REVIEW:

Firm use two-steps to determine how to produce output efficiently.

o 1. Determine which production processes are technologically efficient; so that it
can produce desired level of output with least amount of inputs.
o 2. Select the technologically efficient production process that is also
economically efficient, minimizing the cost of producing a specified amount of
output. ( use of production function and costs of inputs)

7.1 Measuring Costs

Explicit costs: direct, out-of-pocket payments for inputs
Implicit costs: reflect only a forgone opp. Cost, rather than an explicit, current expenditure.

Opportunity Costs:
- Economic cost (or Opportunity cost) the value of the best alternative use of that
resource.
o May equal or exceed a firm’s explicit cost.
o Example of an implicit opp. Cost: “Theres no such thing as a free lunch”

Opportunity Costs of Capital:

- Capital is a durable good: a product that is usable for a long period, many years.
o Two Problems: How to allocate initial purchase cost over time. What to do if the
value of the capital changes over time.
 Problems in measuring the cost of capital can be avoided if we rent
instead of purchase.
 Calculate cost of this capital the same way that it calculates the cost of
nondurable inputs such as labor services/materials.
Sunk Costs:
- Sunk Costs is a past expenditure that cannot be recovered.
- A sunk expenditure is not an opportunity cost.

7.2 Short Run Costs

1. Fixed Cost (F): is a cost that does not vary with the level of output. (Ex: Land, office
space, production facilities, and other overhead expenses)
o Fixed costs are often sunk costs, but not always.
2. Variable Cost (VC): is the production expense that changes with quantity of output
produced.
o Variable cost is the cost of variable inputs—the inputs the firm can adjust to alter
its output level, such as labor and materials.
3. Total Cost ( C):
 o VC + F = C

4. Marginal Cost:
o Marginal Cost (MC): the amount by which a firm’s cost changes if it produces one
more unit of output.
 MC= dC(q)/ dq

*b/c only variable costs change with output….

EQUIVALENT MC= dVC(q)/dq
5. Average Cost:
o Three Average cost measures
o Average Fixed Cost (AFC): the fixed cost divided by the units of output produced
 AFC= F/q

o Average variable cost (AVC): is the variable cost divided by the units of output
produced.
 AVC= VC/q
o Average Cost (AC): total cost divided by the units of output produced
 AC= C/q

o AC= C/q= VC/q + F/q = AVC + AFC

Short- Run Cost Curves:

- Fixed Cost is a horizontal line
- VC curve is zero when output, and rises as output rises.
- VC and C curve are parallel
- The MC curve cuts the U-shaped AC and AVC at their minimums.
- AFC curve falls as output increases, approaches zero.
- The production function determines the shape of a firm’s cost curves.
o it shows amt of inputs needed to produce a given level of output
Shape of the MC curve:
The marginal cost is the change in variable cost as output increases by 1 unit.
- MC=dVC/dq
-In the short run, K is fixed, so to produce more output, extra labor needed.
-MC= w/MP(L)
Ex: So if it takes 4 extra hours to produce one more unit, the MP of one hour of labor is
1/4 and the wage is $10. Then the MC of one more unit of output is 10/ (1/4) = 40

-The MC curve slopes upward due to Diminishing Marginal Returns to labor.

Shape of the AV Curve:
For a firm with only labor as its variable input…
VC= wL

And so… AVC= VC/q = wL/q

b/c… AP(L) = q/L (MP(L) = dq/dl)

AVC is the wage divided by AP(L)…. AVC= w/AP(L)

Effects of Taxes on Costs:

- Affect some or all marginal and average cost curves…
o Ex: a $10 tax per unit (specific tax) which varies with output, affects the firm’s VC
but not FC. Therefore, affecting AC, AVC, and MC, but just not AFC.

Short-Run Cost Summary:

Three Cost- Level Curves:
1. Total Cost
2. Fixed Cost
3. Variable cost
Four cost-Unit Curves:
1. Average cost
2. Average fixed cost
3. Average Variable cost
4. Marginal Cost.
  Given constant input prices, the shapes of the cost, vc, mc, and ac curves are
determined by the production function.
 If a variable input has diminishing marginal returns, the vc and cost curves become
relatively steep as output increases, so the ac and avc, and mc rise with output.
 Both AC and AVC curves fall at quantities where MC is below them & rise where the MC
is above them. SO, the MC cuts both these curves at their min points.

7.3 Long-Run Costs

In the LR, a firm adjusts all its inputs to keep cost of production as low as possible.
- Firms may incur fixed costs in the LR, these fixed costs are avoidable rather than sunk
costs, as in the short run.
o The rent per month paid by a restaurant is a fixed cost b/c it doesn’t vary with #
of meals (output) served. In sr, this fixed cost is a sunk cost. Must pay even if it
doesn’t operate, however in LR it is avoidable b/c it can shut down. LR is
determined by rental contact.
- LR fixed costs= 0
o C=VC
- Three costs in LR: Total cost, average cost, and marginal cost
- In the LR, firm chooses how much labor and capital to use. In SR, only choose how much
labor.
Input Choice:
A firm can produce a given level of output using many different technologically efficient
combinations of inputs…AKA isoquant.
1. Isocost Line:
A firm hires L hours of labor services at wage w.
Labor Cost= wL
Also rents K hours of machine services at a rental rate of r per hour
Capital Costs= rK
C (total cost) = wL + rK

-These combinations of labor and capital that cost the same can be plotted on the isocost line,
which will show combinations of inputs that require same total expenditure.

Find: The slope of any isocost line

1. We rewrite Cost function as K= C/r-(w/r) L.

2. Differentiate dK/dL= -w/r

 Hence, slope of any isocost line depends on relative prices of inputs.

 Isocosts (constrained by cost of inputs) are kind of like Budget lines (constrained
by income)
 2. Minimizing Cost:
1. Lowest- Isocost rule: pick the bundle of inputs where the lowest isocost line
touches the isoquant.
2. Tangency rule: pick the bundle of all inputs where the isoquant is tangent to
the isocost line.
3. Last- dollar rule: pick the bundle of inputs where the last dollar spent on one
input gives as much extra output as the last dollar spent on any other input.

Two Conditions Must Hold to Minimize Cost or Maximize output:

1. MRTS(slope of the isoquant) = Slope of the isocost line

The isoquant is tangent to the isocost.

2. Constraint when minimizing cost is the isoquant formula: q=f(L,K)
Constraint when maximizing output is the isocost formula: C= wL+rK
Expansion Path: shows the cost-minimizing combinations of Labor and Capital for each
output level.

Deriving Long Run Cost function:

To produce q units of output => requires K=q units of capital and L=q/2 units of Labor

Using: C(q) = wL + rK

= wq/2 + rq

= q (w/2 +r ) THEN… q(24/2 + 8) = 20q

The Long Run Cost Function corresponds to the expansion path of C(q) = 20q
 Shape of Long-Run Cost Curves:
- The shapes of AC and MC depend on the shape of the LR Cost curve.
- The Total, MC, AC are the same both the LR and SR cost functions.
- SR AC curves slopes upward at higher levels of output BC of DMR.
o IN LR AC, DMR doesn’t apply, because all factors can be varied.

Economies of Scale: a property of a cost function whereby the AC of production falls as output
expands.
MC < AC
Diseconomies of Scale: property of a cost function whereby the AC of production rises when
output increases
MC > AC
7.4 Lower Costs in the LR
LR AC is always equal or less than the SR AC