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The Cost of
Production
Topics to be Discussed
Chapter 7 Slide 2
Topics to be Discussed
Chapter 7 Slide 3
Introduction
Chapter 7 Slide 4
Introduction
Chapter 7 Slide 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 7 Slide 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 7 Slide 7
Measuring Cost:
Which Costs Matter?
An Example
A firm owns its own building and pays no
rent for office space
Chapter 7 Slide 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 7 Slide 9
Measuring Cost:
Which Costs Matter?
An Example
A firm pays $500,000 for an option to buy a
building.
Chapter 7 Slide 10
Choosing the Location
for a New Law School Building
Chapter 7 Slide 11
Choosing the Location
for a New Law School Building
Chapter 7 Slide 12
Choosing the Location
for a New Law School Building
Fixed Cost
Does not vary with the level of output
Variable Cost
Cost that varies as output varies
Chapter 7 Slide 15
Measuring Cost:
Which Costs Matter?
Fixed Cost
Cost paid by a firm that is in business
regardless of the level of output
Sunk Cost
Cost that have been incurred and cannot
be recovered
Chapter 7 Slide 16
Measuring Cost:
Which Costs Matter?
Chapter 7 Slide 17
Measuring Cost:
Which Costs Matter?
Pizza
Chapter 7 Slide 18
A Firm’s Short-Run Costs ($)
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)
VC TC
MC
Q Q
Chapter 7 Slide 20
Cost in the Short Run
TFC TVC
ATC
Q Q
Chapter 7 Slide 21
Cost in the Short Run
TC
ATC AFC AVC or
Q
Chapter 7 Slide 22
Cost in the Short Run
Chapter 7 Slide 23
Cost in the Short Run
Chapter 7 Slide 24
Cost in the Short Run
VC
MC
Q
VC wL
Chapter 7 Slide 25
Cost in the Short Run
Continuing:
VC wL
wL
MC
Q
Chapter 7 Slide 26
Cost in the Short Run
Continuing:
Q
MPL
L
L 1
L for a 1 unit Q
Q MPL
Chapter 7 Slide 27
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 7 Slide 28
Cost in the Short Run
Chapter 7 Slide 29
Biaya jangka pendek suatu perusahaan
(Rp)
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)
200
0 1 2 3 4 5 6 7 8 9 10 11 12 13 Output
Chapter 7 Slide 31
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 7 Slide 32
Cost Curves for a Firm
Chapter 7 Slide 33
Cost Curves for a Firm
Chapter 7 Slide 34
Cost Curves for a Firm
Chapter 7 Slide 35
Operating Costs for Aluminum Smelting
($/Ton - based on an output of 600 tons/day)
Electricity $316
Alumina 369
Other raw materials 125
Plant power and fuel 10
Subtotal $820
Chapter 7 Slide 36
Operating Costs for Aluminum Smelting
($/Ton - based on an output of 600 tons/day)
Labor $150
Maintenance 120
Freight 50
Subtotal $320
Total operating costs $1140
Chapter 7 Slide 37
The Short-Run Variable
Costs of Aluminum Smelting
Cost
($ per ton)
1300
MC
1200
1140
1100 AVC
Chapter 7 Slide 38
Cost in the Long Run
The User Cost of Capital
Chapter 7 Slide 39
Cost in the Long Run
The User Cost of Capital
Example
Delta buys a Boeing 737 for $150 million
with an expected life of 30 years
Chapter 7 Slide 40
Cost in the Long Run
The User Cost of Capital
Example
User Cost of Capital = $5 million +
(.10)($150 million – depreciation)
Year 1 = $5 million +
(.10)($150 million) = $20 million
Year 10 = $5 million +
(.10)($100 million) = $15 million
Chapter 7 Slide 41
Cost in the Long Run
The User Cost of Capital
Chapter 7 Slide 42
Cost in the Long Run
The User Cost of Capital
Airline Example
Depreciation Rate = 1/30 = 3.33/yr
Chapter 7 Slide 43
Cost in the Long Run
The Cost Minimizing Input Choice
Assumptions
Two Inputs: Labor (L) & capital (K)
Price of labor: wage rate (w)
The price of capital
R = depreciation rate + interest rate
Chapter 7 Slide 44
Cost in the Long Run
The
TheCost
UserMinimizing
Cost of Capital
Input Choice
Question
If capital was rented, would it change the
value of r ?
Chapter 7 Slide 45
Cost in the Long Run
The
TheCost
UserMinimizing
Cost of Capital
Input Choice
Chapter 7 Slide 46
Cost in the Long Run
The Isocost Line
Rewriting C as linear:
K = C/r - (w/r)L
Slope of the isocost: K L w r
Chapter 7 Slide 47
Choosing Inputs
Chapter 7 Slide 48
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.
Q1
K3
C0 C1 C2
L2 L1 L3 Labor per year
Chapter 7 Slide 49
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).
Q1
C2 C1
Chapter 7 Slide 50
Cost in the Long Run
MRTS - K MP L
L MPK
and MPL w
MPK r
Chapter 7 Slide 51
Cost in the Long Run
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 7 Slide 52
Cost in the Long Run
Question
If w = $10, r = $2, and MPL = MPK,
which input would the producer use
more of? Why?
Chapter 7 Slide 53
The Effect of Effluent
Fees on Firms’ Input Choices
Chapter 7 Slide 54
The Effect of Effluent
Fees on Firms’ Input Choices
Chapter 7 Slide 55
The Effect of Effluent
Fees on Firms’ Input Choices
Chapter 7 Slide 56
The Cost-Minimizing
Response to an Effluent Fee
Capital
(machine
hours per Slope of
month) isocost = -10/40
5,000 = -0.25
4,000
3,000
A
2,000
Waste Water
0 5,000 10,000 12,000 18,000 20,000 (gal./month)
Chapter 7 Slide 57
The Cost-Minimizing
Response to an Effluent Fee
Capital
(machine Prior to regulation the
hours per Slope of
isocost = -20/40 firm chooses to produce
month) an output using 10,000
= -0.50
5,000 gallons of water and 2,000
machine-hours of capital at A.
F
4,000
B Following the imposition
3,500 of the effluent fee of $10/gallon
the slope of the isocost changes
3,000 which the higher cost of water to
capital so now combination B
A is selected.
2,000
Chapter 7 Slide 58
The Effect of Effluent
Fees on Firms’ Input Choices
Observations:
The more easily factors can be
substituted, the more effective the fee is
in reducing the effluent.
The greater the degree of substitutes,
the less the firm will have to pay (for
example: $50,000 with combination B
instead of $100,000 with combination A)
Chapter 7 Slide 59
Cost in the Long Run
Chapter 7 Slide 60
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 $3000 Isocost Line output in the long-run.
Chapter 7 Slide 61
A Firm’s Long-Run Total Cost Curve
Cost
per
Year
Expansion Path
F
3000
E
2000
D
1000
Output, Units/yr
100 200 300
Chapter 7 Slide 62
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 63
The Inflexibility of
Short-Run Production
Capital E
per The long-run expansion
year path is drawn as before..
C
Long-Run
Expansion Path
A
K2
Short-Run
P Expansion Path
K1 Q2
Q1
L1 L2 B L3 D F
Labor per year
Chapter 7 Slide 64
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 65
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 66
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 67
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 68
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 69
Long-Run Average
and Marginal Cost
Cost
($ per unit
of output LMC
LAC
Output
Chapter 7 Slide 70
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 7 Slide 71
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 72
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 73
Long-Run Versus
Short-Run Cost Curves
Ec (C / C ) /( Q / Q)
Chapter 7 Slide 74
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 75
Long-Run Versus
Short-Run Cost Curves
Chapter 7 Slide 76
Long-Run Cost with
Constant Returns to Scale
LAC =
LMC
Q1 Q2 Q3 Output
Chapter 7 Slide 77
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 7 Slide 78
Long-Run Cost with Economies
and Diseconomies of Scale
Cost
($ per unit SAC1 SAC3 LAC
of output
SAC2
A
$10
$8
B
Q1 Output
Chapter 7 Slide 79
Long-Run Cost with
Constant Returns to Scale
Chapter 7 Slide 80
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 7 Slide 81
Production with Two
Outputs--Economies of Scope
Examples:
Chicken farm--poultry and eggs
Automobile company--cars and trucks
University--Teaching and research
Chapter 7 Slide 82
Production with Two
Outputs--Economies of Scope
Chapter 7 Slide 83
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 7 Slide 84
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 7 Slide 85
Product Transformation Curve
Each curve shows
Number combinations of output
of tractors with a given combination
of L & K.
Number of cars
Chapter 7 Slide 86
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 7 Slide 87
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 7 Slide 88
Production with Two
Outputs--Economies of Scope
Chapter 7 Slide 89
Production with Two
Outputs--Economies of Scope
Interpretation:
If SC > 0 -- Economies of scope
If SC < 0 -- Diseconomies of scope
Chapter 7 Slide 90
Economies of Scope
in the Trucking Industry
Issues
Truckload versus less than truck load
Direct versus indirect routing
Length of haul
Chapter 7 Slide 91
Economies of Scope
in the Trucking Industry
Questions:
Economies of Scale
Are large-scale, direct hauls cheaper
and more profitable than individual
hauls by small trucks?
Are there cost advantages from
operating both direct and indirect
hauls?
Chapter 7 Slide 92
Economies of Scope
in the Trucking Industry
Empirical Findings
An analysis of 105 trucking firms
examined four distinct outputs.
Short hauls with partial loads
Intermediate hauls with partial loads
Long hauls with partial loads
Hauls with total loads
Chapter 7 Slide 93
Economies of Scope
in the Trucking Industry
Empirical Findings
Results
SC = 1.576 for reasonably large firm
SC = 0.104 for very large firms
Interpretation
Combining partial loads at an intermediate
location lowers cost management difficulties
with very large firms.
Chapter 7 Slide 94
Dynamic Changes in
Costs--The Learning Curve
Chapter 7 Slide 95
The Learning Curve
Hours of labor
per machine lot
10
2
Cumulative number of
machine lots produced
0 10 20 30 40 50
Chapter 7 Slide 96
The Learning Curve
Hours of labor
The horizontal axis per machine lot
measures the
cumulative number of 10
hours of machine
tools the firm has 8
produced
6
The vertical axis
measures the number 4
of hours of labor
needed to produce 2
each lot.
0 10 20 30 40 50
Chapter 7 Slide 97
Dynamic Changes in
Costs--The Learning Curve
If N 1 :
L equals A + B and this measures labor
input to produce the first unit of output
If 0 :
Labor input remains constant as the
cumulative level of output increases, so
there is no learning
Chapter 7 Slide 99
Dynamic Changes in
Costs--The Learning Curve
If 0 and N increases :
L approaches A, and A represent minimum
labor input/unit of output after all learning
has taken place.
The larger :
The more important the learning effect.
8
Doubling cumulative output causes
a 20% reduction in the difference
6 between the input required and
minimum attainable input requirement.
4
0.31
2
Cumulative number of
0 10 20 30 40 50 machine lots produced
Observations
Cost
($ per unit
of output)
Economies of Scale
A
B
AC1
Learning
C AC2
Output
10 1.00 10.0
20 .80 18.0 (10.0 + 8.0)
30 .70 25.0 (18.0 + 7.0)
40 .64 31.4 (25.0 + 6.4)
50 .60 37.4 (31.4 + 6.0)
60 .56 43.0 (37.4 + 5.6)
70 .53 48.3 (43.0 + 5.3)
80 and over .51 53.4 (48.3 + 5.1)
Dynamic Changes in
Costs--The Learning Curve
Scenario
A new firm enters the chemical processing
industry.
Do they:
1) Produce a low level of output and sell at a
high price?
1) To determine if it is profitable to
enter an industry.
Variable
General Motors
cost
Nissan
Toyota
Honda
Volvo
Ford
Chrysler
Quantity of Cars
VC Q
The linear cost function is applicable
only if marginal cost is constant.
Marginal cost is represented by .
VC Q Q 2
VC Q Q Q 2 3
AVC Q Q2
Output
(per time period)
EC = 1, SCI = 0: no economies or
diseconomies of scale
6.5
6.0
A 1955
5.5
5.0
1970
Findings
Decline in cost
Not due to economies of scale
Was caused by:
Lower input cost (coal & oil)
Improvements in technology
Questions