1. Chapter 20
Cost
20-1
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Objectives Fixed cost, variable cost, and total cost Marginal cost
Short run and long run
Shut-down and go-out-of-business decisions
Average cost
Graphing the AFC, AVC, ATC, and MC curves
The production function
The law of diminishing returns
Economies and diseconomies of scale
20-2
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

3. Costs Sales - Costs = Profit or Total Revenue - Total Cost = Profit or
(Bottom Line)
20-3
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4. Fixed Cost Fixed cost stay the same no matter how much output changes
Some examples of fixed cost are rent, insurance, salaries, property taxes, and interest payments
Even when a firm’s output is zero, it incurs the same fixed cost
Fixed costs are sometimes called “sunk cost” because once you have obligated yourself to pay them, that money has been sunk into your firm
The trick is to spread these (fixed) cost over as much output as possible
In other words, to spread your overhead over a large output
20-4
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

5. Variable Cost Variable costs vary with output
Output rises, variable costs rise
Output falls, variable costs fall
Some examples of variable costs are wages of production workers, fuel, raw materials, electricity, and shipping
Sometimes a cost may be part fixed and part variable
The electricity used by production is a variable cost because it will go up or down with production
Even if your output fell to zero, you would still have to pay something on your electric bill
20-5
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

6. Total Cost
Total cost is the sum of fixed and variable costs
TC = FC + VC
20-6
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7. Hypothetical Cost Schedule
Output FC VC TC
$ $ $1400
20-7
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8. Output FC VC TC
$ $ $1400
20-8
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9. FC + VC = TC The black vertical lines are the variable costs
20-9
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10. 20-10
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11. Marginal cost is the cost of producing one additional unit of output
Output FC VC TC MC
$ $ $ $ - , ,
, ,
20-11
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12. Marginal cost is the cost of producing one additional unit of output
Output FC VC TC MC
$ $ $ $ - , ,
, ,
20-12
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13. Marginal cost is the cost of producing one additional unit of output
Output FC VC TC MC
$ $ $ $ - , ,
, ,
At an output of zero VC is always zero
20-13
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

14. Marginal cost is the cost of producing one additional unit of output
Output FC VC TC MC
$ $ $ $ - , ,
, ,
At an output of zero FC is equal to TC
20-14
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

15. The Short Run
As long as there are any fixed costs, we are in the short run
The present time is always in the short run
The short run is the length of time it takes all fixed costs to become variable costs
In other words, the length of time it takes to eliminate all fixed costs
A steel firm might need a couple of years to pay off such fixed costs as interest and rent
Even a grocery store would need a few weeks or months to sublet the store and discharge its other obligations
20-15
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16. The Long Run
The long run is the time at which all costs become variable costs
The long run never exists except in theory
You will never have a situation in which all your costs are variable
This would mean no rent, no insurance, no guaranteed salaries, no depreciation, etc
You never really reach the long run
As you proceed through the short run, you are forced to make decisions that will push the long run farther into the future
20-16
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

17. Average Cost Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $500
$ $ $500
,080
,300
,700
,400
TC = FC + VC
20-17
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

18. Average Cost Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $500 $ -
$ $ $ $ - , , , ,
AFC = FC / Output
20-18
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19. Average Cost Output FC VC TC AFC AVC ATC MC 0 $500 $ 0 $500 $ - $ -
$ $ $ $ $ - , , , ,
AVC = VC / Output
20-19
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20. Average Cost Output FC VC TC AFC AVC ATC MC
$ $ $ $ $ $ - , , , ,
ATC = TC / Output
20-20
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21. Average Cost Output FC VC TC AFC AVC ATC MC
$ $ $ $ $ $ $- , , , ,
MC is the cost of producing one additional unit of output
It is best to use the VC column to calculate the MC. If the TC column is used, you cannot calculate the MC for the first unit of output
20-21
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

22. Graphing the AFC, AVC, ATC, & MC curves
Output FC VC TC AFC AVC ATC MC
$ $ $ $ $ $ $ 0
Much of microeconomic analysis involves:
* filling in a table * drawing a graph * analysis of the graph
20-22
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

23. Distinguishing between FC and AFC curves
Output FC VC TC AFC AVC ATC MC
$ $ $ $ $ $ $ 0
20-23
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

24. Graphing the AVC, ATC, and MC curves
Output FC VC TC AFC AVC ATC MC
$ $ $ $ $ $ $ 0
The marginal cost curve intersects the ATC and AVC at their minimum points
Always do the MC curve first!
20-24
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

25. Hypothetical Cost Schedule
Output VC TC AFC AVC ATC MC $ $ $ $ $ $ , ,
It is hard to tell just looking at the graph. Look at the ATC data in the table above at output levels of 5 and 6. It has to be something less than 166
What is the minimum point on the ATC?
20-25
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26. Output VC TC AFC AVC ATC MC $ $ $ $ $ $ , ,
Minimum point on the AVC is $69.50
Minimum point on the ATC is
20-26
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

27. 20-27
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28. 20-28 The MC curve intersects the ATC and AVC at their minimum points
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

29. 20-29
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30. Graphing the Average Total Cost Curve
20-30
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31. The Production Function and the Law of Diminishing Returns
A production function is the relationship between the maximum amount of output a firm can produce and various quantities of inputs
Number of Total Marginal* Workers Output Output Increasing returns Increasing returns Increasing returns Diminishing returns Diminishing returns Diminishing returns Diminishing returns Diminishing/negative returns
Diminishing/negative returns
*Marginal output is the additional output produced by the last worker hired
The law of diminishing returns states that, as successive units of a variable resource are added to a fixed set of resources, beyond some point the extra, or marginal, product attributable to each additional unit of the variable resource will decline
20-31
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

32. The Production Function and the Law of Diminishing Returns
A production function is the relationship between the maximum amount of output a firm can produce and various quantities of inputs
Number of Total Marginal* Workers Output Output Increasing returns Increasing returns Increasing returns Diminishing returns Diminishing returns Diminishing returns Diminishing returns Diminishing/negative returns
Diminishing/negative returns
*Marginal output is the additional output produced by the last worker hired
The # workers hired is six
The law of diminishing returns states that, as successive units of a variable resource are added to a fixed set of resources, beyond some point the extra, or marginal, product attributable to each additional unit of the variable resource will decline
20-32
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

33. Total Output and Marginal Output
20-33
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34. Economies of Scale
Economies of scale are the economies of mass production, which drive down average total cost (ATC)
Economies of scale are evidenced by the declining part of the ATC curve
In general, we expect large firms to undersell small firms. Reasons are
Quantity discounts
Economies of being established
Spreading fixed cost
Economies of scale enable a business to reduce its cost per unit as output expands
20-34
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35. Diseconomies of Scale
Diseconomies of scale are the inefficiencies that become endemic in large firms
Diseconomies of scale are evidenced by the rising part of the ATC curve
In general, at some point, the larger firms get the more inefficient they become. Reasons are
An expanding and growing bureaucracy
A huge and growing corporate authority
Diseconomies of scale increase inefficiencies and also increase cost per unit
20-35
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

36. A Summing Up
The overlapping forces of increasing returns and economies of scale drive down ATC
Eventually, the overlapping forces of diminishing returns and diseconomies of scale push ATC back up again
The u-shaped ATC is very important in economic analysis and in business strategy
What size size plant do we build?
How many workers do we hire?
What is the output at which our firm would operate most efficiently
20-36
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

37. The Decision to Operate or Shut Down
A firm has two options in the short run
It can operate or shut down
It operates when total revenue exceed variable costs
When variable costs are greater than total revenue, it shuts down
If variable costs equal total revenue, flip a coin
20-37
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

38. The Decision to Shut Down
A firm has two options in the short run
The firm can operate
If it operates, it will produce the output that will yield the highest possible profits
If it is losing money, it will operate at that output at which losses are minimized
The firm can shut down
If the firm shuts down, the output is zero
Shutting down does not mean zero total costs
The firm must still meet its fixed costs
Remember, at an output of zero total cost equals fixed costs
The firm can not go-out-of-business until all fixed cost obligations are eliminated
20-38
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

39. (All dollar figures in millions)
Problem 1 Problem Problem 3
Fixed costs $ $ $ 8
Variable costs
Total Revenue
Decision
Operate
Problem # 1 Decision - Operate or Shut Down?
Short-Run Choices
Operate
TC = FC + VC ($5 + $6) = $11
TR = …
Loss = $4
Shut Down
TC = (FC) = $5
TR = …
Loss = $5
20-39
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

40. (All dollar figures in millions)
Problem 1 Problem Problem 3
Fixed costs $ $ $ 8
Variable costs
Total Revenue
Decision
Operate
Shut Down
Problem # 2 Decision - Operate or Shut Down?
Short-Run Choices
Operate
TC = FC + VC ($10 + $9) = $19
TR = …
Loss = $11
Shut Down
TC = (FC) = $10
TR = …
Loss = $10
20-40
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

41. (All dollar figures in millions)
Problem 1 Problem Problem 3
Fixed costs $ $ $ 8
Variable costs
Total Revenue
Decision
Operate
Shut Down
Shut Down
Problem # 3 Decision - Operate or Shut Down?
Short-Run Choices
Operate
TC = FC + VC ($8 + $12) = $20
TR = …
Loss = $10
Shut Down
TC = (FC) = $8
TR = …
Loss = $8
20-41
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

42. (All dollar figures in millions)
Problem 1 Problem Problem 3
Fixed costs $ $ $ 8
Variable costs
Total Revenue
Decision
Operate
Shut Down
Shut Down
In the short run A firm has two options
The firm operates when total revenue exceed variable cost
The firm shuts down when variable cost are greater than total revenue
Note: Fixed costs are not relevant in the operate/shut down decision!
20-42
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

43. The Decision to Go Out of Business or Stay In Business
In the long run firms must decide to stay in business or go out of business
The firm will stay in business if the total revenue is greater than its total cost
The firm will go out of business if the total cost exceeds total revenue
Going out of business means that all fixed cost obligations are met
Does everybody who is losing money go out of business?
Eventually (most sooner rather than later)
There are always exceptions to the rule
20-43
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

44. Deriving the Shut-Down and Break-Even Points
The firm can make the same shut-down or operate decisions on the basis of price and average variable cost.
A firm will shut down if VC > TR or if VC > Price X Output
A firm will shut down if
VC > Price X Output
Let’s divide both side of the above equation by Output
VC > Price X Output
Output
Output
AVC
>
Price
OPERATE
AVC < Price
SHUT DOWN
20-44
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

45. Deriving the Shut-Down and Break-Even Points
The firm can make the same stay in business or go out of business decisions on the basis of price and average total cost.
A firm will go out of business if TC > TR or if TC > Price X Output
A firm will go out of business if
TC > Price X Output
Let’s divide both side of the above equation by Output
TC > Price X Output
Output
Output
ATC
>
Price
STAY IN BUSINESS
ATC < Price
GO OUT OF BUSINESS
20-45
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46. Average Total Cost Average Variable Cost, and Marginal Cost
20-46
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47. Varying Factory Capacities
Each of these ATCs represents a different size factory, with a different optimum level of output represented by the minimum point on the ATC curve
20-47
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48. Varying Factory Capacities
ATC1 has the lowest capacity, while ATC5 has the highest capacity
20-48
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49. Varying Factory Capacities
The answer is ATC4
What size factory would a firm choose to build to produce 400 units of output?
20-49
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50. Varying Factory Capacities
Changes in the plant size are long run changes. In the long, a firm could be virtually any plant size provided it had the requisite financing.
20-50
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51. Current Issue: Wedding Hall or City Hall
Every wedding, big or small incurs fixed cost and variable cost
Fixed cost would be the flowers, photographer, the wedding hall, the gowns, the videographer, tux rentals, clergy
Variable cost would be food and drinks, the number of guest will affect the size of the wedding hall
A relatively small wedding that cost $20,000 and might pull in gifts worth $10,000
A much larger wedding might cost $100,000 and might pull in gifts worth $50,000
Do you go for the large wedding or smaller one?
20-51
Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.