1 Module 14 Cost in the Short Run

Objectives:Objectives:  Understand the relationship between the short run production function and short run costs. 2

Objectives:Objectives:  Define total cost, total variable cost and total fixed cost.  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost. 2

Objectives:Objectives:  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost.  Define average total cost, average variable cost, average fixed cost and marginal cost.  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost.  Define average total cost, average variable cost, average fixed cost and marginal cost. 2

Objectives:Objectives:  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost.  Define average total cost, average variable cost, average fixed cost and marginal cost.  Know and be able to use the cost formulas to calculate costs.  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost.  Define average total cost, average variable cost, average fixed cost and marginal cost.  Know and be able to use the cost formulas to calculate costs. 2

Objectives:Objectives:  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost.  Define average total cost, average variable cost, average fixed cost and marginal cost.  Know and be able to use the cost formulas to calculate costs.  Understand the relationship between marginal product and marginal cost of production.  Understand the relationship between the short run production function and short run costs.  Define total cost, total variable cost and total fixed cost.  Define average total cost, average variable cost, average fixed cost and marginal cost.  Know and be able to use the cost formulas to calculate costs.  Understand the relationship between marginal product and marginal cost of production. 2

 Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost. Objectives …cont’d. 3

 Understand the relationship between marginal product and marginal cost of production.  Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost.  Understand what happens to average fixed cost as output increases and what this implies about the average total cost and average variable cost curves.  Understand the relationship between marginal product and marginal cost of production.  Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost.  Understand what happens to average fixed cost as output increases and what this implies about the average total cost and average variable cost curves. Objectives …cont’d. 3

 Understand the relationship between marginal product and marginal cost of production.  Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost.  Understand what happens to average fixed cost as output increases and what this implies about the average total cost and average variable cost curves.  Be able to graph the cost curves.  Understand the relationship between marginal product and marginal cost of production.  Understand the relationship between marginal cost and average total cost and marginal cost and average variable cost.  Understand what happens to average fixed cost as output increases and what this implies about the average total cost and average variable cost curves.  Be able to graph the cost curves. Objectives …cont’d. 3

 Costs are derived from the production function. Objective 1 Understand the relationship between the short run production function and short run costs 4

 Costs are derived from the production function.  Consider a simple 2-input short run production function, like the one we used for the Acme Box Company: like the one we used for the Acme Box Company: Q = f (L, K 0 ) where L= the variable input, labor and K 0 = the fixed input, capital Objective 1 Understand the relationship between the short run production function and short run costs 4

 Costs are derived from the production function.  Consider a simple 2-input short run production function, like the one we used for the Acme Box Company: like the one we used for the Acme Box Company: Q = f (L, K 0 ) where L= the variable input, labor and K 0 = the fixed input, capital  From the production function we can write an expression for total cost. Total Cost = Labor Costs + Capital Cost Total Cost = Labor Costs + Capital Cost = Total Variable Cost + Total Fixed Cost = Total Variable Cost + Total Fixed Cost Objective 1 Understand the relationship between the short run production function and short run costs 4

 Total Fixed Costs (TFC)  Total Fixed Costs (TFC) refers to the total expenditure by the firm for fixed inputs. Objective 2 Define Total Fixed Cost, …. 5

 Total Fixed Costs (TFC)  Total Fixed Costs (TFC) refers to the total expenditure by the firm for fixed inputs.  overheads  Fixed costs do not change when firms increase or decrease their output. The lay person thinks of fixed costs as overheads. Objective 2 Define Total Fixed Cost, …. 5

 Total Fixed Costs (TFC)  Total Fixed Costs (TFC) refers to the total expenditure by the firm for fixed inputs.  overheads  Fixed costs do not change when firms increase or decrease their output. The lay person thinks of fixed costs as overheads. Objective 2 Define Total Fixed Cost, …. 5

16   Total Variable Costs (TVC) refer to total expenditure on variable inputs, for example, the wages paid for labor services and the cost of raw materials purchased to produce the product. 6 Objective 2: …total variable cost and total cost

  Total Variable Costs (TVC) refer to total expenditure on variable inputs, for example, the wages paid for labor services and the cost of raw materials purchased to produce the product.   Total Costs (TC) refer to the total expenditure on all inputs used to produce a product. It is the sum of fixed costs and variable costs.   Total Variable Costs (TVC) refer to total expenditure on variable inputs, for example, the wages paid for labor services and the cost of raw materials purchased to produce the product.   Total Costs (TC) refer to the total expenditure on all inputs used to produce a product. It is the sum of fixed costs and variable costs. 6 Objective 2: …total variable cost and total cost

18 Objective 2: ….fixed cost, variable cost and total cost Total Cost = Total Fixed Cost + Total Variable Cost

Can you determine these values? 8

Objective 3  Average costs  Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables,one corresponding to each category of costs. Define average total cost, average variable cost, average fixed cost and marginal cost 9

Objective 3  Average costs  Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables,one corresponding to each category of costs. 1.Average Fixed cost (AFC) Define average total cost, average variable cost, average fixed cost and marginal cost 9

Objective 3  Average costs  Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables,one corresponding to each category of costs. 1.Average Fixed cost (AFC) 2.Average Variable Cost (AVC) Define average total cost, average variable cost, average fixed cost and marginal cost 9

Objective 3  Average costs  Average costs tells you how much a product costs per unit of output. In the short run, there are three average cost variables,one corresponding to each category of costs. 1.Average Fixed cost (AFC) 2.Average Variable Cost (AVC) 3.Average Total Cost (ATC) or simply Average Cost (AC) Define average total cost, average variable cost, average fixed cost and marginal cost 9

Total Cost = Average Total Cost x Quantity 10 Objective 3…the three “average” cost variables..

Total Cost = Average Total Cost x Quantity 10 Objective 3…the three “average” cost variables..

Total Cost = Average Total Cost x Quantity    10 Objective 3…the three “average” cost variables..

 Marginal Cost  Marginal Cost is the addition to total cost resulting from producing one more unit of output. 11

 Marginal Cost  Marginal Cost is the addition to total cost resulting from producing one more unit of output. 11

 Marginal Cost  Marginal Cost is the addition to total cost resulting from producing one more unit of output. 11

 Marginal Cost  Marginal Cost is the addition to total cost resulting from producing one more unit of output.  Since fixed cost is constant, the equation above equals: 11

 Marginal Cost  Marginal Cost is the addition to total cost resulting from producing one more unit of output.  Since fixed cost is constant, the equation above equals:  In the short run, marginal cost is independent of fixed costs. 11

Objective 4 Know and be able to use the cost formulas to calculate costs. Know and be able to use the cost formulas to calculate costs. 12

Objective 4  Example: We will revisit the Acme Box Company. Suppose Acme’s Fixed Costs equals $1,000 and the firm hires labor at a constant wage of $60 per unit. Know and be able to use the cost formulas to calculate costs. Know and be able to use the cost formulas to calculate costs. 12

Suppose Acme’s fixed costs equals $1,000. Labor(L) Total Product or Output (Q) Marginal Product of labor (MPL) (MPL) Total Fixed Cost (TFC)$ Objective 4: Calculating Costs … 13

Acme’s hires labor at a constant wage of $60 per unit of labor. Its labor are its variable cost. Labor Costs = wage rate x labor units Objective 4: Calculating Costs … (1)(2)(3)(4)(5)=(1)x$60 Labor(L) Total Product (Q) Marginal Product (MPL) (MPL) Total Fixed Cost (TFC) $ Total Variable Cost (TVC) $ x60= x60= x60=

Acme’s Total Cost = Fixed Cost + Variable Cost Objective 4: Calculating Costs … (1)(2)(3)(4)(5) (6)=(4) +(5) Labor(L) Total Product (Q) Marginal Product (MPL) (MPL) Total Fixed Cost (TFC) $ Total Variable Cost (TVC) $ Total Cost (TC)$ = = =

Average Fixed Cost = Fixed Cost ÷ Output Objective 4: Calculating Costs … 16 (1)(2)(3)(4)(5) (6)=(4) +(5) (7)=(4) (2) (7)=(4) ÷(2) Labor(L) Total Product or Output (Q) Marginal Product (MPL) (MPL) Total Fixed Cost (TFC) $ Total Variable Cost (TVC) $ Total Cost (TC)$ Average Fixed Cost (AFC) $ ÷8= ÷23= ÷42=

Average Variable Cost = Total Variable Cost ÷ Output Objective 4: Calculating Costs … 17 (1)(2)(3)(4)(5)(6)(7) (8)=(5) +(2) Labor(L) Total Product or Output (Q) Marginal Product (MPL) (MPL) Total Fixed Cost (TFC) $ Total Variable Cost (TVC) $ Total Cost (TC)$ Average Fixed Cost (AFC in $) Average Variable Cost (AVC in $) ÷8= ÷23= ÷42=

Average Total Cost = Total Cost ÷ Output, or Average Total Cost = Average Fixed Cost + Average Variable Cost Objective 4: Calculating Costs … 18 (1)(2)(3)(4)(5)(6)(7)(8) (9)=(6) (2) (9)=(6) ÷ (2) Labor(L) Total Product or Output (Q) Marginal Product (MPL) (MPL) Total Fixed Cost (TFC) $ Total Variable Cost (TVC) $ Total Cost (TC)$ Average Fixed Cost (AFC in $) Average Variable Cost (AVC in $) Average Total Cost (ATC in $) ÷8= ÷ 8= ÷23= ÷23= ÷42= ÷ 42=

Marginal Cost = ∆ Total Cost ÷ ∆ Output, or in the short run, Marginal Cost = ∆ Variable Cost ÷ ∆ Output Objective 4: Calculating Costs … 19 (1)(2)(3)(4)(5)(6)(7)(8)(9)(10)=∆(5)÷(3) Labor(L) Total Product or Output (Q) Marginal Product (MPL) (MPL) Fixed Cost (TFC) $ Variable Cost (TVC) $TotalCost(TC)$ Average Fixed Cost (AFC) $ Average Variable Cost (AVC) $ Average Total Cost (ATC) $ Marginal Cost (MC)$ ÷ 8= ÷ 15= ÷ 19=

Objective 5 Understand the relationship between marginal product and marginal cost of production. 20

Objective 5 Below is a segment of the Table for the Acme Box Company. Understand the relationship between marginal product and marginal cost of production. 20 Labor(L) Total Product or Output (Q) Marginal Product of labor (MPL) Marginal Cost (MC)$

Objective 5 Below is a segment of the Table for the Acme Box Company. Understand the relationship between marginal product and marginal cost of production. 20 Labor(L) Total Product or Output (Q) Marginal Product of labor (MPL) Marginal Cost (MC)$ Increasing Marginal Returns segment

Objective 5 Below is a segment of the Table for the Acme Box Company. Understand the relationship between marginal product and marginal cost of production. 20 Labor(L) Total Product or Output (Q) Marginal Product of labor (MPL) Marginal Cost (MC)$ Increasing Marginal Returns segment Diminishing Marginal Returns segment

 In the increasing marginal returns segment, when marginal product is rising, marginal cost is falling. Objective 5:..the relationship between marginal product and marginal cost of production. 21

 In the increasing marginal returns segment, when marginal product is rising, marginal cost is falling.  In the diminishing marginal returns segment, when marginal product is falling, marginal cost is rising. Objective 5:..the relationship between marginal product and marginal cost of production. 21

 In the increasing marginal returns segment, when marginal product is rising, marginal cost is falling.  In the diminishing marginal returns segment, when marginal product is falling, marginal cost is rising.  In the negative marginal returns segment, what do you think is happening to marginal cost? Yes, it is rising fast! Objective 5:..the relationship between marginal product and marginal cost of production. 21

What then is the shape of the marginal cost curve? 22 Objective 5:..the law of diminishing marginal returns and the shape of the marginal cost curve

What then is the shape of the marginal cost curve? It is U-shaped. 22 Objective 5:..the law of diminishing marginal returns and the shape of the marginal cost curve

Objective 6: Understand the relationship between marginal cost, average total cost, and average variable cost 23

Objective 6:  When marginal cost (MC) is less than either average total cost (ATC) or average variable cost (AVC), it causes ATC or AVC to fall. Understand the relationship between marginal cost, average total cost, and average variable cost 23

Objective 6:  When marginal cost (MC) is less than either average total cost (ATC) or average variable cost (AVC), it causes ATC or AVC to fall.  When MC is greater than either ATC or AVC, it causes ATC or AVC to rise.  When marginal cost (MC) is less than either average total cost (ATC) or average variable cost (AVC), it causes ATC or AVC to fall.  When MC is greater than either ATC or AVC, it causes ATC or AVC to rise. Understand the relationship between marginal cost average total cost and average variable cost average total cost and average variable cost 23

Objective 6:  When marginal cost (MC) is less than either average total cost (ATC) or average variable cost (AVC), it causes ATC or AVC to fall.  When MC is greater than either ATC or AVC, it causes ATC or AVC to rise.  The MC curve intersects both the AVC and ATC curves at their minimum points.  When marginal cost (MC) is less than either average total cost (ATC) or average variable cost (AVC), it causes ATC or AVC to fall.  When MC is greater than either ATC or AVC, it causes ATC or AVC to rise.  The MC curve intersects both the AVC and ATC curves at their minimum points. Understand the relationship between marginal cost, average total cost, and average variable cost average total cost, and average variable cost 23

 The average total cost and average variable curves are also U-shaped. 24 Objective 6: …the marginal cost, average total cost and average variable cost curves

 The average total cost and average variable curves are also U-shaped. 24 Objective 6: …the marginal cost, average total cost and average variable cost curves  Like the marginal cost curve, their shapes are also influenced by the law of diminishing marginal returns.

Objective 7 Understand what happens to average fixed cost as output increases cost as output increases. 25

 Average fixed costs falls as output increases.....think of this as “spreading your overheads”. Objective 7 Understand what happens to average fixed cost as output increases cost as output increases. 25

ATC = AVC + AFC ATC = AVC + AFC  AFC = ATC – AVC 26

ATC = AVC + AFC ATC = AVC + AFC  AFC = ATC – AVC  As output expands, AFC gets smaller and smaller, which means that the difference between the ATC and the AVC curves decreases. 26

ATC = AVC + AFC ATC = AVC + AFC  AFC = ATC – AVC  As output expands, AFC gets smaller and smaller, which means that the difference between the ATC and the AVC curves decreases. 26

Objective 8 Be able to graph the cost curves 27

Graph the cost curves using the data for the Acme Box Company. Objective 8 Be able to graph the cost curves 27

Graph the cost curves using the data for the Acme Box Company. Can you identify the curves in the diagram? Graph the cost curves using the data for the Acme Box Company. Can you identify the curves in the diagram? Objective 8 Be able to graph the cost curves 27

64 H = Average Fixed Cost curve 31

E = Marginal Cost curve 28

F = Average Total Cost curve 29

G = Average variable Cost curve 30

68 E = Marginal Cost curve a = minimum point on the marginal cost curve. Diminishing marginal returns set in at this point. 28

69 G = Average Variable Cost curve b = minimum point on the average variable cost curve. The marginal cost curve cuts the average variable cost curve at this point. 30

70 F = Average Total Cost curve C = minimum point on the average total cost curve. The marginal cost curve cuts the average total cost at this point. 29

You should be able to draw and identify these graphs. 32