Managerial Economics Eighth Edition Truett + Truett Chapter 6: Cost of Production John Wiley & Sons, Inc. 11/17/2018 Slides by Jim Witsmeer

Session Outline Types of Costs ($) Costs in the Long Run Total Average Marginal Interrelationships Costs in the Short Run Fixed Variable Total Average Marginal Comparison with Long Run Interrelationships Cost Elasticity Cost Estimation 11/17/2018

Discussion of Costs ($) Social costs Private costs Implicit or opportunity costs Historical or explicit costs Fixed costs (do not vary with output quantity) Variable costs (vary with output quantity) Semi-variable costs (can divide into fixed & variable) Incremental costs (added cost due to action) Why are all costs considered variable in the long run? Should social costs be considered in business decisions? 11/17/2018

Long-Run Total Cost (LTC) Input b L K Long-Run Total Cost is the least cost combination of inputs for each production quantity (AKA, the expansion path) 11/17/2018

Long-Run Average & Marginal Cost (LAC & LMC) Long-Run Average Cost $ Q Arc LMC LMC Long-Run Marginal Cost 11/17/2018

Relationship of LTC, LAC and LMC Long-Run Marginal Cost (LMC) is minimum when the rate of increase of Long-Run Total Cost is smallest. Long-Run Marginal Cost (LMC) equals Long-Run Average Cost (LAC) when Long-Run Average Cost (LAC) is at its minimum 11/17/2018

Numerical Example Step through long-run cost numerical example in the textbook 11/17/2018

Short-Run Total Cost (STC) In the short run we have fixed costs in addition to variable costs. Short-Run Total Cost (STC) equals Total Fixed Cost (TFC) plus Total Variable Cost (TVC). TFC does not change with production output. TVC increases as quantity produced is increased. 11/17/2018

Short-Run Average & Marginal Cost (SAC & SMC) Average Fixed Cost is Total fixed Cost divided by production output. Similarly Average Variable Cost is: Short–Run Average Total Cost: Short-Run Marginal Cost is: or 11/17/2018

Comparing Long and Short Run Costs On the Long-Run Total Cost curve every point represents a least-cost combination. On the Short-Run Total Cost curve one or more inputs are fixed so that only a single point can be a least-cost combination of inputs. The STC curves intersect the cost axis at the value of the Total Fixed Cost (TFC). 11/17/2018

Relationship of (STC, TVC, TFC, SMC, SAC, AVC, AFC & SAC) TVC = PLL TFC= PKK STC The minimum short-run marginal cost occurs where TFC and TVC have the least slope. Minimum average variable cost occurs when AVC = SMC. Minimum short-run average cost occurs when SAC = SMC. 11/17/2018

Relationship of Average Product of L and Average Variable Cost (AVC) If the average productivity of the variable input increases there will be a corresponding drop in the average variable cost. 11/17/2018

Relationship of Marginal Product of L and Short-Run Marginal Cost Q L Arc MPL Arc SMCL $ If the marginal productivity of the variable input increases there will be a corresponding drop in the short-run marginal cost. Similarly using calculus 11/17/2018

Relationship of Short-Run to Long-Run Average Costs In the long run all total costs represent least-costs. Therefore all average costs must be least cost as well. There are various short-run cost curves for various values of the fixed input. In the short run only one point represents least cost. The optimum operating point in the short run (minimum SAC) is normally higher than the least cost in the long run. 11/17/2018

Cost Elasticity Cost Elasticity: Percentage change in LTC Percentage change in Q Cost Elasticity: or Economies of scale correspond to Increasing Returns to Scale Diseconomies of scale correspond to Decreasing Returns to Scale Economies of scale or Diseconomies of scale or 11/17/2018

Is the LAC Curve Continuous and Stable? NO,it has discrete changes (see Figure 6-15 in text) because: Not all combinations of inputs are practical Processes make discrete jumps NO, it can change because of: Introduction of new technology The learning curve Economies of scope 11/17/2018

Choosing the Optimal Plant Size How many plants should we have? One large plant gains possible economies of scale. Many plants reduce transportation costs. One large plant is more vulnerable to labor disputes. One large plant is more vulnerable to acts of God. Many plants increase political representation. 11/17/2018

Estimating Costs Similar to estimating demand but generally more accurate. Estimating methods include: Regression analysis using linear and other specialized functions General forecasting methods Product specialized forecasting methods 11/17/2018

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