1 Chapter 7: Costs and Cost Minimization In this chapter we will cover:  Different Types of Cost -Explicit and Implicit Costs -Opportunity Costs -Economic.

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Presentation transcript:

1 Chapter 7: Costs and Cost Minimization In this chapter we will cover:  Different Types of Cost -Explicit and Implicit Costs -Opportunity Costs -Economic and Accounting Costs  Isocost Lines  Cost Minimization  Short-Run and Long-Run situations

2 Explicit Costs: Costs that involve an exchange of money -ie: Rent, Wages, Licence, Materials Implicit Costs: Costs that don’t involve an exchange of money -ie: Wage that could have been earned working elsewhere; profitability of a goat if used mowing lawns instead of for meat

3  Definition: Value of the next best alternative; total benefit of choosing the next best option IE: Instead of opening his own Bait shop, which cost $5,000 per month to run (explicit cost), Buck could have worked for Worms R Us for $2,000 per month (implicit cost). His opportunity cost is $2,000 (alternate wage) + $5,000 (the amount he WOULDN’T have to pay each month) = $7,000

4 Economic Costs Economic Costs = Explicit + Implicit Costs Economists & Accountants calculate costs differently: – Economists are interested in studying how firms make production & pricing decisions. They include all costs. Accounting Costs = Explicit Costs Accounting Costs –Accountants are responsible for keeping track of the money that flows into and out of firms. They focus on explicit costs.

5 Economic Costs Revenue Economic Profit Implicit Costs Explicit Costs Revenue Accounting Profit Explicit Costs Economist’s View Accountant’s View Profit: Economists vs Accountants

6 One of the goals of a firm is to produce output at a minimum cost. This minimization goal can be carried out in two situations: 1)The long run (where all inputs are variable) 2)The short run (where some inputs are not variable)

7 Suppose that a firm’s owners wish to minimize costs… Let the desired output be Q 0 Technology: Q = f(L,K) Owner’s problem: min TC = rK + wL K,L Subject to Q 0 = f(L,K)

8 From the firm’s cost equation: TC 0 = rK + wL One can obtain the formula for the ISOCOST LINE: K = TC 0 /r – (w/r)L The isocost line graphically depicts all combinations of inputs (labour and capital) that carry the same cost.

9 Isocost curves are similar to indifference curves, and the tangency condition of cost minimization is also similar to the tangency condition of consumers: MRTS L,K = -MP L /MP K = -w/r