MICROECONOMICS: Theory & Applications Chapter 8: The Cost of Production By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc. 11th Edition, Copyright 2012 PowerPoint prepared by Della L. Sue, Marist College

Learning Objectives Delineate the nature of a firm’s cost – explicit as well as implicit. Outline how cost is likely to vary with output in the short run and various measures of short-run cost. Detail the typical shapes of a firm’s short-run cost curves. See how a firm will choose to combine inputs in its production process in the long run when all inputs are variable. Show how input price changes affect a firm’s cost curves. (continued) Copyright 2012 John Wiley & Sons, Inc.

Learning Objectives (continued) Differentiate between a firm’s long-run and short-run cost curves. Understand how the minimum efficient scale of production is related to market structure. Cover economies of scope – is it cheaper for one firm to produce products jointly than it is for separate firms to produce the same products independently? Overview how cost functions can be empirically estimated through surveys and regression analysis. Copyright 2012 John Wiley & Sons, Inc.

The Nature of Cost Recall: Explicit costs – arise from transactions in which the firm purchases inputs or the services of inputs from other parties Implicit costs – costs associated with the use of the firm’s own resources and reflect the fact that these resources could be employed elsewhere Opportunity cost reflects both explicit and implicit costs. Copyright 2012 John Wiley & Sons, Inc.

Measures of Short-Run Cost Total fixed cost (TFC) – the cost incurred by the firm that does not depend on how much output it produces Total variable cost (TVC) – the cost incurred by the firm that depends on how much output it produces Copyright 2012 John Wiley & Sons, Inc.

Five Other Measures of Short-Run Cost Total cost (TC) – the sum of total fixed and total variable cost at each output level Marginal cost (MC) – the change in total cost that results from a one-unit change in output Average fixed cost (AFC) – total fixed cost divided by the amount of output Average variable cost (AVC) – total variable cost divided by the amount of output Average total cost (ATC) – total cost divided by the output Copyright 2012 John Wiley & Sons, Inc.

Table 8.1 Copyright 2012 John Wiley & Sons, Inc.

Behind Cost Relationships A firm’s costs are determined by its production function: Input combinations (quantities) Input prices The shape of the TVC curve is determined by the shape of the TP curve, which in turn reflects diminishing marginal returns. Copyright 2012 John Wiley & Sons, Inc.

Figure 8.1 – From Total Product to Total Variable Cost Copyright 2012 John Wiley & Sons, Inc.

Figure 8.2 - Short-Run Total and Per-Unit Cost Curves Copyright 2012 John Wiley & Sons, Inc.

Marginal Cost Law of diminishing marginal returns => marginal product curve of the variable input generally rises and then falls as output increases. The marginal product of labor varies with output => marginal cost also varies with output As a result, the MC curve will first fall and then rise. Thus, the law of diminishing marginal returns lies behind the MC curve. Copyright 2012 John Wiley & Sons, Inc.

Average Cost The average product curve rises, reaches a maximum, and then falls, due to the law of diminishing marginal productivity. As a result, the AVC curve will fall and then rise. The AFC curve declines over the entire range of output as the amount of total fixed cost is spread over ever-larger rates of output. The ATC curve is the sum of AFC and AVC. It measures the average unit cost of all inputs, both fixed and variable, and must also be U-shaped. Copyright 2012 John Wiley & Sons, Inc.

Marginal-Average Relationships When marginal cost is below average (total or variable) cost, average cost will decline. When marginal cost is above average cost, average cost rises. When average cost is at a minimum, marginal cost is equal to average cost. Copyright 2012 John Wiley & Sons, Inc.

Figure 8.3 – Graphical Derivation of Average and Marginal Cost Curves Copyright 2012 John Wiley & Sons, Inc.

Isocost Lines An isocost line is a line that identifies all the combinations of capital and labor, two factor inputs, that can be purchased at a given total cost. The line intersects each axis at the quantity of that input that the firm could purchase if only that input were purchased. The slope of an isocost line is (minus) the ratio of input prices, w/r, indicating the relative prices of inputs. Copyright 2012 John Wiley & Sons, Inc.

Least Costly Input Combination A point of tangency between an isocost line and an isoquant show the least costly way of producing a given output level. Alternatively, a point of tangency shows the maximum output attainable at a given cost as well as the minimum cost necessary to produce that output. Copyright 2012 John Wiley & Sons, Inc.

Interpreting the Tangency Points Golden rule of cost minimization: a rule that says that to minimize cost, the firm should employ inputs in such a way that the marginal product per dollar spent is equal across all inputs Copyright 2012 John Wiley & Sons, Inc.

If the firm is not producing at a tangency point… Whenever MPL/w > MPK/r, a firm can increase output without increasing production cost by shifting outlays from capital to labor. Whenever MPL/w < MPK/r, a firm can increase output without increasing production cost by shifting outlays from labor to capital. Copyright 2012 John Wiley & Sons, Inc.

The Expansion Path The expansion path is a curve formed by connecting the points of tangency between isocost lines and the highest respective attainable isoquants. Copyright 2012 John Wiley & Sons, Inc.

Figure 8.4 - Isocost Lines and the Long-Run Expansion Path Copyright 2012 John Wiley & Sons, Inc.

Is Production Cost Minimized? Cost minimization is NOT the same as profit maximization… Cost minimization occurs at all points on the expansion path, but profit maximization involves selecting the most profitable output from among those on the expansion path. Copyright 2012 John Wiley & Sons, Inc.

Table 8.2 – The Productivity Gains from Privatization Copyright 2012 John Wiley & Sons, Inc.

Input Price Changes and Cost Curves The input substitution effect is the effect of a change in the price of an input on a firm’s relative use of the input to produce a given level of output. Copyright 2012 John Wiley & Sons, Inc.

Figure 8.5 – A Higher Input Price Shifts Cost Curves Upward Copyright 2012 John Wiley & Sons, Inc.

Long-Run Cost Curves LTC shows the minimum cost at which each rate of output may be produced, just as the expansion path does. LMC and LAC are derived from the LTC in the same way that the short-run marginal and average curves are derived from the short-run total cost curve. LAC is U-shaped…why? Economies of scale Diseconomies of scale Copyright 2012 John Wiley & Sons, Inc.

Figure 8.6 - Long-Run Cost Curves Copyright 2012 John Wiley & Sons, Inc.

Economies of Scale and Diseconomies of Scale Economies of scale – a situation in which a firm can increase its output more than proportionally to its total input cost Reflects increasing returns to scale Diseconomies of scale – a situation in which a firm’s output increases less than proportionally to its total input cost Reflects decreasing returns to scale Copyright 2012 John Wiley & Sons, Inc.

The Long Run and Short Run Revisited Summary: Long-run average cost curve (LAC): the lowest average cost attainable when all inputs are variable Each point on the LAC is associated with a different short-run scale of operation that the firm could choose. Copyright 2012 John Wiley & Sons, Inc.

FIGURE 8.7 - Short- and Long-Run Average Cost Curves Copyright 2012 John Wiley & Sons, Inc.

Learning by Doing Learning by doing is associated with improvements in productivity resulting from a firm’s cumulative output experience Advantages of Learning by Doing to Pioneering Firms Attainment of lower production costs Incentive to produce more in any given period Limits to Advantages: Benefits spill over to other firms New products can give newer firms a competitive advantage Copyright 2012 John Wiley & Sons, Inc.

Figure 8.8 - Learning by Doing Versus Economies of Scale Copyright 2012 John Wiley & Sons, Inc.

Importance of Cost Curves to Market Structure Minimum efficient scale – the scale of operations at which average cost per unit reaches a minimum Impact on industry structure Number of firms Proportion of industry output by each firm Degree of competition Copyright 2012 John Wiley & Sons, Inc.

Figure 8.3 – Minimum Efficient Plant Scales Copyright 2012 John Wiley & Sons, Inc.

Figure 8.9 - Cost Curves and the Structure of Industry Copyright 2012 John Wiley & Sons, Inc.

Using Cost Curves: Controlling Pollution Question: Can the government’s program to reduce pollution be accomplished at the lowest possible cost? If marginal costs of firms differ, the total cost of pollution abatement can be reduced: Increase abatement when MC is less Decrease abatement where MC is greater Result: firms should operate where their MC are equal. Copyright 2012 John Wiley & Sons, Inc.

Figure 8.10 – Cost of Pollution Abatement Copyright 2012 John Wiley & Sons, Inc.

Economies of Scope and Diseconomies of Scope Economies of scope – a case where it is cheaper for one firm to produce products jointly than it is for separate firms to produce the same products independently Diseconomies of scope – a case where it is cheaper for separate products to be produced independently than for one firm to produce the same products jointly Copyright 2012 John Wiley & Sons, Inc.

Estimating Cost Functions Techniques: Surveys New entrant/survivor technique – method for determining the minimum efficient scale of production in an industry based on investigating the plant sizes either being built or used by firms in the industry Econometric specification Copyright 2012 John Wiley & Sons, Inc.

Figure 8.11 - Different Possible Cost Functions Copyright 2012 John Wiley & Sons, Inc.

The Mathematics Behind Production Cost: The Marginal-Average Cost Relationship Analogous to the derivation of the relationship between marginal and average product curves Relationship holds for both the long-run and short-run cost curves Copyright 2012 John Wiley & Sons, Inc.

The Mathematics Behind Production Cost: Cost Minimization The firm’s input choices can be viewed as either: Maximizing output for a given level of total cost, or Minimizing the cost necessary to produce a given output (continued) Copyright 2012 John Wiley & Sons, Inc.

The Mathematics Behind Production Cost: Cost Minimization Copyright 2012 John Wiley & Sons, Inc.

The Mathematics Behind Production Cost: Cost Minimization Copyright 2012 John Wiley & Sons, Inc.

Constrained minimization The Mathematics Behind Production Cost: Minimizing the Cost of Pollution Abatement For pollution to be reduced at the lowest possible cost, each firm must be operating where the marginal cost of pollution abatement is the same. Lagrangian technique Constrained minimization Copyright 2012 John Wiley & Sons, Inc.

The Mathematics Behind Production Cost: Minimizing the Cost of Pollution Abatement Copyright 2012 John Wiley & Sons, Inc.

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