1. 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

2. 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)
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3. 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.
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4. 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.
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5. 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
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6. 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
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7. Table 8.1
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8. 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.
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9. Figure 8.1 – From Total Product to Total Variable Cost
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10. Figure 8.2 - Short-Run Total and Per-Unit Cost Curves
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11. 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.
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12. 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.
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13. 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.
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14. Figure 8.3 – Graphical Derivation of Average and Marginal Cost Curves
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15. 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.
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16. 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.
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17. 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
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18. 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.
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19. 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.
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20. Figure 8.4 - Isocost Lines and the Long-Run Expansion Path
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21. 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.
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22. Table 8.2 – The Productivity Gains from Privatization
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23. 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.
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24. Figure 8.5 – A Higher Input Price Shifts Cost Curves Upward
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25. 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
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26. Figure 8.6 - Long-Run Cost Curves
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27. 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
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28. 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.
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29. FIGURE 8.7 - Short- and Long-Run Average Cost Curves
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30. 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
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31. Figure 8.8 - Learning by Doing Versus Economies of Scale
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32. 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
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33. Figure 8.3 – Minimum Efficient Plant Scales
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34. Figure 8.9 - Cost Curves and the Structure of Industry
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35. 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.
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36. Figure 8.10 – Cost of Pollution Abatement
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37. 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
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38. 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
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39. Figure 8.11 - Different Possible Cost Functions
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40. 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
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41. 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)
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42. The Mathematics Behind Production Cost: Cost Minimization
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43. The Mathematics Behind Production Cost: Cost Minimization
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44. 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
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45. The Mathematics Behind Production Cost: Minimizing the Cost of Pollution Abatement
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