The Cost of Production

Each firm uses various inputs (resources) in its production activity. Commonly used inputs: labor and capital Prices of inputs (wages, rents) Cost of Production

Measuring Cost: Which Costs Matter?

It is clear that if a firm has to rent equipment or buildings, the rent they pay is a cost What if a firm owns its own equipment or building?
How

are costs calculated here?

Measuring cost:
Accounting Cost actual expenses plus depreciation charges for capital equipment.

Economic Cost cost to a firm of utilizing economic resources in production, including opportunity cost.
Opportunity cost the value of a highest forgone alternative; cost associated with opportunities that are forgone when a firms resources are not put to their highest-value use.

Example when economic cost differs from accounting cost: -shop owner who does not pay herself a salary and/or owns the building

Economic cost.
Some costs vary with output, while some remain the same no matter amount of output Fixed Cost (FC) cost that does not vary with the level of output. - have to be paid as long as the firm stays in business (even if output is zero) Variable Cost (VC) cost that varies as the level of output varies. Total Cost (TC or C) total economic cost of production, consisting of fixed and variable costs. TC=FC+VC

Which costs are variable and which are fixed depends on the time horizon Short time horizon most costs are fixed Long time horizon many costs become variable In determining how changes in production will affect costs, we must consider if it affects fixed or variable costs

A Firms Short Run Costs

Cost Curves for a Firm

TC
Cost 400
($ per year)

300

Total cost is the vertical sum of FC and VC.

VC

200

Variable cost increases with production and the rate varies with increasing & decreasing returns.

100

Fixed cost does not vary with output

50
0 1 2 3 4 5 6 7 8 9 10 11 12 13

FC
Output

 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

Per-Unit, or Average, Costs

Average Total cost firms 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

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

A Firms Short Run Costs

Cost Curves
120 100
Cost ($/unit)

80 60 40 20

MC

ATC
AVC AFC

0 0 Output (units/yr) 12

Marginal Product and Costs

Suppose a firm pays each worker $50 a day.

Units of Labor 0 1 2 3 4 5 6

Total Product 0 10 25 45 60 70 75

MP 10 15 20 15 10 5

VC 0 50 100 150 200 250 300

MC 5 3.33 2.5 3.33 5 10

Short-run Costs and Marginal Product

production with one input L labor; (capital is fixed) Assume the wage rate (w) is fixed Variable costs is the per unit cost of extra labor times the amount of extra labor: VC=wL Denote - change. For example VC is change in variable cost.

MC=VC/Q ;
where MPL=Q/L

MC =w/MPL,

With diminishing marginal returns: marginal cost increases as output increases.

Shifts of the Cost Curves

Changes in resource prices or technology will cause costs to change

Cost curves shift

FC increases by 100

Shift of FC curve
Cost 400
($ per year)

TC

TC VC
300

200 150 100 FC

50
0 1 2 3 4 5 6 7 8 9 10 11 12 13

FC
Output

Summary
In the short run, the total cost of any level of output is the sum of fixed and variable costs: TC=FC+VC Average fixed (AFC), average variable (AVC), and average total costs (ATC) are fixed, variable, and total costs per unit of output; marginal cost is the extra cost of producing 1 more unit of output. AFC is decreasing AVC and ATC are U-shaped, reflecting increasing and then diminishing returns. Marginal cost curve (MC) falls and then rises, intersecting both AVC and ATC at their minimum points.