CDAE Class 20 Nov 2 Last class: 5. Production 6. Costs Quiz 6 (Sections 5.1 – 5.7) Today: Results of Quiz 5 6. Costs Next class: 6. Costs Important dates: Problem set 5 due Tuesday, Nov. 7 Final exam: 3:30 – 6:30pm, Friday, Dec. 15

Result of Quiz 6 N = 47 Range = 4 – 9.5 Average = 7.65

6. Costs 6.1. Basic concepts of costs 6.2. Cost minimizing input choice 6.3. Cost curves 6.4. Short-run and long-run costs 6.5. Per unit short-run cost curves 6.6. Shifts in cost curves 6.7. An example 6.8. Applications

6.1. Basic concepts of costs Opportunity cost, accounting cost, and economic cost: -- Opportunity cost : the cost of a good or service as measured by the alternative uses of the resources that are foregone by producing the good or service. e.g., one acre of land, 10 hours of labor and $20 of capital can be used to produce 800 lb. of hay OR 60 bu. of soybeans. What is the opportunity cost of producing 60 units of soybeans?

6.1. Basic concepts of costs Opportunity cost, accounting cost, and economic cost: -- Accounting cost : the cost of a good or service as measured by what was paid for it (i.e., out-of-pocket expenses, historical costs of machines and depreciation related to them, and other bookkeeping entries). e.g., accounting cost of producing 60 bu. of soybeans:

6.1. Basic concepts of costs Opportunity cost, accounting cost, and economic cost: -- Economic cost : the payment required to keep a resource in its present use, or the amount that the resource would be worth in its next best alternative use. e.g., Mr. Smith is making 60k a year with IBM -- the next best offer in this region is also 60K.

6.1. Basic concepts of costs Labor costs, capital costs, and entrepreneurial costs: Labor costs = w L Capital costs = v K Entrepreneurial cost e.g., Phil has a flexible job with a wage rate of $10 per hour. He also has his own roofing business and has just completed a project: Revenue: $3000Materials: $1100 Hired labor: $500 His labor: 50 hrs Accounting profit =Economic profit = Entrepreneurial cost =

6.1. Basic concepts of costs Two simplifying assumptions: (1) All the inputs are aggregated into labor and capital inputs (L and K) (2) The inputs are hired in perfectly competitive markets

6.1. Basic concepts of costs Costs and profits Total economic costs = TC = wL + vK Total revenues = TR = Pq = P f (L, K) Total economic profits =  = TR – TC = Pq – wL – vK = P f(L, K) – wL – vK where q = f (L, K) is the production function

6.2. Cost-minimizing input choice A graphical analysis (Fig. 6.1) What is the condition for the best point? Slope of the cost line = slope of the isoquant -w/v = -RTS w/v = RTS What will happen if the two are not equal? e.g., if w/v = 0.5 and RTS = 0.8, the producer will increase ? and decrease ? to minimize cost. Note that this is similar to the analysis of utility maximization in Chapter A firm’s expansion path.

Class exercise (Thursday, Nov. 2) If the cost is TC = 4L + 5K and the rate of technical substitution (RTS) is equal to 1.2, what will be the directions of change in L and K to minimize the cost? Why?

6.3. Cost curves Possible shapes of the total cost curve (1) Constant returns to scale (2) Decreasing returns to scale (3) Increasing returns to scale (4) Optimal scale (increasing returns to scale followed by decreasing returns to scale)

6.3. Cost curves Average cost (AC) and marginal cost (MC) (1) What is the AC and what is the MC? (2) AC and MC curves (a) Constant returns to scale (b) Decreasing returns to scale (c) Increasing returns to scale (d) Optimal scale (3) Optimal scale: Relationship between AC and MC (4) Optimal scale: Lowest AC input choice

6.4. Short run and long run costs Distinction between short run and long run Very short run: Short run: Long run: Input flexibility in the short-run and long run Short-run total costs Short-run fixed, variable & total costcurves Input choice in the short run

6.5. Per-unit short run cost curves Short-run average cost SAC = Short-run marginal costSMC = SAC and SMC curves (Fig. 6.8) Long-run average cost and marginal cost Relationship between short-run and long-run cost curves