Applied Microeconomics

Cost
 Outline

• Variable and Fixed cost

3
 Breaking Down Costs
• In the previous lecture we derived the
total cost function, TC(x)
• Total cost can be separated into
variable cost, VC(x), and fixed cost, F
• Fixed cost can be separated into
avoidable fixed cost FA and unavoidable
fixed cost FU

4
 Variable Costs
• A cost is variable if it depends on
quantity produced
• Examples: paper costs for a publisher,
flour costs for a baker, bottle costs for a
wine-maker

5
 Fixed Costs
• A cost is fixed if it does not depend on the
quantity produced
• Avoidable fixed costs are fixed costs that do
not have to be paid if the firm shuts down
• Unavoidable or sunk fixed costs have to be
paid even if the firm shuts down production
• The distinction between fixed and variable,
and avoidable or unavoidable fixed costs
depends on the time horizon as we will see…

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 Total, Variable, and Fixed
Costs
40
35
30
25 TC
Cost

20 VC
15 F
10
5
0
0,01 1 2 3 4
Quantity

7
 Sunk Costs
• What is wrong with the following
statement:
“One reasoning for choosing incineration
over containment is that so much money
has already been spent on pursuing the
incineration option.  If we go with
containment, that money will all have been
wasted.”

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 Sunk Costs
• Sunk or unavoidable costs are cost
that have already been incurred and
cannot be undone
• Such costs should be ignored when
making production decisions

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 Sunk Costs Example
• Suppose a pharmaceutical company owns
a piece of land that it can develop.
• The company has two subsequent
decisions to make:
 At time 0: Whether to sell the land for $0.7M or
build an endostatin plant on it at a cost of $0.9M
 At time 1: If it builds the plant, whether to shut it
down, to operate at low capacity, or to operate at
high capacity

10
 Sunk Costs Example
• The profits from the different outcomes
are (in millions of dollars):
 Decision Revenue Cost Profit
 Sell land 0.7 0.0 0.7
 Build, shut down 0.0 0.9 -0.9
 Build, low output 2.0 3.0 -1.0
 Build, high output 3.0 4.1 -1.1
• Hence, at time 0, the company should
sell the land
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 Sunk Costs Example
• Suppose now that for some reason the
decision to build the plant is made at time 0
• The payoffs to the different strategies at time
1 are (in millions of euros):
 Decision Profits Gross of S. C. Net of S. C.
 Shut down 0.0 -0.9
 Low output -0.1 -1.0
 High output -0.2 -1.1
• Hence, the sunk cost does not affect the
optimal decision at time 1 – to shut down!
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 Sunk Costs
• There are numerous instances where
investors (and governments!) keep on
investing in loss-making project just because
they have already wasted a lot of money on
them
• The tendency for people to let sunk costs
affect their decisions is called the fallacy of
sunk cost (or the Concorde fallacy or
throwing good money after bad)
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 The Mathematics of Costs
• The average cost per unit of output is
AC(x)=TC(x)/x
• The marginal cost is MC(x)=TC’(x) in if
the cost function is differentiable
• If production can only be made in
discrete quantities, the marginal cost
function is MC(x)=TC(x+1)-TC(x)

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 Total, Marginal, and
Average Cost
40
35
30
25 TC
Cost

20 MC
15 AC
10
5
0
0,01 1 2 3 4
Quantity

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 Total Cost and Marginal
Cost
• The following relationship holds
between marginal cost and total cost:
MC(x)=TC’(x)
TC(x)=0∫x MC(s)ds+F
• Hence, total variable cost at x is the
area under the marginal cost curve and
to the left of x

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Total, Variable, and Marginal
Cost
40
35
30
25
TC
Cost

20
MC
15
10
5
0
0,01 1 2 3 4
Quantity
Area=VC(4)
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 Average and Marginal Cost
Near Zero
• If there is a fixed cost (TC(0)>0), then
average cost explodes as x goes to
zero: limx→0TC(x)/x=limx→0F/x=∞
• If there is no fixed cost (TC(0)=0), then
average cost converges to MC(0) as
production tends to zero:
limx→0TC(x)/x=limx→0(TC(x)-TC(0))/x
=MC(0)
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 Average and Marginal Cost
Near Zero
Fixed Cost No Fixed Cost

40
40
35
35
30
30
25 TC
TC 25
Cost

20 MC 20 MC

Cost
AC
15 15 AC
10 10
5 5
0 0
0,01 1 2 3 4
0,01 1 2 3 4
Quantity
Quantity

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 Relationship Between
Marginal and Average Cost
• By taking the derivative of the average cost
we obtain: AC’(x)=TC’(x)/x-TC(x)/x2
= (MC(x)-AC(x))/x
• Hence:
 Average cost is increasing (decreasing) whenever
marginal cost is higher (lower) than average cost
 If marginal cost crosses the average cost curve,
this is occurs exactly at the quantity where
average cost is minimized

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 Efficient Scale
• The output at which the average cost is
minimized is called the efficient scale of
production x*
• With a U-shaped average-cost curve it can be
found where AC’(x*)=0
• Recalling that the marginal cost crosses the
average cost curve exactly at this point gives
us a useful tool for finding this quantity:
solving MC(x*)=AC(x*)
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 Efficient Scale

40
35
30
25 TC
Cost

20 MC
15 AC
10
5
0
0,01 1 2 3 4
Quantity

22
Efficient Scale
 The Time Horizon of
Production
• Suppose Boeing Corp. currently is
producing three 747s per month at a
total cost of $65M
• What would it cost to increase
production to six 747s per month?
• Depends on the time horizon:
Next month?
In 12 months?

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 The Time Horizon of
Production
• Recall that the total cost function, TC(x), gave
the minimum cost of producing x units using
the available technology and the necessary
inputs for this
• Implicit in our derivation of this function was
that the quantity of all factors of production
(inputs) could be chosen freely
• However, this assumption is not true in the
short run
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 The Short Run and Long
Run
• The short run is defined as a time horizon
such that the quantity of some of the firm’s
factors of production are fixed
• The long run is defined as a time horizon
such that the quantity of all factors of
production are variable
• The time span of both concepts depends on
the particular industry

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 Example: Long Run
• Suppose a firm want to produce xL units
of output, that it has production function
f(K,L)=K+L, and that the market prices
of K and L are given by r<w respectively
• Solving minK,LKr+Lw subject to K+L=xL
gives us K=xL, L=0, and the long-run
total cost LTC(xL)=xLr

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 Example: Short Run
• Suppose that capital is fixed at K= xL, but that
labor is flexible in the short run
• If the firm want to increase production to x+ in
the short run, it solves:
minLxLr+Lw subject to xL+L= x+
• Solving gives us K=xL, L=x+-xL, and the short-
run total cost STC(x+,xL)=xLr+(x+-xL)w
• If the firm instead want to reduce production to
x- in the short run, cost will be the same as in
the long run STCS(x-,xL)=xLr
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 Example: Short- and Long-
Run Total Cost Functions
STC(x,xL)
Total Cost

LTC(x)

STC(xL,xL)=LTC(xL)

x- xL x+ Quantity
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 Short- and Long-Run Total
Costs Functions
• In theory, the following relationships
hold for the short-run and long-run
total cost functions (where xL is the
status-quo level of production and x is
the new level):
1. LTC(x)≤STC(x,xL)
2. LTC(xL)=STC(xL,xL)

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 Are the Two Relationships
Realistic?
• Labor utilization can be increased temporarily
by overtime instead of hiring
• Suppliers may be more likely to change
prices over time
• Assumes the mix of inputs is such that cost is
minimized at xL, but what if prices of inputs
changes dramatically so that this is not true?
• In general, more information is needed
about the firm to verify the assumptions

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 Long-Run and Short-Run
Average and Marginal Cost
3000 3000

2500 2500

2000 2000
LTC(x) LTC(x)

Cost
Cost

1500 1500
STC(x,16) STC(x,16)
1000 1000

500 500

0 0
1
3
5
7
9
11
13
15

1
3
5
7
9
11

15

19

23
25
17
19
21
23
25

13

17

21
Quantity Quantity
250
600

500 200

400 150 LMC(x)

LAC(x)
Cost

300 SMC(x,16)
SAC(x,16) 100
200
50
100
0
0
1
3
5
7
9
11

19
21
23
25
13
15
17
1
3
5
7
9
11
13
15
17
19
21
23
25

Quantity
Quantity 31
 Multiproduct Firms
• When firms produce more than one output, concepts
such as average cost are not well defined
• If production processes are independent, then each
can be treated as a separate firm
• If this is not the case, we can have either economies
of scope (cheaper to produce together) or
diseconomies of scope (cheaper to produce
separately)
• Empirical studies reveal that refineries, and car
producers have economies of scope, and railroads
diseconomies of scope in passanger and freight

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 Durable Assets
• Some assets can be used more than one period
 Buildings and land
 Machines
 Human capital
 Goodwill
 Demand-side assets such as reputation
• In theory, look at the sum of discounted of cash
flows
• Accountants use depreciation over time instead
of change in cash-flow at purchase
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 Know How
• Firms sometimes learn less costly ways of
producing by experience “learning by doing”
• The experienced curve is a way of modeling
this
• In this model total cost depends on current
production x and the cumulative amount
produced before the current period X, TC(X,x)
• Empirical support from computer chips: with
each doubling of cumulative output of
EPROM chips, average cost falls by 22%

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 Conclusions
• Total cost can be separated in avoidable and
unavoidable fixed cost, and variable cost
• Sunk costs should be ignored when making
production decisions
• At the efficient scale average cost is minimized
and marginal cost equals average cost
• Short-run total costs are generally equal to the
long-run costs at the status quo level of
production and higher at other levels

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