COST ANALYSIS Chapter 6 slide 1 General Principles: - Only Differential Costs Matter. Ignore Costs that are fixed across Options. Examples MBA Degree City-Owned.

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COST ANALYSIS Chapter 6 slide 1 General Principles: - Only Differential Costs Matter. Ignore Costs that are fixed across Options. Examples MBA Degree City-Owned Land Surplus Factory Space Starting a Business Cost of Capital $100 K at 15% Revenues $200 K Expenses -$110 K Your Wage -$65 K -$15 K Economic Profit $10 K - Opportunity Costs Should Not be Ignored.

ORDERING A BEST SELLER Demand: P = 24 - Q MC = $12 per book A. Find optimal Q and P. MR = Q = 12 Q = 6 hundred, P = $18 Cont. = ( )(600) = $3,600. B. Suppose average book earns $4 and shelf space is limited. MC = (Opp Cost) Q = 4 hundred, P = $20. Cont. = ( )(400) = $1,600. C. Suppose demand falls to P = Q. How many of the 400 books should the store sell and how many should it return for $6 each? MC = (Opp Cost) MR = Q = 10, Q = 2 hundred, P = $14. Cont. = (14 -16)(200) + (6 - 12)(200) = -$1,

COST ANALYSIS MC Short-Run Cost Behavior Diminishing Marginal Productivity leads to Increasing MC. Example: MC = Wage/MP L W = $12/Hr, MP L = 4/Hr then MC = $3/unit AC 6.3

LONG-RUN COST 6.4 The shape of LR average cost depends upon returns to scale. Constant LAC reflects Constant Returns to Scale. SAC 1 SAC 2 SAC 3 Flat LAC reflects Constant Returns to Scale. With plant fixed, SAC is U-shaped and lies above LAC.

OPTIMAL OUTPUT MC Q* P* Demand MR Q* Low Demand versus High Demand AC 6.5 In either case, the firm ’ s Optimal output occurs where: MR = MC

THE SHUT-DOWN RULE MC P* Demand MR 1. In the long run, the firm should shut down when: P < AC. AVC 6.6 AC 2. In the short run, the firm should produce Q* because: P > AVC. Q*