1. 1 Intermediate Microeconomic Theory Cost Curves

2. 2 Cost Functions We have solved the first part of the problem: given factor prices, what is cheapest way to produce q units of output? Given by conditional factor demands for each input i, x i (w 1,…, w n, q) However, this is only half the problem. To model behavior of the firm, we also have to derive how much output a firm will find optimal to produce, given input and output prices.

3. 3 Cost functions Key to firm’s output decision is the firm’s cost function Gives the total cost of producing a given amount of output, given some input prices and assuming the firm acts optimally (i.e. cost minimizes). Suppose a firm used n inputs for production, with conditional demand functions for each input given by: x 1 (w 1,…, w n, q) : x n (w 1,…, w n, q) What would be the generic form for its cost function?

4. 4 Cost functions: Example Consider a firm with Cobb-Douglas technology of the form q = f(x 1, x 2 ) = x 1 0.25 x 2 0.25 If w 1 = 4 and w 2 = 1, what will be optimal way to produce q = 5? What will be this firm’s cost function given these prices and technology? How much will it cost to produce q = 5 optimally?

5. 5 Cost functions and Opportunity Costs It is important to remember that a cost function includes all costs of production, including opportunity costs. With Cobb-Douglas technology assumed, figuring out costs is easy because we have implicitly assumed only two inputs. Things can be more complicated though.

6. 6 Cost functions with Opportunity Costs Suppose I am considering getting into the chair making business, where I would deliver however many chairs I make to Ikea one year from now. To make any chairs at all, I need to buy a saw which costs $400 (though I can re-sell it for $200 at the end of the year) Then, each chair I make requires 3 boards of wood (at $2/board). Making chairs also required time. Specifically, I can turn my time into chairs according to the production function q = L 0.5. If I currently have $1000 in savings at 10% annual interest, and any time I spent making chairs would mean less time working at my current job which pays $20/hr, what would be my cost function for making chairs?

7. 7 Short run vs. Long(er) run It is often important to distinguish between the Short-Run (SR) and Long(er)-Run (LR) when considering costs. Short-run: some factors of production are fixed (i.e. can’t be adjusted). Long(er)-run: previously fixed factors of production can be adjusted.

8. 8 Short Run Cost Curve The key aspect of a fixed factor of production is that it will mean there will be some component of cost that is the same regardless of how much output (if any) is produced (in short run). How does this relate to the chair making example? What might be some other production processes that have fixed inputs the short run?

9. 9 Short Run Cost Curve Analytically Short-run cost function where x 2 fixed at x 2 f (and only two inputs) C SR (q) = w 1 x 1 (w 1,w 2,q|x 2 = x 2 f ) + w 2 x 2 f Short run cost function where there are n inputs, where inputs 1 to k are variable and k to n are fixed: C SR (q) = c v (q) + F So, short-run cost function can be written

10. 10 Short Run vs. Long Run Costs Analytically Example: Consider again a firm where: q = f(L, K) = L 0.25 K 0.25, w L = 4, w K = 1. From before, we know long-run cost function in this case will be C(q) = 4q 2 Suppose in the short-run Capital (K) is fixed at 16 machine hrs. What is short-run cost function?

11. 11 Short-Run Cost function Given how cost functions are derived, will the cost of producing any given level of output be greater in the short-run or the longer run?

12. 12 Cost functions and Returns-to-Scale We can also describe returns-to-scale via a cost function. Consider the “Unit cost function C(1)” (Cost of producing one unit) if C(q) > qC(1) then Decreasing Returns to Scale (DRS) if C(q) = qC(1) then Constant Returns to Scale (CRS) if C(q) < qC(1) then Increasing Returns to Scale (IRS)

13. 13 Cost functions and Returns-to-Scale Consider Cobb-Douglas production function f(L,K) = L 0.25 K 0.25, with w L = 4 and w K = 1 Recall that the (Long-Run) cost function for this technology was C LR (q) = 4q 2. Does this exhibit CRS, DRS, or IRS? What about if C LR (q) = 4q? What about if C LR (q) = 4q 0.5 ? Graphically? In calculus?

14. 14 Cost functions and Returns-to-Scale Now consider a Cobb-Douglas production function f(L,K) = L 0.25 K 0.25, with w L = 4 and w K = 1, but where K is fixed at 16, or Does this cost function exhibit DRS, CRS, IRS? C(q) = q 4 /4 + 16

15. 15 Cost functions and Returns-to-Scale From now on, we will generally be considering relatively Short-run (i.e. at least one factor fixed), so cost functions will exhibit DRS at some point.

16. 16 Cost Curves In modeling optimal firm behavior, it will often be helpful to think of costs graphically via “cost curves”. The first thing we want to think about is how the cost of producing “one more unit” changes over the production cycle. Consider a “discrete” cost function where: c(1) = $20 c(2) = $30 c(3) = $35 c(4) = $45 c(5) = $60 What would graph of this look like? What if we graphed cost of “one more”? How does this relate to Returns-to-scale? What might we call the cost of producing “one more unit” and its associated curve?

17. 17 Marginal Costs Graphically Marginal Cost Curve – MC(q) Denotes the cost of producing a “little bit” more, given you have already produced q units So MC(q) ≈ [C(q+1) – C(q)]/1 Actually rate of change, however, so MC(q) ≈ [C(q+Δq) – C(q)]/Δq And taking the limit as Δq goes to 0, Therefore, we can get an idea of what the MC(q) curve looks like from the cost curve and vice versa. C(q) q MC(q) $ $ q

18. 18 Cost Curves In modeling optimal firm behavior, it will often be helpful to think of two other “cost curves” as well. Average Cost Curve – AC(q) Denotes the average cost of producing each unit, given q units are produced. AC(q) = C(q)/q Average Variable Cost Curve – AVC(q) As discussed above, we can often think of our SR cost function as: C(q) = c v (q) + F So AVC(q) = c v (q)/q

19. 19 Cost Curves Consider our example, C(q) = q 4 /4 + 16 (i.e. the cost function that arises from production function f(L,K)= L 0.25 K 0.25 with K fixed at 16 and w L = 4, w K = 1) What is equation for AC(q)? What is Avg. Cost per unit for producing 2 units? What is equation for AVC(q)? What is Avg. Variable Cost per unit for producing 2 units? What is equation for MC(q)? What is Marginal Cost at 2 units?

20. 20 Cost Curves (cont.) How do these curves relate to each other? First note: MC(q) ≈ [C(q) – C(q-1)]/1 Next, recall: AVC(q) = c v (q)/q = [C(q)-F]/q (noting that c v (q) = C(q)- F) = [C(q)-C(0)]/q (noting that C(0) = F) = [(C(q)-C(q-1) + (C(q-1)-C(q-2))+…+(C(1)-C(0))]/q So AVC(q) ≈ [MC(q) + MC(q-1) + …+ MC(1)]/q

21. 21 Cost Curves (cont) Given AVC(q) ≈ [MC(q) + MC(q-1) + …+ MC(1)]/q, AVC is essentially the average Marginal cost of producing each unit, given firm has produced q units. Therefore, If MC(q) < AVC(q) over some range of q, then AVC(q) must be decreasing over that range (if you continually add something below the average, average will go down) Alternatively, if MC(q) > AVC(q) over some range of q, then AVC(q) must be increasing over that range (if you continually add something above the average, average will go up) So MC(q) must intersect AVC(q) at the q with the minimum Average Variable cost (call it q*)

22. 22 MC(q) and AVC(q) q*q $ MC(q) AVC(q)

23. 23 Cost Curves (cont) Now, recall AC(q) = C(q)/q = [c v (q) + F]/q = AVC(q) + F/q So AC(q) - AVC(q) = F/q (difference between AC(q) and AVC(q) decreases as q increases) Also, AC(q) ≈ [MC(q) + MC(q-1) + …+ MC(1)]/q + F/q Therefore, if MC(q) < AC(q) over some range of q, then AC(q) must be decreasing over that range. Alternatively, if MC(q) > AC(q) over some range of q, then AC(q) must be increasing over that range. So MC(q) also intersects AC(q) at the q with the minimum Average Cost (call it q**).

24. 24 MC(q) and AVC(q) q* q**q $ F MC(q) AVC(q) AC(q)

25. 25 Long-run vs. Short-run MC curves Recall our discussion of long-run vs. short-run. For example, consider a firm deciding how large of a plant to build. Suppose there are three possible size plants. Each plant size will be associated with its own cost curve and MC curve: In the short-run, the firm is stuck with a given plant size, but over the longer-run they can choose which plant size to use based on how much they plan to build. How will cost curve and MC curve change from the short-run to the longer-run?