1. COST OF PRODUCTION

2. 2 Graphing Cost Curves Total Cost Curves: The total variable cost curve has the same shape as the total cost curve— increasing output increases variable cost

3. 3 The Short Run Cost Function

4. 4 ATC = AFC + AVC

5. 5 Total cost $400 350 300 250 200 150 100 50 0 FC 24 M 68102030 Quantity of earrings VC TC L Total Cost Curves O TC = (VC + FC)

6. 6 Average and Marginal Cost Curves The marginal cost curve goes through the minimum point of the average total cost curve and average variable cost curve. Each of these curves is U-shaped. The average fixed cost curve slopes down continuously.

7. 7 Downward-Sloping Shape of the Average Fixed Cost Curve The average fixed cost curve looks like a child’s slide – it starts out with a steep decline, then it becomes flatter and flatter. It tells us that as output increases, the same fixed cost can be spread out over a wider range of output.

8. 8 The U Shape of the Average and Marginal Cost Curves When output is increased in the short-run, it can only be done by increasing the variable input.

9. 9 The U Shape of the Average and Marginal Cost Curves The law of diminishing marginal productivity sets in as more and more of a variable input is added to a fixed input. Marginal and average productivities fall and marginal costs rise.

10. 10 The U Shape of the Average and Marginal Cost Curves And when average productivity of the variable input falls, average variable cost rise.

11. 11 The U Shape of the Average and Marginal Cost Curves The average total cost curve is the vertical summation of the average fixed cost curve and the average variable cost curve.

12. 12 The U Shape of the Average and Marginal Cost Curves If the firm increased output enormously, the average variable cost curve and the average total cost curve would almost meet. The firm’s eye is focused on average total cost—it wants to keep it low.

13. 13 Cost $30 28 26 24 22 20 18 16 14 12 10 8 6 4 2 0 Quantity of earrings 246810121416182022 2426283032 Per Unit Output Cost Curves AFC AVC ATC MC

14. 14 The Short Run Cost Function

15. 15 The Short Run Cost Function A change in input prices will shift the cost curves. – If fixed input costs are reduced then ATC will shift downward. AVC and MC will remain unaffected.

16. 16 The Short Run Cost Function A change in input prices will shift the cost curves. – If variable input costs are reduced then MC, AVC, and AC will all shift downward.

17. 17 The Short Run Cost Function

18. 18 A Firm’s Short Run Costs

19. 19 Cost Curves for a Firm Output Cost ($ per year) 100 200 300 400 012345678910111213 VC Variable cost increases with production and the rate varies with increasing & decreasing returns. TC Total cost is the vertical sum of FC and VC. FC 50 Fixed cost does not vary with output

20. 20 Costs that are fixed in the short run may not be fixed in the long run Typically in the long run, most if not all costs are variable

21. 21 The Short Run Cost Function Average total cost (ATC) is the average per- unit cost of using all of the firm’s inputs (TC/Q) – Average variable cost (AVC) is the average per- unit cost of using the firm’s variable inputs (TVC/Q) – Average fixed cost (AFC) is the average per-unit cost of using the firm’s fixed inputs (TFC/Q)

22. 22 Per-Unit, or Average, Costs Average Total cost – firm’s total cost divided by its level of output (average cost per unit of output) ATC=AC=TC/Q Average Fixed cost – fixed cost divided by level of output (fixed cost per unit of output) AFC=FC/Q Average variable cost – variable cost divided by the level of output. AVC=VC/Q

23. 23 Marginal Cost – change (increase) in cost resulting from the production of one extra unit of output Denote “∆” - change. For example ∆TC - change in total cost MC=∆TC/∆Q Example: when 4 units of output are produced, the cost is 80, when 5 units are produced, the cost is 90. MC=(90-80)/1=10 MC=∆VC/∆Q since TC=(FC+VC) and FC does not change with Q

24. 24 Cost Curves MC ATC AVC AFC

25. 25 Short-Run Cost Functions

26. 26

27. 27 The Relationship Between Productivity and Costs The shapes of the cost curves are mirror- image reflections of the shapes of the corresponding productivity curves.

28. 28 The Relationship Between Productivity and Costs When one is increasing, the other is decreasing. When one is at a maximum, the other is at a minimum.

29. 29 Costs per unit Productivity of workers at this output $18 16 14 12 10 8 6 4 2 04812162024 9 8 7 6 5 4 3 2 1 04812162024 AVC MC Output A AP of workers MP of workers The Relationship Between Productivity and Costs

30. 30 Relationship Between Marginal and Average Costs The marginal cost and average cost curves are related. – When marginal cost exceeds average cost, average cost must be rising. – When marginal cost is less than average cost, average cost must be falling.

31. 31 Relationship Between Marginal and Average Costs Marginal cost curves always intersect average cost curves at the minimum of the average cost curve.

32. 32 Relationship Between Marginal and Average Costs The position of the marginal cost relative to average total cost tells us whether average total cost is rising or falling.

33. 33 Relationship Between Marginal and Average Costs To summarize: If MC > ATC, then ATC is rising. If MC = ATC, then ATC is at its low point. If MC < ATC, then ATC is falling.

34. 34 Relationship Between Marginal and Average Costs Marginal and average total cost reflect a general relationship that also holds for marginal cost and average variable cost. If MC > AVC, then AVC is rising. If MC = AVC, then AVC is at its low point. If MC < AVC, then AVC is falling.

35. 35 Relationship Between Marginal and Average Costs As long as average variable cost does not rise by more than average fixed cost falls, average total cost will fall when marginal cost is above average variable cost,

36. 36 Relationship Between Marginal and Average Costs Costs per unit $90 80 70 60 50 40 30 20 10 0 Quantity Area B Area AArea C MC ATC AVC 123456789 Q1Q1 B ATC MC Q0Q0 A

37. 37 Long-Run Cost Curves Long-Run Total Cost = LTC = f(Q) Long-Run Average Cost = LAC = LTC/Q Long-Run Marginal Cost = LMC =  LTC/  Q

38. 38 Relationship Between Long-Run and Short-Run Average Cost Curves

39. 39 The LR Relationship Between Production and Cost In the long run, all inputs are variable. – What makes up LRAC?

40. 40 The Long-Run Cost Function LRAC is made up for SRACs – SRAC curves represent various plant sizes – Once a plant size is chosen, per-unit production costs are found by moving along that particular SRAC curve

41. 41 The Long-Run Cost Function The LRAC is the lower envelope of all of the SRAC curves. – Minimum efficient scale is the lowest output level for which LRAC is minimized Is LRAC a function of market size? What are implications?

42. 42 The Long-Run Cost Function Reasons for Economies of Scale… Increasing returns to scale Specialization in the use of labor and capital Economies in maintaining inventory Discounts from bulk purchases Lower cost of raising capital funds Spreading promotional and R&D costs Management efficiencies

43. 43 The Long-Run Cost Function Reasons for Diseconomies of Scale… Decreasing returns to scale Input market imperfections Management coordination and control problems