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  1. 1. 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
  2. 2. 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?
  3. 3. 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 firm’s 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
  4. 4. 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
  5. 5. 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
  6. 6. A Firm’s Short Run Costs
  7. 7. Cost Curves for a Firm Output Cost ($ per year) 100 200 300 400 0 1 2 3 4 5 6 7 8 9 10 11 12 13 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. FC50 Fixed cost does not vary with output
  8. 8. • 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
  9. 9. 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
  10. 10. 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
  11. 11. A Firm’s Short Run Costs
  12. 12. Cost Curves 0 20 40 60 80 100 120 0 12 Output (units/yr) Cost($/unit) MC ATC AVC AFC
  13. 13. Marginal Product and Costs Suppose a firm pays each worker $50 a day. Units of Labor Total Product MP VC MC 0 0 10 0 5 1 10 15 50 3.33 2 25 20 100 2.5 3 45 15 150 3.33 4 60 10 200 5 5 70 5 250 10 6 75 300
  14. 14. Short-run Costs and Marginal Product • production with one input L – labor; (capital is fixed) • Assume the wage rate (w) is fixed • Variable costs is the per unit cost of extra labor times the amount of extra labor: VC=wL Denote “∆” - change. For example ∆VC is change in variable cost. MC=∆VC/∆Q ; MC =w/MPL, where MPL=∆Q/∆L With diminishing marginal returns: marginal cost increases as output increases.
  15. 15. Shifts of the Cost Curves Changes in resource prices or technology will cause costs to chan Cost curves shift FC increases by 100
  16. 16. Shift of FC curve Output Cost ($ per year) 100 200 300 400 0 1 2 3 4 5 6 7 8 9 10 11 12 13 VC TC FC50 FC’150 TC’
  17. 17. Summary In the short run, the total cost of any level of output is the sum of fixe and variable costs: TC=FC+VC Average fixed (AFC), average variable (AVC), and average total cos (ATC) are fixed, variable, and total costs per unit of output; margina 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 diminish returns. Marginal cost curve (MC) falls and then rises, intersecting both AVC and ATC at their minimum points.