Introduction to Microeconomics

Lecture 6: Analysis of Cost

Faculty of Mathematics and Natural Science
Universitas Gadjah Mada

2018
Analysis of Cost
Concept of Costs

Cost Structure

Economic Analysis of Cost

Rationale
 Economists normally assume that the goal of a firm is to
maximize profit, and they find that this assumption works well
in most cases.
 How does a firm maximize profit?
Maximizing Profit
 What is profit?
 Profits (𝜋) are given by:
𝜋 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
Firm’s Profit
 What is profit?
 Profits (𝜋) are given by:
𝜋 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡

Total revenue is the Total cost is the market

amount a firm receives for value of the inputs a firm
the sale of its output uses in production
Firm’s Profit
 What is profit?
 Profits (𝜋) are given by:
𝜋 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝜋 = 𝑃. 𝑄 − 𝑇𝐶
Firm’s Profit
To illustrate the firm’s profit, suppose that a firm (which is a rose producer)
sell a fresh-cut rose for $1 (𝑃 = 1).
Firm’s Profit
Maximizing Profit (1)
To maximize profit in a competitive market:
𝜋 = 𝑃. 𝑄 − 𝑇𝐶
1. Maximizing quantity of product:
𝜋1 = 𝑃. 𝑄 ↑ −𝑇𝐶
It implies
𝜋1 > 𝜋
Maximizing Profit (2)
To maximize profit in a competitive market:
𝜋 = 𝑃. 𝑄 − 𝑇𝐶
2. Minimizing cost:
𝜋2 = 𝑃. 𝑄 −↓ 𝑇𝐶
It implies
𝜋2 > 𝜋
Analysis of Cost
 Having considered that cost is an important aspect of
increasing firm’s profit, this lecture is devoted to a thorough
analysis of cost.
 But, what is meant by cost?
Economic and Accounting Costs
Analysis of Costs

Economic costs Accounting costs

Cost is the value of Costs that would appear on
sacrificed opportunities. accounting statements.
Economic and Accounting Costs
Analysis of Costs

Economic costs Accounting costs

Explicit and Implicit cost Explicit cost

Costs that involve
Costs that involve Costs that do not a direct monetary
a direct monetary involve outlays of outlay
outlay cash.
Economic and Accounting Costs
Analysis of Costs

Economic costs Accounting costs

Sunk costs Non-sunk cost

Costs that have Cost that are incurred
already been incurred only if a particular
and cannot be decision is made.
recovered
Economic and Accounting Profits

 Economists include all

opportunity costs when
analyzing a firm,
whereas accountants
measure only explicit
costs.

 Therefore, economic
profit is smaller than
accounting profit.
Analysis of Cost
Concept of Costs

Cost Structure

Economic Analysis of Cost

Production Function and Costs
 In the last lecture, we studied a firm’s production function:
𝑄 = 𝑓 𝐾, 𝐿
 Total costs for the firm during a period are therefore given by
𝑇𝐶 = 𝑟𝐾 + 𝑤𝐿

This total cost is the sum of all the economic costs the firm incurs
when it uses labor and capital services to produce output.
Production Function and Costs

Suppose we have Cookie Factory:

 We assume that the size of the
factory is fixed and that the
manager can vary the quantity
of cookies produced only by
changing the number of
workers they employ.
 The table shows how the
quantity of cookies produced
per hour at the factory depends
on the number of workers.
Analysis of Cost
Concept of Costs

Cost Structure

Economic Analysis of Cost

Short Run Versus Long Run
 Frequently, it is more useful to start the cost analysis in the
short-run.
 In microeconomics, the concept of short run and long run are
convenient analytical simplifications to help us focus our
attention on the interesting features of the problem at hand:
 Short run is the period of time in which at least one of the firm’s input
quantities cannot be changed.
 Long run is the period of time that is long enough for the firm to vary
the quantities of all of its inputs as much as it desires.
Short-run Analysis
 In the short run it is (relatively) easy to hire and fire workers but
relatively difficult to change the level of the capital stock.
 Therefore, the short run total cost:
𝑇𝐶 = 𝑤𝐿 + 𝑟𝐾
𝑇𝐶 = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
𝑇𝐶 = 𝑉𝐶 + 𝐹𝐶
Short-run Analysis
 In the short run it is (relatively) easy to hire and fire workers but
relatively difficult to change the level of the capital stock.
 Therefore, the short run total cost:
𝑇𝐶 = 𝑤𝐿 + 𝑟𝐾
𝑇𝐶 = 𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 + 𝐹𝑖𝑥𝑒𝑑 𝐶𝑜𝑠𝑡
𝑇𝐶 = 𝑉𝐶 + 𝐹𝐶

Variable costs are costs that vary Fixed costs are costs that do not
with the quantity of output vary with the quantity of output
produced produced.
Average and Marginal Cost
Frequently, it is more useful to analyze costs on a per-unit-of-
output basis rather than on a total basis.
1. Average total cost functions (AC)
Average total cost tells us the cost of a typical unit of output if total cost is divided
evenly over all the units produced.

2. Marginal cost functions (MC)

Marginal cost tells us the increase in total cost (extra cost) that arises from
producing an additional unit of output.
Average and Marginal Cost
Frequently, it is more useful to analyze costs on a per-unit-of-
output basis rather than on a total basis.
1. Average total cost functions (AC)
𝑇𝐶
𝐴𝐶 =
𝑄
2. Marginal cost functions (MC)
𝜕𝑇𝐶
𝑀𝐶 =
𝜕𝑄
Average and Marginal Cost
Frequently, it is more useful to analyze costs on a per-unit-of-
output basis rather than on a total basis.
1. Average total cost functions (AC)
𝐹𝐶 + 𝑉𝐶
𝐴𝐶 =
𝑄
2. Marginal cost functions (MC)
𝜕𝑇𝐶
𝑀𝐶 =
𝜕𝑄
Average and Marginal Cost
Frequently, it is more useful to analyze costs on a per-unit-of-
output basis rather than on a total basis.
1. Average total cost functions (AC)
𝐴𝐶 = 𝐴𝐹𝐶 + 𝐴𝑉𝐶
2. Marginal cost functions (MC)
𝜕𝑇𝐶
𝑀𝐶 =
𝜕𝑄
Short-run Cost Curve
𝑻𝑪 𝑻𝑪

𝑸
Short-run Cost Curve
𝑻𝑪 𝑻𝑪
𝑻𝑪, 𝑭𝑪, 𝑽𝑪
𝑻𝑪

𝑽𝑪

𝑸
𝑭𝑪

𝑸
Short-run Cost Curve
𝑻𝑪 𝑻𝑪
𝑻𝑪, 𝑭𝑪, 𝑽𝑪
𝑻𝑪

𝑽𝑪

𝑸
𝑭𝑪
𝑨𝑪, 𝑨𝑪,
𝑴𝑪 𝑴𝑪 𝑴𝑪
𝑸

𝑨𝑪

𝑸
Short-run Average Cost (AC) Curve
𝑨𝑭𝑪 𝑨𝑽𝑪 𝑨𝑪

𝑨𝑪

𝑨𝑭𝑪 𝑨𝑽𝑪

𝑸 𝑸 𝑸
The average fixed costs decrease The average variable costs eventually The combination of these two effects
as output is increased. increase as output is increased. produces a U-shaped average cost curve.
Measures of Cost: An Illustration
Total Cost Curve

The total-cost curve gets

steeper as the quantity
of output increases
because of diminishing
marginal product.
Measures of Cost: An Illustration
Average and Marginal Cost Curves
These cost curves show three
features that are typical of many
firms:
1. Marginal cost rises with the
quantity of output.
2. The average-total cost curve is
U-shaped.
3. The marginal-cost curve
crosses the average-total-cost
curve at the minimum of
average total cost.
THANK YOU