© 2010 W. W. Norton & Company, Inc. 21 Cost Curves

© 2010 W. W. Norton & Company, Inc. 2 Types of Cost Curves u A total cost curve is the graph of a firm’s total cost function. u A variable cost curve is the graph of a firm’s variable cost function. u An average total cost curve is the graph of a firm’s average total cost function.

© 2010 W. W. Norton & Company, Inc. 3 Types of Cost Curves u An average variable cost curve is the graph of a firm’s average variable cost function. u An average fixed cost curve is the graph of a firm’s average fixed cost function. u A marginal cost curve is the graph of a firm’s marginal cost function.

© 2010 W. W. Norton & Company, Inc. 4 Types of Cost Curves u How are these cost curves related to each other? u How are a firm’s long-run and short- run cost curves related?

© 2010 W. W. Norton & Company, Inc. 5 Fixed, Variable & Total Cost Functions u F is the total cost to a firm of its short- run fixed inputs. F, the firm’s fixed cost, does not vary with the firm’s output level. u c v (y) is the total cost to a firm of its variable inputs when producing y output units. c v (y) is the firm’s variable cost function. u c v (y) depends upon the levels of the fixed inputs.

© 2010 W. W. Norton & Company, Inc. 6 Fixed, Variable & Total Cost Functions u c(y) is the total cost of all inputs, fixed and variable, when producing y output units. c(y) is the firm’s total cost function;

© 2010 W. W. Norton & Company, Inc. 7 y $ F

8 y $ c v (y)

© 2010 W. W. Norton & Company, Inc. 9 y $ F c v (y)

© 2010 W. W. Norton & Company, Inc. 10 y $ F c v (y) c(y) F

© 2010 W. W. Norton & Company, Inc. 11 Av. Fixed, Av. Variable & Av. Total Cost Curves u The firm’s total cost function is For y > 0, the firm’s average total cost function is

© 2010 W. W. Norton & Company, Inc. 12 Av. Fixed, Av. Variable & Av. Total Cost Curves u What does an average fixed cost curve look like? u AFC(y) is a rectangular hyperbola so its graph looks like...

© 2010 W. W. Norton & Company, Inc. 13 $/output unit AFC(y) y0 AFC(y)  0 as y 

© 2010 W. W. Norton & Company, Inc. 14 Av. Fixed, Av. Variable & Av. Total Cost Curves u In a short-run with a fixed amount of at least one input, the Law of Diminishing (Marginal) Returns must apply, causing the firm’s average variable cost of production to increase eventually.

© 2010 W. W. Norton & Company, Inc. 15 $/output unit AVC(y) y0

© 2010 W. W. Norton & Company, Inc. 16 $/output unit AFC(y) AVC(y) y0

© 2010 W. W. Norton & Company, Inc. 17 Av. Fixed, Av. Variable & Av. Total Cost Curves u And ATC(y) = AFC(y) + AVC(y)

© 2010 W. W. Norton & Company, Inc. 18 $/output unit AFC(y) AVC(y) ATC(y) y0 ATC(y) = AFC(y) + AVC(y)

© 2010 W. W. Norton & Company, Inc. 19 $/output unit AFC(y) AVC(y) ATC(y) y0 AFC(y) = ATC(y) - AVC(y) AFC

© 2010 W. W. Norton & Company, Inc. 20 $/output unit AFC(y) AVC(y) ATC(y) y0 Since AFC(y)  0 as y , ATC(y)  AVC(y) as y  AFC

© 2010 W. W. Norton & Company, Inc. 21 $/output unit AFC(y) AVC(y) ATC(y) y0 Since AFC(y)  0 as y , ATC(y)  AVC(y) as y  And since short-run AVC(y) must eventually increase, ATC(y) must eventually increase in a short-run.

© 2010 W. W. Norton & Company, Inc. 22 Marginal Cost Function u Marginal cost is the rate-of-change of variable production cost as the output level changes. That is,

© 2010 W. W. Norton & Company, Inc. 23 Marginal Cost Function u The firm’s total cost function is and the fixed cost F does not change with the output level y, so u MC is the slope of both the variable cost and the total cost functions.

© 2010 W. W. Norton & Company, Inc. 24 Marginal and Variable Cost Functions u Since MC(y) is the derivative of c v (y), c v (y) must be the integral of MC(y). That is,

© 2010 W. W. Norton & Company, Inc. 25 Marginal and Variable Cost Functions MC(y) y0 Area is the variable cost of making y’ units $/output unit

© 2010 W. W. Norton & Company, Inc. 26 Marginal & Average Cost Functions u How is marginal cost related to average variable cost?

© 2010 W. W. Norton & Company, Inc. 27 Marginal & Average Cost Functions Since

© 2010 W. W. Norton & Company, Inc. 28 Marginal & Average Cost Functions Since Therefore, as

© 2010 W. W. Norton & Company, Inc. 29 Marginal & Average Cost Functions Since Therefore, as

© 2010 W. W. Norton & Company, Inc. 30 Marginal & Average Cost Functions as

© 2010 W. W. Norton & Company, Inc. 31 $/output unit y AVC(y) MC(y)

© 2010 W. W. Norton & Company, Inc. 32 $/output unit y AVC(y) MC(y)

© 2010 W. W. Norton & Company, Inc. 33 $/output unit y AVC(y) MC(y)

© 2010 W. W. Norton & Company, Inc. 34 $/output unit y AVC(y) MC(y)

© 2010 W. W. Norton & Company, Inc. 35 $/output unit y AVC(y) MC(y) The short-run MC curve intersects the short-run AVC curve from below at the AVC curve’s minimum.

© 2010 W. W. Norton & Company, Inc. 36 Marginal & Average Cost Functions Similarly, since

© 2010 W. W. Norton & Company, Inc. 37 Marginal & Average Cost Functions Similarly, since Therefore, as

© 2010 W. W. Norton & Company, Inc. 38 Marginal & Average Cost Functions Similarly, since Therefore, as

© 2010 W. W. Norton & Company, Inc. 39 $/output unit y MC(y) ATC(y) as

© 2010 W. W. Norton & Company, Inc. 40 Marginal & Average Cost Functions u The short-run MC curve intersects the short-run AVC curve from below at the AVC curve’s minimum. u And, similarly, the short-run MC curve intersects the short-run ATC curve from below at the ATC curve’s minimum.

© 2010 W. W. Norton & Company, Inc. 41 $/output unit y AVC(y) MC(y) ATC(y)

© 2010 W. W. Norton & Company, Inc. 42 Short-Run & Long-Run Total Cost Curves u A firm has a different short-run total cost curve for each possible short- run circumstance.  Suppose the firm can be in one of just three short-runs; x 2 = x 2 or x 2 = x 2  x 2 < x 2  < x 2 . or x 2 = x 2 .

© 2010 W. W. Norton & Company, Inc. 43 y 0 F = w 2 x 2 F c s (y;x 2 ) $

© 2010 W. W. Norton & Company, Inc. 44 y F 0 F = w 2 x 2 F F  = w 2 x 2  c s (y;x 2 ) $

© 2010 W. W. Norton & Company, Inc. 45 y F 0 F = w 2 x 2 F  = w 2 x 2  A larger amount of the fixed input increases the firm’s fixed cost. c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 46 y F 0 F = w 2 x 2 F  = w 2 x 2  A larger amount of the fixed input increases the firm’s fixed cost. Why does a larger amount of the fixed input reduce the slope of the firm’s total cost curve? c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 47 MP 1 is the marginal physical productivity of the variable input 1, so one extra unit of input 1 gives MP 1 extra output units. Therefore, the extra amount of input 1 needed for 1 extra output unit is Short-Run & Long-Run Total Cost Curves

© 2010 W. W. Norton & Company, Inc. 48 MP 1 is the marginal physical productivity of the variable input 1, so one extra unit of input 1 gives MP 1 extra output units. Therefore, the extra amount of input 1 needed for 1 extra output unit is Short-Run & Long-Run Total Cost Curves units of input 1.

© 2010 W. W. Norton & Company, Inc. 49 MP 1 is the marginal physical productivity of the variable input 1, so one extra unit of input 1 gives MP 1 extra output units. Therefore, the extra amount of input 1 needed for 1 extra output unit is Short-Run & Long-Run Total Cost Curves units of input 1. Each unit of input 1 costs w 1, so the firm’s extra cost from producing one extra unit of output is

© 2010 W. W. Norton & Company, Inc. 50 MP 1 is the marginal physical productivity of the variable input 1, so one extra unit of input 1 gives MP 1 extra output units. Therefore, the extra amount of input 1 needed for 1 extra output unit is Short-Run & Long-Run Total Cost Curves units of input 1. Each unit of input 1 costs w 1, so the firm’s extra cost from producing one extra unit of output is

© 2010 W. W. Norton & Company, Inc. 51 Short-Run & Long-Run Total Cost Curves is the slope of the firm’s total cost curve.

© 2010 W. W. Norton & Company, Inc. 52 Short-Run & Long-Run Total Cost Curves is the slope of the firm’s total cost curve. If input 2 is a complement to input 1 then MP 1 is higher for higher x 2. Hence, MC is lower for higher x 2. That is, a short-run total cost curve starts higher and has a lower slope if x 2 is larger.

© 2010 W. W. Norton & Company, Inc. 53 y F 0 F = w 2 x 2 F  = w 2 x 2  F  F  = w 2 x 2  c s (y;x 2  ) c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 54 Short-Run & Long-Run Total Cost Curves u The firm has three short-run total cost curves.  In the long-run the firm is free to choose amongst these three since it is free to select x 2 equal to any of x 2, x 2 , or x 2 . u How does the firm make this choice?

© 2010 W. W. Norton & Company, Inc. 55 y F 0 F  yy  For 0  y  y, choose x 2 = ? c s (y;x 2  ) c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 56 y F 0 F  yy  For 0  y  y, choose x 2 = x 2. c s (y;x 2  ) c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 57 y F 0 F  yy  For 0  y  y, choose x 2 = x 2. For y  y  y , choose x 2 = ? c s (y;x 2  ) c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 58 y F 0 F  yy  For 0  y  y, choose x 2 = x 2. For y  y  y , choose x 2 = x 2 . c s (y;x 2  ) c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 59 y F 0 F  yy  For 0  y  y, choose x 2 = x 2. For y  y  y , choose x 2 = x 2 . For y   y, choose x 2 = ? c s (y;x 2  ) c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 60 y F 0 F  c s (y;x 2  ) yy  For 0  y  y, choose x 2 = x 2. For y  y  y , choose x 2 = x 2 . For y   y, choose x 2 = x 2 . c s (y;x 2 ) $ F

© 2010 W. W. Norton & Company, Inc. 61 y F 0 c s (y;x 2 ) F  c s (y;x 2  ) yy  For 0  y  y, choose x 2 = x 2. For y  y  y , choose x 2 = x 2 . For y   y, choose x 2 = x 2 . c(y), the firm’s long- run total cost curve. $ F

© 2010 W. W. Norton & Company, Inc. 62 Short-Run & Long-Run Total Cost Curves u The firm’s long-run total cost curve consists of the lowest parts of the short-run total cost curves. The long-run total cost curve is the lower envelope of the short-run total cost curves.

© 2010 W. W. Norton & Company, Inc. 63 Short-Run & Long-Run Total Cost Curves u If input 2 is available in continuous amounts then there is an infinity of short-run total cost curves but the long-run total cost curve is still the lower envelope of all of the short-run total cost curves.

© 2010 W. W. Norton & Company, Inc. 64 $ y F 0 F  c s (y;x 2 ) c s (y;x 2  ) c(y) F

© 2010 W. W. Norton & Company, Inc. 65 Short-Run & Long-Run Average Total Cost Curves u For any output level y, the long-run total cost curve always gives the lowest possible total production cost. u Therefore, the long-run av. total cost curve must always give the lowest possible av. total production cost. u The long-run av. total cost curve must be the lower envelope of all of the firm’s short-run av. total cost curves.

© 2010 W. W. Norton & Company, Inc. 66 Short-Run & Long-Run Average Total Cost Curves  E.g. suppose again that the firm can be in one of just three short-runs; x 2 = x 2 or x 2 = x 2  (x 2 < x 2  < x 2  ) or x 2 = x 2  then the firm’s three short-run average total cost curves are...

© 2010 W. W. Norton & Company, Inc. 67 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 )

© 2010 W. W. Norton & Company, Inc. 68 Short-Run & Long-Run Average Total Cost Curves u The firm’s long-run average total cost curve is the lower envelope of the short-run average total cost curves...

© 2010 W. W. Norton & Company, Inc. 69 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 ) AC(y) The long-run av. total cost curve is the lower envelope of the short-run av. total cost curves.

© 2010 W. W. Norton & Company, Inc. 70 Short-Run & Long-Run Marginal Cost Curves u Q: Is the long-run marginal cost curve the lower envelope of the firm’s short-run marginal cost curves?

© 2010 W. W. Norton & Company, Inc. 71 Short-Run & Long-Run Marginal Cost Curves u Q: Is the long-run marginal cost curve the lower envelope of the firm’s short-run marginal cost curves? u A: No.

© 2010 W. W. Norton & Company, Inc. 72 Short-Run & Long-Run Marginal Cost Curves u The firm’s three short-run average total cost curves are...

© 2010 W. W. Norton & Company, Inc. 73 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 )

© 2010 W. W. Norton & Company, Inc. 74 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 ) MC s (y;x 2 )MC s (y;x 2  ) MC s (y;x 2  )

© 2010 W. W. Norton & Company, Inc. 75 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 ) MC s (y;x 2 )MC s (y;x 2  ) MC s (y;x 2  ) AC(y)

© 2010 W. W. Norton & Company, Inc. 76 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 ) MC s (y;x 2 )MC s (y;x 2  ) MC s (y;x 2  ) AC(y)

© 2010 W. W. Norton & Company, Inc. 77 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 ) MC s (y;x 2 )MC s (y;x 2  ) MC s (y;x 2  ) MC(y), the long-run marginal cost curve.

© 2010 W. W. Norton & Company, Inc. 78 Short-Run & Long-Run Marginal Cost Curves u For any output level y > 0, the long- run marginal cost of production is the marginal cost of production for the short-run chosen by the firm.

© 2010 W. W. Norton & Company, Inc. 79 y $/output unit AC s (y;x 2  ) AC s (y;x 2  ) AC s (y;x 2 ) MC s (y;x 2 )MC s (y;x 2  ) MC s (y;x 2  ) MC(y), the long-run marginal cost curve.

© 2010 W. W. Norton & Company, Inc. 80 Short-Run & Long-Run Marginal Cost Curves u For any output level y > 0, the long- run marginal cost is the marginal cost for the short-run chosen by the firm. u This is always true, no matter how many and which short-run circumstances exist for the firm.

© 2010 W. W. Norton & Company, Inc. 81 Short-Run & Long-Run Marginal Cost Curves u For any output level y > 0, the long- run marginal cost is the marginal cost for the short-run chosen by the firm. u So for the continuous case, where x 2 can be fixed at any value of zero or more, the relationship between the long-run marginal cost and all of the short-run marginal costs is...

© 2010 W. W. Norton & Company, Inc. 82 Short-Run & Long-Run Marginal Cost Curves AC(y) $/output unit y SRACs

© 2010 W. W. Norton & Company, Inc. 83 Short-Run & Long-Run Marginal Cost Curves AC(y) $/output unit y SRMCs

© 2010 W. W. Norton & Company, Inc. 84 Short-Run & Long-Run Marginal Cost Curves AC(y) MC(y) $/output unit y SRMCs u For each y > 0, the long-run MC equals the MC for the short-run chosen by the firm.