Chapter 7

Costs
 Topics

1. The Nature of Costs.

2. Short-Run Costs.

3. Long-Run Costs.

4. Lower Costs in the Long Run.

5. Cost of Producing Multiple Goods.

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 The Nature of Costs

• Economists measure all relevant costs.

– Explicit costs – direct, out-of-pocket payments
for inputs to its production process within a given
time period
– Implicit costs – reflect only a forgone opportunity
rather than an explicit, current expenditure.
• Accountants measure costs in ways that are
more consistent with tax laws and other
laws.

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 Opportunity Costs

• Economic cost or opportunity cost - the

value of the best alternative use of a
resource.

• The economic or opportunity cost includes

both explicit and implicit costs.

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 Solved Problem 7.1

• Meredith’s firm sends her to a conference for

managers and has paid her registration fee.
Included in the registration fee is free admission to
a class on how to price derivative securities such as
options. She is considering attending, but her most
attractive alternative opportunity is to attend a talk
by Warren Buffett about his investment strategies,
which is scheduled at the same time. Although she
would be willing to pay $100 to hear his talk, the
cost of a ticket is only $40. Given that there are no
other costs involved in attending either event, what
is Meredith’s opportunity cost of attending the
derivatives talk?
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 Solved Problem 7.1: Answer

• To calculate her opportunity cost, determine

the benefit that Meredith would forgo by
attending the derivatives class.
• Because she incurs no additional fee to attend
the derivatives talk, Meredith’s opportunity cost
is the foregone benefit of hearing the Buffett
speech. Because she values hearing the Buffett
speech at $100, but only has to pay $40, her
net benefit from hearing that talk is $60 (=
$100 – $40). Thus, her opportunity cost of
attending the derivatives talk is $60.

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 Costs of Durable Inputs

• Durable good – a product that is usable for

years.
• Two issues may arise in measuring the cost
of durable goods:
– How to allocate the initial purchase cost over
time.
– What to do if the value of the capital changes
over time.

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 Sunk Costs

• Sunk cost – a past expenditure that cannot

be recovered.

• Sunk cost is not relevant to a manager

when deciding how much to produce now.

• If an expenditure is sunk, it is not an

opportunity cost.

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 Short-Run Costs

• Fixed cost (F) – a production expense that

does not vary with output.

• Variable cost (VC) – a production expense

that changes with the quantity of output
produced.

• Cost (total cost, C) – the sum of a firm’s

variable cost and fixed cost:

C = VC + F

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 Marginal Cost

• Marginal cost (MC) – the amount by

which a firm’s cost changes if the firm
produces one more unit of output.
C
MC 
q
– And since only variable cost changes with
output:
VC
MC 
q

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 Average Costs

• Average fixed cost (AFC) – the fixed cost

divided by the units of output produced:
AFC = F/q.

• Average variable cost (AVC) – the

variable cost divided by the units of output
produced:
AVC = VC/q.

• Average cost (AC) – the total cost divided

by the units of output produced:
AC = C/q
AC = AFC + AVC.

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 Table 7.1 Variation of Short-Run
Cost with Output

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 (a)

Cost, $
400

VC

27
Figure 7.1 Short-Run 216
A 1

Cost Curves
20
1
B
120

48 F

0 2 4 6 8 10
Quantity, q, Units per day
(b)

Cost per unit, $

60

MC

AC
28 a
27 AVC
b
20

8
AFC

0 2 4 6 8 10
Quantity, q, Units per day

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 Relationship Between Average
and Marginal Cost Curves
Cost per unit, $

60
When MC is and when MC is
lower than AC, MC
When andlarger
whenthan
MCAC,
is
ACMCis is AC is increases
lower than larger than AVC,
decreasing…
AVC, AVC is AVC is increases
decreasing…
AC
28 a …so MC = AC, at the
27 AVC lowest point of the
b
20 AC curve!
…so MC = AVC, at
the lowest point of
8 the AVC curve!

0 2 4 6 8 10
Quantity, q, Units per d ay

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 Figure 7.2 Variable Cost and
Total Product of Labor
Quantity, q, Units per day

Total product,
d
13 Variable cost

c
10

b
5

a
1

0 5 20 46 77 L, Hours of labor per day

50 200 460 770 VC = wL, Variable cost, $

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 Shape of the Marginal Cost
Curve
MC = DVC/Dq.
• But in the short run,

DVC = wDL

– Therefore,
MC = wDL/Dq

• The additional output created by every additional

unit of labor is:
Dq/ DL = MPL
– Therefore,
MC = w/ MPL

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 Shape of the Average Cost
Curves

AVC = VC/q.
– But in the short-run, with only labor as an input:
AVC = VC/q = wL/q

– And since q/L = APL, then

AVC = VC/q = w/APL

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 Application: Short-Run Cost
Curves for a Beer Manufacturer

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 Effects of Taxes on Costs

• Taxes applied to a firm shift some or all of

the marginal and average cost curves.

• For example, suppose that the government

collects a specific tax of $10 per unit of
output from the firm.

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 Figure 7.3 Effect of a Specific
Tax on Cost Curves

Costs per unit, $ A $10.00 tax shifts MC a = MC b + 10

80
both the AC and
MC by exactly MC b
$10…

$10
AC a = AC b + 10

37
$10 AC b

27

0 5 8 10 15
q, Units per d ay

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 Solved Problem 7.2

• What is the effect of a lump-sum franchise

tax on the quantity at which a firm’s after
tax average cost curve reaches its
minimum? (Assume that the firm’s before-
tax average cost curve is U-shaped.)

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 Solved Problem 7.2: Answer

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 Long-Run Costs

• Fixed costs are avoidable in the long run.

– In the long-run, F = 0.
– As a result, the long-run total cost equals:
C = VC

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 Isocost Line

• Isocost line - all the combinations of inputs

that require the same (iso-) total
expenditure (cost).

• The firm’s total cost equation is:

C = wL + rK.

Capital
Labor Costs
Costs

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 Isocost Line (cont.)

• The firm’s total cost equation is:

C = wL + rK.

– We get the Isocost equation by setting the

costs at a particular level:
C = wL + rK.

– And then solving for K (variable along y-axis):

C - w L
K= r r

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 Table 7.2 Bundles of Labor and
Capital That Cost the Firm $200

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 Figure 7.4 A Family of Isocost
Lines
For each extra unit of Isocost Equation
K, Units of capital per year

capital it uses, the

C - w L
firm must use two K= r r
fewer units of labor
to hold its cost Initial Values
constant.
$200 e C = $200
10 =
$20 w = $10
7.5
d
r = $20
c
5 Slope = -1/2 = w/r
DK = 2.5 b
2.5
DL = 5 $200 isocost

a
5 10 15 $200
= 20
$10
L, Units of labor per year

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 Figure 7.4 A Family of Isocost
Lines (cont.)
Isocost Equation
K, Units of capital per year

C - w L
$200 K= r
15 =
$20 r
An increase in C….
$200 e C = $300
10 =
$20 w = $10
r = $20

$200 isocost $300 isocost

a
$200 $300
= 20 = 30
$10 $10
L, Units of labor per year

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 Figure 7.4 A Family of Isocost
Lines (cont.)
Isocost Equation
K, Units of capital per year

C - w L
$200 K= r r
15 =
$20
A decrease in C….
$200 e
C = $100
10 =
$20 w = $10
r = $20
$100
5=
$20

$100 isocost $200 isocost $300 isocost

a
$100 $200 $300
= 10 = 20 = 30
$10 $10 $10
L, Units of labor per year

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 Combining Cost and Production
Information
• The firm can choose any of three equivalent
approaches to minimize its cost:
– Lowest-isocost rule - pick the bundle of
inputs where the lowest isocost line touches the
isoquant.
– Tangency rule - pick the bundle of inputs
where the isoquant is tangent to the isocost
line.
– Last-dollar rule - pick the bundle of inputs
where the last dollar spent on one input gives
as much extra output as the last dollar spent on
any other input.

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 Figure 7.5 Cost Minimization

Isocost Equation
K, Units of capital per hour

Which of these three

Isocost would allow C - w L
the firm to produce K= r r
$3,000 the 100 units of
isocost output at the lowest Isoquant Slope
possible cost? MPL
- = MRTS
$2,000
MPK
isocost

Initial Values
$1,000 q = 100
isocost
w = $24
r = $8

0 50 L, Units of labor per hour

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 Figure 7.5 Cost Minimization

Isocost Equation
K, Units of capital per hour

q = 100 isoquant C - w L
K= r r
$3,000
isocost
Isoquant Slope
MPL
303
y - = MRTS
$2,000
MPK
isocost

Initial Values
$1,000 q = 100
isocost
100
x C = $2,000
w = $24
z
28 r = $8
0 24 50 116
L, Units of labor per hour

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 Cost Minimization

• At the point of tangency, the slope of the

isoquant equals the slope of the isocost.
Therefore,
w
MRTS   last-dollar rule: cost is
r minimized if inputs are
MPL chosen so
MRTS  
MPK that the last dollar spent
MPL w on labor adds as much
 extra output as the last
MPK r
dollar spent on capital.
MPL MPK

w r
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 Figure 7.5 Cost
Minimization Initial Values
q = 100
MPL = 0.6q/L C = $2,000
K, Units of capital per hour

q = 100 isoquant MPK = 0.4q/K w = $24

r = $8
$3,000
isocost
MPL MPK 1.2 0.4
= = = = 0.05
y w r 24 8
303
$2,000
isocost
Spending one more dollar on
labor at x gets the firm as much
extra output as spending the
$1,000
isocost same amount on capital.
x
100

z
28

0 24 50 116
L, Units of labor per hour

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 Figure 7.5 Cost Initial Values
Minimization q = 100
C = $2,000
MPL = 0.6q/L w = $24
K, Units of capital per hour

q = 100 isoquant MPK = 0.4q/K r = $8

if So
the…the
firm shifts
firm one
$3,000 MPL 2.5 dollar
shouldfrom
shift
capital to
isocost = 24 = 0.1
w labor,
evenoutput
more falls by
MPK 0.017
resources
becausefromthere is
303
y
0.13
r = 0.017
8 =
less
capital
capital
to labor—
but also
$2,000
isocost increases
which increases
by 0.1 the
because
marginalthere
product
is more
labor
of capital
for a net
andgain of
$1,000 0.083
decreases
more the
output at
isocost
x
themarginal
same cost….
product
100
of labor.
z
28

0 24 50 116
L, Units of labor per hour

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 Solved Problem 7.3

• Use the tangency rule to determine the

cost-minimizing bundles of labor and
capital for a general Cobb-Douglas
production function, q = ALαKβ, and for the
specific beer production function that
underlies Figure 7.5, q = 1.516L0.6K0.4,
where w = 24 and r = 8.

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 Solved Problem 7.3: Answer

• The
  slope of a Cobb-Douglas isoquant is
MRTS = –(α/β)(K/L) and cost is minimized
if the MRTS equals the slope of the isocost,
–w/r: –(α/β)(K/L) = –w/r
• Rearrange this expression: K=wβL/(rα)
• With α = 0.6, β = 0.4, w = 24 and r=8,
KL/(80.6)=2L
• At a cost-minimizing input bundle, the firm
uses twice as many units of K as of L.

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 Figure 7.6 Change in Factor
Price
Minimizing Cost Rule
K, Units of capital per hour

q = 100 isoquant
Original MPL MPK
isocost,
$2,000 A decrease in w…. w = r
Initial Values
q = 100
C = $2,000
New isocost,
$1,032
w = $24
x
r = $8
100
w2 = $8
52
v C2 = $1,032

0 50 77 L, Workers per hour

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 The Long-Run Expansion Path
and the Long-Run Cost Function

• Expansion path - the cost-minimizing

combination of labor and capital for each
output level.

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 Figure 7.7(a) Expansion Path
and Long-Run Cost Curve

K, Units of capital per hour

$4,000
isocost

$3,000
isocost

Expansion path

$2,000
isocost

z
200
y
150
x
100
q = 200 Isoquant

q = 150 Isoquant
q = 100 Isoquant
0 50 75 100 L, Workers per hour

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 Figure 7.7(b) Expansion Path
and Long-Run Cost Curve

Long-run cost curve

C, Cost, $

4,000 Z

3,000 Y

2,000 X

0 100 150 200 q , Units per hour

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 Figure 7.8 Long-
Run Cost Curves

• The shape of long run

cost curves is
determined by the
production function
relationship between
output and inputs.

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 Economies of Scale

• Economies of scale - property of a cost

function whereby the average cost of
production falls as output expands.
• Diseconomies of scale - property of a cost
function whereby the average cost of
production rises when output increases.

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 Table 7.3 Returns to Scale and
Long-Run Costs

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 Figure 7.9 Long-Run Average Cost as
the Envelope of Short-Run Average
Average cost, $ Cost Curves

LRAC
SRAC 3

SRAC 1 SRAC 3 SRAC 2

b
12 d
10
a c

0 q1 q2 q, Output per day

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 Figure 7.10 Long-Run and
Short-Run Expansion Paths
K, Capital per day In the short run, the firm cannot
vary
In theitslong
capital,
run, so
theits short-run
beer
expansion
manufacturer pathincreases
is horizontal at
its output
the fixed more
by using level of
of both
output.
inputs, so its
$4,616 long-run expansion path is upward
sloping.

Long-run expansion path

$4,000

$2,000
z
200

x y Short-run
100 expansion path
200 isoquant

100 isoquant
0 50 100 159 L, Workers per day

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 Cost of Producing Multiple
Goods
• Economies of scope - situation in which it
is less expensive to produce goods jointly
than separately.

• Production possibility frontier - the

maximum amount of outputs that can be
produced from a fixed amount of input.

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