EC4004 Lecture 10: Costs
Dr. S. Kinsella

Dates: October 17th -24th
Best of 2 attempts
10% of Final Grade

Yesterday

Production Function

Marginal Products

Diminishing Marginal
Productivity

Isoquants

Marginal Rate of
Technical substitution

Today: Returns to
Scale; Costs

Constant Returns to Scale

A
Capital
per week
4
q = 40
3
q = 30
2
q = 20
1
q = 10
0 1 2 3 4 Labor
per week
(a) Constant Returns to Scale

Decreasing Returns to
Scale

A Capital A
Capital
per week per week
4 4
q = 40
3 3 q = 30
q = 30
2 2
q = 20 q = 20
1 1
q = 10 q = 10
Labor Labor
0 1 2 3 4 per week 0 1 2 3 4 per week
(a) Constant Returns to Scale (b) Decreasing Returns to Scale

Increasing Returns to
Scale

Capital
per week
A
K2 q2
K1 q1
K0 q0
Labor
0 L0 L1 L2 per week

Technical Change
Capital
per week
K1
K0
A
q0
q’0
Labor
0 L1 L0 per week

Opportunity cost: cost of a good as
measured by the alternative uses foregone
by producing good or service.
Accounting cost: concept that goods or
services cost what was paid for them.
Economic cost: amount required to keep a
resource in its present use; the amount that
it would be worth in its next best alternative
use.

Labour Costs
Wage, w

The cost of capital services (machine-
hours) is the rental rate (v) which is
the cost of hiring one machine for one
hour.

Economic profit is revenue minus all
costs including these entrepreneurial
costs.

Total costs = TC = wL + vK. (8.1)
Assuming the firm produces only one
output, total revenue equals the price of
the product (P) times its total output [q
= f(K,L) where f(K,L) is the firm’s
production function].

Economic profits (π):
Difference between a firm’s total
revenues and its total economic costs.

Minimizing the Costs of
Producing q1
Capital
per week
TC1
TC2
TC3
K*
q1
Labor
0 L* per week

Cost minimization requires that the
marginal rate of technical substitution
(RTS) of L for K equals the ratio of the
inputs’ costs, w/v:

The firm’s expansion path is the set
of cost-minimizing input
combinations a firm will choose to
produce various levels of output
(when the prices of inputs are held
constant).

Firm’s Expansion Path
Capital
per week
TC1 TC3
TC2
Expansion path
q3
K1 q2
q1
Labor
0 L1 per week

Cost Curves

Possible Shapes of the Total Cost
Curve
Total TC Total TC
cost cost
Quantity Quantity
0 0 per week
per week
(a) Constant Returns to Scale (b) Decreasing Returns to Scale
TC
Total Total
cost TC cost
Quantity 0 Quantity
0 per week
per week
(c) Increasing Returns to Scale (d) Optimal Scale

Average Costs
Average cost is total cost divided by output; a
common measure of cost per unit.
If the total cost of producing 25 units is €100, the
average cost would be:
AC = €100/25 = €4

Marginal Cost
The additional cost of producing one
more unit of output is marginal cost.
If the cost of producing 24 units is €98
and the cost of producing 25 units is
€100, the marginal cost of the 25th
unit is €2.

Average and Marginal Cost Curves
AC, MC AC, MC MC
AC
AC, MC
Quantity Quantity
0 0 per week
per week
(a) Constant Returns to Scale (b) Decreasing Returns to Scale
AC, MC AC
AC, MC MC
AC
MC Quantity
Quantity 0 q* per week
0 per week
(c) Increasing Returns to Scale (d) Optimal Scale

Shifts in Cost Curves
Any change in economic conditions
that affects the expansion path will
also affect the shape and position of
the firm’s cost curves.
Three sources of such change are:
change in input prices
technological innovations, and
economies of scope.

Next Time
Production & Supply
Chapter 9, Do Ex. 81,
8.3, 8.7

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EC4004 Lecture 10: Costs
Dr. S. Kinsella