ($)
Rate of Fixed
Output Cost
Variable
Cost
Total
Cost
Marginal
Cost
Average
Fixed
Average
Variable
Average
Total
(FC) (VC) (TC) (MC) Cost Cost Cost
(AFC) (AVC) (ATC)

0 50 0 50 --- --- --- ---

1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
Cost Curves for a Firm
TC
Total cost
is the vertical
Cost 400 sum of FC
($ per and VC.
year) VC
Variable cost
increases with
300 production and
the rate varies with
increasing &
decreasing returns.

200

Fixed cost does not

100 vary with output
50 FC

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output

Chapter 1 27
Cost Curves for a Firm
Cost
($ per
100
unit)
MC

75

50 ATC
AVC

25

AFC
0 1 2 3 4 5 6 7 8 9 10 11 Output (units/yr.)

Chapter 1 28
Cost Curves for a Firm
• The line drawn
P TC
from the origin to
400
the tangent of the VC
variable cost
300
curve:
– Its slope equals
AVC 200

– The slope of a A
point on VC equals 100
FC
MC
– Therefore, MC = 0 1 2 3 4 5 6 7 8 9 10 11 12 13
AVC at 7 units of
Output
output (point A)
Chapter 1 29
Cost Curves for a Firm
• Unit Costs Cost
($ per
unit)

– AFC falls 100

continuously MC
75
– When MC < AVC
or MC < ATC, AVC 50
ATC
& ATC decrease AVC
– When MC > AVC 25

or MC > ATC, AVC AFC

& ATC increase 0 1 2 3 4 5 6 7 8
Output (units/yr.)
9 10 11

Chapter 1 30
Cost Curves for a Firm
• Unit Costs Cost
($ per
unit)

– MC = AVC and 100

ATC at minimum MC
75
AVC and ATC
– Minimum AVC 50
ATC
occurs at a lower AVC
output than 25

minimum ATC due AFC

to FC 0 1 2 3 4 5 6 7 8 9 10 11
Output (units/yr.)

Chapter 1 31
Cost in the Long Run
The User Cost of Capital

• User Cost of Capital = Economic

Depreciation + (Interest Rate)(Value
of Capital)

Chapter 1 32
 Producing a Given
Output at Minimum Cost
Capital Q1 is an isoquant
per for output Q1.
year Isocost curve C0 shows
all combinations of K and L
that can produce Q1 at this
K2 cost level.

Isocost C2 shows quantity

CO C1 C2 are
Q1 can be produced with
three combination K2L2 or K3L3.
isocost lines However, both of these
A are higher cost combinations
K1 than K1L1.

Q1
K3

C0 C1 C2
L2 L1 L3 Labor per year

Chapter 1 33
Input Substitution When
an Input Price Change
Capital If the price of labor
per changes, the isocost curve
year becomes steeper due to
the change in the slope -(w/L).

This yields a new combination

of K and L to produce Q1.
B Combination B is used in place
of combination A.
K2
The new combination represents
the higher cost of labor relative
A to capital and therefore capital
K1 is substituted for labor.

Q1

C2 C1

L2 L1 Labor per year

Chapter 1 34
Cost in the Long Run
• Isoquants and Isocosts and the
Production Function
MRTS = - ∆K = MPL
∆L MPK

Slope of isocost line = ∆K = −w

∆L r

and = MPL =w
MPK r

Chapter 1 35
Cost in the Long Run
• The minimum cost combination can
then be written as:
MPL = MPK
w r
– Minimum cost for a given output will
occur when each dollar of input added
to the production process will add an
equivalent amount of output.

Chapter 1 36
Cost in the Long Run
• Question
– If w = $10, r = $2, and MPL = MPK,
which input would the producer use
more of? Why?

Chapter 1 37
The Effect of Effluent
Fees on Firms’ Input Choices

• Firms that have a by-product to

production produce an effluent.

• An effluent fee is a per-unit fee that

firms must pay for the effluent that
they emit.

• How would a producer respond to an

effluent fee on production?
Chapter 1 38
Cost in the Long Run
• Cost minimization with Varying
Output Levels
– A firm’s expansion path shows the
minimum cost combinations of labor and
capital at each level of output.

Chapter 1 39
A Firm’s Expansion Path
Capital
per The expansion path illustrates
year the least-cost combinations of
labor and capital that can be
used to produce each level of
150 $3000 Isocost Line output in the long-run.

$2000 Expansion Path

Isocost Line
100
C
75
B
50
300 Unit Isoquant
A
25
200 Unit
Isoquant
Labor per year
50 100 150 200 300

Chapter 1 40
A Firm’s
Cost Long-Run Total Cost Curve
per
Year
Expansion Path
F
3000

E
2000

D
1000

Output, Units/yr
100 200 300

Chapter 1 41
Long-Run Versus
Short-Run Cost Curves

• What happens to average costs when

both inputs are variable (long run)
versus only having one input that is
variable (short run)?

Chapter 1 42
The Inflexibility of
Short-Run Production

Capital E
per The long-run expansion
year path is drawn as before..
C

Long-Run
Expansion Path
A

K2
Short-Run
P Expansion Path
K1 Q2

Q1

L1 L2 B L3 D F

Chapter 1 Labor per year 43

Long-Run Versus
Short-Run Cost Curves

• Long-Run Average Cost (LAC)

– Constant Returns to Scale
• If input is doubled, output will double and
average cost is constant at all levels of
output.

Chapter 1 44
Long-Run Versus
Short-Run Cost Curves

• Long-Run Average Cost (LAC)

– Increasing Returns to Scale
• If input is doubled, output will more than
double and average cost decreases at all
levels of output.

Chapter 1 45
Long-Run Versus
Short-Run Cost Curves

• Long-Run Average Cost (LAC)

– Decreasing Returns to Scale
• If input is doubled, the increase in output is
less than twice as large and average cost
increases with output.

Chapter 1 46
Long-Run Versus
Short-Run Cost Curves

• Long-Run Average Cost (LAC)

– In the long-run:
• Firms experience increasing and decreasing
returns to scale and therefore long-run
average cost is “U” shaped.

Chapter 1 47
Long-Run Versus
Short-Run Cost Curves

• Long-Run Average Cost (LAC)

– Long-run marginal cost leads long-run
average cost:
• If LMC < LAC, LAC will fall
• If LMC > LAC, LAC will rise
• Therefore, LMC = LAC at the minimum of
LAC

Chapter 1 48
Long-Run Average
and Marginal Cost
Cost
($ per unit
of output LMC

LAC

Output

Chapter 1 49
Long-Run Versus
Short-Run Cost Curves

• Question
– What is the relationship between long-
run average cost and long-run marginal
cost when long-run average cost is
constant?

Chapter 1 50
Long-Run Versus
Short-Run Cost Curves

• Economies and Diseconomies of

Scale
– Economies of Scale
• Increase in output is greater than the
increase in inputs.
– Diseconomies of Scale
• Increase in output is less than the increase
in inputs.

Chapter 1 51
Long-Run Versus
Short-Run Cost Curves

• Measuring Economies of Scale

Ec = Cost − output elasticity

= %Δ in cost from a 1% increase
in output

Chapter 1 52
Long-Run Versus
Short-Run Cost Curves

• Measuring Economies of Scale

Ec = (∆C / C ) /( ∆Q / Q)

Ec = (∆C / ∆Q) /(C / Q) = MC/AC

Chapter 1 53
Long-Run Versus
Short-Run Cost Curves

• Therefore, the following is true:

– EC < 1: MC < AC
• Average cost indicate decreasing economies of scale
– EC = 1: MC = AC
• Average cost indicate constant economies of scale
– EC > 1: MC > AC
• Average cost indicate increasing diseconomies of
scale

Chapter 1 54
Long-Run Versus
Short-Run Cost Curves

• The Relationship Between Short-Run

and Long-Run Cost
– We will use short and long-run cost to
determine the optimal plant size

Chapter 1 55
Long-Run Cost with
Constant Returns to Scale

Cost With many plant sizes with SAC = $10

($ per unit the LAC = LMC and is a straight line
of output
SAC1 SAC2 SAC3

SMC1 SMC2 SMC3

LAC =
LMC

Q1 Q2 Q3 Output
Chapter 1 56
Long-Run Cost with
Constant Returns to Scale

• Observation
– The optimal plant size will depend on the
anticipated output (e.g. Q1 choose SAC1,etc).
– The long-run average cost curve is the
envelope of the firm’s short-run average cost
curves.

• Question
– What would happen to average cost if an
output level other than that shown is chosen?

Chapter 1 57
Long-Run Cost with
Constant Returns to Scale

• What is the firms’ long-run cost

curve?
– Firms can change scale to change
output in the long-run.
– The long-run cost curve is the dark blue
portion of the SAC curve which
represents the minimum cost for any
level of output.

Chapter 1 58
Long-Run Cost with
Constant Returns to Scale

• Observations
– The LAC does not include the minimum
points of small and large size plants?
Why not?
– LMC is not the envelope of the short-run
marginal cost. Why not?

Chapter 1 59
Production with Two
Outputs--Economies of Scope

• Examples:
– Chicken farm--poultry and eggs
– Automobile company--cars and trucks
– University--Teaching and research

Chapter 1 60
Production with Two
Outputs--Economies of Scope

• Economies of scope exist when the joint

output of a single firm is greater than the
output that could be achieved by two
different firms each producing a single
output.
• What are the advantages of joint
production?
– Consider an automobile company producing
cars and tractors

Chapter 1 61
Production with Two
Outputs--Economies of Scope

• Advantages
1) Both use capital and labor.
2) The firms share management
resources.
3) Both use the same labor skills and
type of machinery.

Chapter 1 62
Production with Two
Outputs--Economies of Scope

• Production:
– Firms must choose how much of each to
produce.
– The alternative quantities can be
illustrated using product transformation
curves.

Chapter 1 63
Product Transformation Curve
Each curve shows
Number combinations of output
of tractors with a given combination
of L & K.

O2 O1 illustrates a low level

of output. O2 illustrates
a higher level of output with
two times as much labor
O1 and capital.

Number of cars

Chapter 1 64
Production with Two
Outputs--Economies of Scope

• Observations
– Product transformation curves are
negatively sloped
– Constant returns exist in this example
– Since the production transformation
curve is concave is joint production
desirable?

Chapter 1 65
Production with Two
Outputs--Economies of Scope

• Observations
– There is no direct relationship between
economies of scope and economies of
scale.
• May experience economies of scope and
diseconomies of scale
• May have economies of scale and not have
economies of scope

Chapter 1 66
Production with Two
Outputs--Economies of Scope

• The degree of economies of scope

measures the savings in cost and can be
written:
C(Q1) + C (Q 2) − C (Q1, Q 2)
SC =
C (Q1, Q 2)

– C(Q1) is the cost of producing Q1

– C(Q2) is the cost of producing Q2
– C(Q1Q2) is the joint cost of producing both
products
Chapter 1 67
Dynamic Changes in
Costs--The Learning Curve

• The learning curve measures the

impact of worker’s experience on the
costs of production.

• It describes the relationship between

a firm’s cumulative output and
amount of inputs needed to produce
a unit of output.

Chapter 1 68
The Learning Curve
Hours of labor
per machine lot
10

2
Cumulative number of
machine lots produced
0 10 20 30 40 50

Chapter 1 69
Summary
• Managers, investors, and economists
must take into account the
opportunity cost associated with the
use of the firm’s resources.

• Firms are faced with both fixed and

variable costs in the short-run.

Chapter 1 70
Summary
• When there is a single variable input,
as in the short run, the presence of
diminishing returns determines the
shape of the cost curves.

• In the long run, all inputs to the

production process are variable.

Chapter 1 71
Summary
• The firm’s expansion path describes
how its cost-minimizing input choices
vary as the scale or output of its
operation increases.

• The long-run average cost curve is

the envelope of the short-run
average cost curves.

Chapter 1 72
Summary
• A firm enjoys economies of scale
when it can double its output at less
than twice the cost.
• Economies of scope arise when the
firm can produce any combination of
the two outputs more cheaply than
could two independent firms that
each produced a single product.

Chapter 1 73
Summary
• A firm’s average cost of production
can fall over time if the firm “learns”
how to produce more effectively.

• Cost functions relate the cost of

production to the level of output of
the firm.

Chapter 1 74
End of Chapter 7
The Cost of
Production