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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: 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.
  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 Cost in the Short run
  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 TVC Variable cost increases with production and the rate varies with increasing & decreasing returns. TC Total cost is the vertical sum of FC and VC. TFC50 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= TVC/ Q∆ ∆ since TC=(TFC+TVC) and TFC 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 $50 a day. Units of Labor Total Product MP VC MC 0 0 0 0 1 10 10 50 5 2 25 15 100 3.33 3 45 20 150 2.5 4 60 15 200 3.33 5 70 10 250 5 6 75 5 300 10
  14. 14. Short-run Costs and Marginal Product  production with one input L – labor; (capital is fixed)  Assume the wage rate (w) is fixed  Variable costs is the per unit cost of extra labor times the amount of extra labor: VC=wL D Denote “∆” - change. For example ∆VC is change in variable cost. MC=∆VC/∆Q ; MC =w/MPL, where MPL=∆Q/∆L With diminishing marginal returns: marginal cost increases as output increases.
  15. 15. Shifts of the Cost Curves Changes in resource prices or technology will cause costs to change ⇒ Cost curves shift FC increases by 100
  16. 16. Shift of FC curve Output Cost ($ 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 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. A FC is decreasing AVC and ATC are U-shaped, reflecting increasing and then diminishing return Marginal cost curve (MC) falls and then rises, intersecting both AVC and ATC at their minimum points.
  18. 18. Closing Questions: Q1: Those things that must be forgone to acquire a good are called  a. substitutes.  b. opportunity costs.  c. explicit costs.  d. competitors.
  19. 19.  Q2: Explicit costs  a. require an outlay of money by the firm.  b. include all of the firm's opportunity costs.  c. include income that is forgone by the firm's owners.  d. Both b and c are correct.
  20. 20.  Q4: An example of an explicit cost of production would be  a. the cost of forgone labour earnings for an entrepreneur.  b. the lost opportunity to invest in capital markets when the money is invested in one's business.  c. lease payments for the land on which a firm’s factory stands.  d. Both a and c are correct.
  21. 21. Q5: The amount of money that a wheat farmer could have earned if he had planted barley instead of wheat is  a. an explicit cost.  b. an accounting cost  c. an implicit cost.  d. forgone accounting profit.